The roots of this year’s financial crisis go back to a small team of bankers at J.P. Morgan in New York led by Bill Demchak, once unknown on “main street.” His team created and then industrialized credit derivatives, which have enveloped the global markets, growing to a mind-numbing $58 trillion worth of credit contracts helping bring down Wall Street leaving Morgan with its biggest exposure of all.

From the moment news of the economic crisis became known, every so-called economic expert has attempted to explain exactly how and why the United States, and now the whole world, finds itself  somewhere between a recession and another great depression.

If credit derivatives are at fault it would then be imperative that we have some understanding of what they are…..right? Well that is easier said then done.

Let me explain: Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options and swaps.

A credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.

Now if that sounds like a lesson in “double-talk” or “gibberish” you are not far from the truth. Even experts have difficulty understanding and explaining what this all means.

In fact, most of the financial instruments used during the economic build-up and meltdown were devised by mathematicians and physicists making it almost impossible for most to understand.

The story continues……

Long celebrated as a way for banks to diffuse their risks, the credit derivatives invented by Demchak’s team have instead multiplied them. The new credit vehicles encouraged banks and other financial firms to take on riskier loans than they should have; helped increase leverage in the global financial system; and exposed a much wider array of financial firms to the risk of default.

To get a better perspective of events, here is a brief time-line courtesy of Portfolio magazine:

1991 – Bankers Trust creates the first credit-default swap, essentially inventing the derivatives market. It will be several year before C.D.S trading begins to boom.
1994 – Orange County California goes bankrupt based on bad bets on interest-rate derivatives. It is the first major sign of trouble in the ballooning derivatives market.
1997 – The Asian financial crisis begins. J.P. Morgan worries about its exposure to Asian loans.
1998 – December: J.P. Morgan come up with the Broad Indexed Secured Trust Offering or BISTRO, a structure devised by an A-team of finance whizzes. Its goal is to mitigate the bank’s exposure to corporate credit risk. Morgan is hailed as an innovator when it reaches the market.
2001 – The C.D.S. market explodes, backing more than $900 billion worth of credit by years end.
2003 – Warren Buffet calls derivatives “financial weapons of mass destruction” in his letters to stockholders.
2007 – The C.D.S. market reaches colossal heights, backing $62 trillion worth of credit.
2008 – March: Bear Stearns collapses. The Federal Reserve backstops its takeover by J.P. Morgan Chase which is worried in part about an unwinding of Bear’s derivatives contracts.
**** – October: After suffering an insurance rating downgrade and a subsequent liquidity crisis, A.I.G. – once the world’s largest insurance company – teeters on the brink of bankruptcy before being nationalized by the federal government. The company had written hundreds of billions of dollars’ worth of protection on mortgage-backed securities.

Credit derivatives aren’t, of course, solely to blame for the pandemic that has helped bring down Wall Street. They didn’t single-handedly force Bear Stearns and Lehman Brothers to bulk up on toxic debt, dooming them to collapse.

BUT, they made the financial world more complex, more opaque and so convoluted that the detection of any problems and their solution is a crapshoot.

The creation of credit derivatives, only a decade ago, is more responsible than anything else for binding the global financial world together more closely so that when one domino fell it was certain to knock down the next one and so on and on.

And it did……

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