This is the second of four posts explaining how the economic crisis of 2008 came about. Make sure to read Part 1 on housing bubbles if you haven’t already done so.

A very significant part of the financial world today revolves around the use of products called financial derivatives. This post will examine what they are, the two most important ones for the crash (CDOs and credit default swaps), and a brief history of their deregulation.

Firstly, what is a derivative? Essentially, it is a type of contract that itself is not worth anything, but derives its value from something else, like an asset or an index. An easy-to-understand example is one called a future. In a future, farmer Andrew and seller Bethany agree in September that come April, Andrew will sell Bethany 100 cows. Now, cows currently cost £100 each, but Andrew is concerned about the crop blight. Maybe it will kill off his neighbour’s crops, and his cows will be fatter and worth much more. At the same time, maybe his cows will be underfed and worth much less than £100. Bethany and Andrew’s future agreement means that Bethany will pay £100 per cow no matter which way the price goes. By doing this, both Bethany and Andrew can lower the risk that they will lose a lot of money over the agreement.

Now the two most important derivatives to the 2008 crash: CDOs and credit default swaps. Bear in mind that these are much more complicated contracts than I can hope to describe accurately, indeed it had been suggested that they were deliberately created to be needlessly complicated so that law makers would be unable to understand them and thus unable to ban otherwise dodgy practices. If you have never heard an explanation of these before, I personally would recommend reading their explanations several times, until you are confident enough that you could explain it to a friend; when I first learnt about them, I only half understood and had to repeatedly go back and check again.

CDOs – Collateralised Debt Obligations

To start, it should be noted that a CDO by itself is not a derivative, but more a specialised form of corporate bond. However, it becomes a derivative when combined with the CDSs below, and is then known as a ‘synthetic CDO’. Whether it is a derivative or not is irrelevant to understanding the crash, but is worth noting for those more interested in the fine details of corporate finance. So on with the definition.

A CDO is when organisation A brings together a large number of loans and pools together to create one big CDO. The CDO now sliced into ‘tranches’, lets call them safe, medium and risky. Other financial players may now invest in these three tranches, as they are sold on the bond market alongside conventional bonds. The three tranches can be imagined as three rock pools, where the highest one flows into the middle and the middle flows into the bottom one. When organisation A collects money from the various sources that make up the CDO, they first pay off money into the top rock pool, and assuming everyone pays, then then fill up the medium pool, and then the ‘risky’ bottom pool. However, if the stream of money lessens, for example when a risky loan is not paid back, the stream may fill up the top and middle pools, but only a little bit of the bottom pool. To compensate for the likelihood of failure to get the money back, each of the three pools gets a different return on investment. Investors in the safe pool may only get back 4% of their investment, whereas the medium investors may get back 6% and risky investors 8%. An important feature of the CDO is that although the loans are still passing through the bank, their ownership technically passes on to the investor in that tranche. Therefore, the bank no longer has those ‘risky’ loans on their books, and allows their business to appear more stable than it really is, were the bank to be audited.

Essentially, provided there aren’t too many failures of people to repay their loans to organisation A, things will go smoothly. Unsurprisingly, prior to 2008, there were too many unpaid loans. As you can see below, prior to the crash, the amount of money involved in these products grew staggeringly high:

Credit default swaps

The CDS, although technically complicated, can simply be thought of as a type of insurance on loan repayments. If bank A is receiving loan repayments from housing developer B, it would lose its money were B to default on that loan. As a result, it takes out a CDS from bank C, and just like any other type of insurance, they pay regular small fees, with the potential of a large payout should B default. By doing this, A lowers the amount of risk they are taking by giving B a loan.

Now, the big change from normal insurance occurs in that fact that the CDS is so complicated that it was not regulated, and so it allowed people to take CDSs out on things they weren’t involved in. For example, in our situation above, bank D could also take the CDS out from C, getting money if B doesn’t repay A. To explain why this is bad, imagine Fred takes out fire insurance on his house. He can only receive money if he loses his house, so his interests are balanced out. However, it is illegal for George to take out the same insurance on Fred’s house, because he has no balanced interest: he doesn’t live in Fred’s house, so he can only win from the house burning down, and obviously we don’t want a situation where people have financial incentives to burn down each others’ house. Moreover, the banks got wise to the fact that they could give a bad loan to homeowner X, take out a CDS, then benefit from the homeowner defaulting, which prior to 2008 became commonplace. Like the CDO market, this became ridiculously lucrative – by 2007, the outstanding CDS amount was estimated to be around $62 trillion.

Financial deregulation – a brief history

Financial deregulation is when the government loosens the restrictions on what financial institutions can do. There is a huge amount to say here, but for brevity, a few examples will be given so readers can get a general picture of how the situation has developed.

One early shift, and perhaps the birth of the modern finance sector was the changes for investment banks after the second world war. Initially, investment groups were collections of, say, a dozen wealthy businessmen, who pooled their own money and worked out where they thought the markets were growing. The rules were lifted and allowed banks to invest their clients’ money, and unsurprisingly, people are more willing to risk other people’s money than their own.

The real period of financial deregulation began in the ’80s under Thatcher and Reagan, but continued right up until 2008. One problem was that in the US, former bankers of huge institutions were repeatedly appointed to positions like chairman of the federal reserve or secretary to the treasury. Men like Donald Regan (not Ronald), Alan Greenspan, Larry Summers, Henry Paulson, Robert Rubin and others exacted undue influence on presidents who didn’t understand the complexities of the issues involved.

In 1982, the Garn – St Germain Act allowed savings banks to give out credit cards and issue non-residential real estate loans, which previously only commercial banks were allowed to do.

In the UK, in 1986, Thatcher passed a number of laws allowing more freedom for the financial services. For example, the barrier between stockbrokers and stockerjobbers was removed, allowing the creation of integrated investment banks, and foreign companies were now allowed to buy City of London firms.

A key instance of deregulation in the US is the Gramm- Leach- Bliley Act of 1999, repealing the Glass- Steagall Act from the 1930s. The latter banned the merging of retail and investment banks. When Citigroup and Travelers merged in 1998, they were given an exemption until the GLB Act passed the next year.

The following year, the Commodities Futures Moderization Act (passed under Clinton, with support from both parties) banned the Commodities Future Tradings Commission from giving any regulation for a number of derivatives, including credit default swaps.

In 2004, the final major deregulatory act before the crisis passed, where the Securities and Exchange Commission allowed various financial institutions to increase the leverage ratio (explained in the next post), essentially allowing them to use many times more money than they held in reserves, with ratios up to 50:1 in cases like Fannie Mae and Freddie Mac.

Altogether, readers should not be surprised to see why the 2008 crash was so damaging – it was the culmination of almost 30 years of removing rules that discouraged risky trading.

Part 3 deals with the differences between the different types of financial institution, leverage and sub-prime mortgages.