The financial meltdown engulfing Wall Street would not have happened without the advent of complex financial contracts known as derivatives. Why were they created, and why were so many supposedly smart people fooled?

What is a derivative?

In a very real sense, it’s a bet. A derivative is a contract in which an investor agrees to pay for either a commodity or financial instrument at a set price today, in return for the right to take profits if that asset’s value rises. Some derivatives, such as stock options and commodities futures, have been used for years and are considered completely benign. A farmer, for example, can agree to sell a ton of wheat he’ll harvest in three months to a major grain buyer for $1,000. That deal enables the farmer to lock in the price of wheat as he’s growing it. In exchange for that guarantee, the grain buyer gets an assurance he’ll have a steady supply of grain while also safeguarding against future price increases. Both sides, in other words, reduce risk and future uncertainties. But in recent years, a new, highly toxic form of financial derivative has spread like wildfire throughout the financial system, ultimately laying waste to some of Wall Street’s oldest and most prestigious firms.

What are these new derivatives?

They’re called credit derivatives, and were designed to serve as a kind of insurance against borrowers defaulting on their debts. Credit derivatives first appeared on the scene in the boom of the 1990s, but really became popular in the early 2000s, when Federal Reserve Chairman Alan Greenspan sought to stave off a post-9/11 recession by slashing interest rates from 6.5 percent to 1 percent. Money became very easy to borrow, and tens of millions of people bought homes or took out second mortgages, many of which were offered to financially shaky buyers at “subprime’’ rates. Those mortgages were then bundled into securities, and firms such as Lehman Brothers and Merrill Lynch created credit derivatives to protect investors in case the securities defaulted.

Why were these securities so popular?

They provided above-market rates of return, and because these complex instruments were so poorly understood, they seemed more solid—and less risky—than they really were. Investors thought that they were getting AAA-rated securities. The sellers—caught up in the assumption that housing prices would continue to rise indefinitely—also thought they were safe from losses. Each security involved hundreds or thousands of individual mortgages, chopped into pieces, so that the risk of default appeared small. And by selling them, investment banks and brokerage firms made hundreds of millions in upfront fees and premium payments. That’s why global insurance giant AIG also jumped into the derivatives game. “It is hard for us, without being flippant, to see us losing even one dollar in any of those transactions,” Joseph Cassano, then AIG’s head of credit derivatives, declared last year, expressing a common sentiment.

Was everyone so clueless?

No. Concern about financial derivatives first surfaced in the late 1990s, and congressional Democrats launched a drive to bring them under federal oversight. The effort was beaten back by Republicans led by then­–Sen. Phil Gramm of Texas, who pushed through a law that explicitly exempted financial derivatives from federal regulation. By 2003, the pace of derivatives trading had exploded, leading Warren Buffett, one of the world’s most successful investors, to call derivatives “financial weapons of mass destruction.”

Why was Buffett alarmed?

Because the well-being of the entire global financial system rested in part on a hidden world of multitrillion-dollar bets that financial regulators couldn’t control or even monitor. Indeed, since 2000, credit default swaps became one of Wall Street’s most popular products, with firms such as AIG, Lehman Brothers, and Bear Stearns selling swaps covering trillions of dollars in bonds. At Cassano’s urging, AIG became the biggest player in the field, selling protection on $527 billion in bonds.

So what went wrong?

Home prices started to fall and interest rates started to rise. When rates rose, many subprime borrowers with adjustable-rate mortgages found themselves unable to make their monthly payments. They also couldn’t sell, because the demand for houses began to crash. Very quickly, as defaults mounted, the derivatives that had made so many bankers and investors rich lost their value. In turn, firms such as AIG and Lehman, which had guaranteed these securities, couldn’t meet their debts. It was a worst-case scenario, causing the collapse of many banks and investment firms. Despite the federal government’s rescue efforts, many financial executives worry that further damage is yet to come, because of bad debt hidden in other banks’ derivative holdings. “It’s not the corpses you can see that scare you,” says one Wall Street banker. “It’s the corpses you can’t see that could pop out at any time.”

Can derivatives be brought under control?

Washington and Wall Street are struggling to find a way. One of the most popular ideas is to set up a clearinghouse for all financial derivatives trades. Regulators would monitor the clearinghouse to be sure that no market player took on more risk than it could afford. And firms would have to keep money on deposit to show that they could honor their guarantees. The question now is whether safeguards can be put in place before another AIG-style meltdown unfolds. “If it all goes horribly wrong, it will not be just Wall Street that suffers,” says veteran investor Michael Panzer, who has warned against derivatives for years. “Those seeking a mortgage, a college education, a job, or even day-to-day sustenance will be left wanting.”

The derivatives in your portfolio

If some of your savings are in a mutual fund, you’re probably an investor in derivatives. Many bond funds, including the nine most widely held funds, use derivatives both to protect against losses and to increase returns, because these swaps can appreciate in value when the prospects for a company and the overall economy improve. Funds aren’t required to disclose derivatives holdings, although those that make them a major part of their strategy typically do so. To see if your fund holds derivatives, check its prospectus and the listing of holdings contained in Securities and Exchange Commission form NQ. Those forms can be accessed at Sec.gov. If you’re still unsure about your fund’s holdings and don’t want to take the chance, financial advisors say, don’t hesitate to switch to an ultra-safe government bond fund. “Don’t be complacent,” says financial advisor Lawrence Glazer. “If you are uncomfortable with something, don’t be afraid to make a change.”