The Causes of the Financial Crisis: Some Comments on the Comments
It’s interesting that so many comments on my earlier post cited derivatives as a factor in the financial crisis. There is literally no evidence of this. Many people who say it have just been told it’s a fact—mostly by the media, parroting the government-- and have come to believe it. There is only one example of a company being brought down by credit default swaps—AIG—and that was because AIG did an incredibly stupid thing—they took only one side of the risk and did not hedge. They sold credit protection. Everyone else in this market was hedged; they sold protection and they bought protection.
The proof of this is Lehman, which was a major player in the CDS market. Lehman failed, but there is no evidence that any other company was brought down by Lehman’s inability to meet its credit default swap obligations. The reason for that is simple. CDS is like insurance; it protects against a loss. If your insurer fails, you haven’t actually suffered a loss unless you have a fire before you have bought new insurance coverage. Those who had bought protection from Lehman had to go back into the market and buy new protection. There might have been a small loss if the protection was more expensive than what they had been paying to Lehman, but it was not devastating.
This illustrates the point of my original post. Most people have only heard what they have been told about the financial crisis, but this is not the whole truth. In the case of derivatives, it’s not even close to the truth. If you’re interested in the complete story of what caused the financial crisis, you can read my dissent from the majority report of the Financial Crisis Inquiry Commission, which can be downloaded from the AEI website. It’s 100 pages.