How did banks spread more risk throughout the entire system? And how did they do it with so called derivatives? Derivatives are after all instruments to manage risk.
First, let’s examine what a derivative is. A derivative is alike an insurance contract. Let’s take the case of an accident insurance. In the accident insurance scenario, if an actual accident happens, the insurer pays the insurance buyer an agreed payout for such an event. If no accident happens, the insurance company pockets the insurance premium. For as long as the insurance buyer keeps buying insurance and does not incur accidents, the insurance company remains profitable.
Insurance firms manage their risk by selling insurance over a broad spectrum of the population. Here the law of large numbers rules. The larger the population covered, the smaller the percentage of the population that will likely draw on their insurance coverage.
When one bank wants to manage its risk, it buys a derivative product the way a normal person buys accident insurance. Another bank sells the derivative, acting like an insurance company.
The cost of the derivative is like the insurance premium. The risk event for a derivative buyer is normally a credit default, or interest rate or market going against the position of the derivative buyer. If the risk event being insured does not happen, the derivative seller pockets the premium as profit.
If he sells enough derivatives over a broad array of transactions, a derivative seller can become very profitable.
What happens if the insurance buyer and seller are in the same line of business? In the case of commercial banks, they acted both as the buyers and the sellers of derivative products.
In the same way each bank managed its own risk, each also sought to increase profits by selling insurance to other banks seeking to manage their own risk.
In this scenario, what happens when there is a default in one of the banks whose default risk is insured by another bank? There is a cross-default. What happens is the insuring bank re-insured its own default risk by buying derivative somewhere else? Now you’re beginning to see the ramifications of a system-wide credit default contagion.
How did banks manage to delude each other, and sell this garbage to one another? By means of creative packaging. They simply pooled risky loans and assets together with more stable ones, then sliced and diced these pools, then sold the various slices to different investors.
The way they valued these new investment instruments, pooling the risky assets with the good ones diluted the riskiness of the risky assets. Then slicing and dicing these pools, and then distributing these over a broad investor base, created the impression, at least from the eyes of each individual investor, of erasing the risk altogether. Now that risk had been cut, parcelled, and spread over a broad spectrum of investors, the likelihood of default on one parcel of the asset pool, it now seemed, was minimal.
Similarly, just because a master chef cuts and slices a slab of bad meat, and distributes small bits and pieces of it over a large array of dishes, doesn’t automatically mean that the risk of a major food poisoning from any one of the dishes had been averted. The risk of getting food poisoning had simply now been spread throughout all the dishes.
Banks, it turns out, are not only good intermediaries of capital, they are also good intermediaries of risk. The spread of risk looks very much like the spread of AIDS. First the banks were successful in infecting each other with a virus that impedes immunity to infection. Now comes the spectre known as stagflation, which can potentially spread the infection of credit default across several sectors.
What oh what will happen to the most exposed banks?
Update: Similar-themed post here.