Explain how derivatives were used to increase risk making the financial crisis of 2007–2009 more severe.

Question

What will be an ideal response?

Answer 1

U.S. investment banks bought many credit default swaps (CDSs) to protect themselves from potential losses related to the complicated financial securities they were buying and selling. When American homeowners began defaulting on their mortgages, returns on these investments fell and the value of these mortgage-related products declined rapidly. But when banks tried to redeem their CDS contracts, the insurers, who had not expected these new financial products to fail en masse, did not have enough cash on hand to cover the contracts. For instance, the huge insurance company American International Group (AIG) sold many CDSs to financial firms with investments in mortgage-backed securities. When those securities began to fail in September 2008, the firms that had insured their investments in those securities by purchasing CDSs tried to collect the money AIG had agreed to pay if default occurred. However, AIG had miscalculated the default risks of the securities it had insured with its CDSs—it had not expected so many of them to fail at the same time and it did not have enough money to make all of the payments due to the purchasers of these CDSs.