At Financial Crisis Inquiry, a Claim That Derivatives Played 'No Role'

The Financial Services Inquiry Commission opened a two-day hearing into the role of the derivatives in the financial crisis. The first panel consisted of academics gathered to educate the commission about what derivatives are.

The second speaker, Steven Kohlhagen, a former academic and Wall Street derivatives executive, said something heretical in his opening statement: Credit default swaps (CDSs) and derivatives generally had "no role" in causing the financial crisis.

Blame It on Miscommunication?

The overvaluation of collateralized debt obligations (CDOs), whose plummeting value was part of the financial crisis, Kohlhagen argued, resulted from two things: Broadly, from the bubble in housing prices, and specifically, from the failure of communication between the people who made the models underlying the CDOs and those who had knowledge of the quality of the mortgages going into those models.

Kohlhagen claims that the model builders had no idea how poor the underwriting standards and mortgages had become, and the people who did know about the lousy mortgage quality had no idea how that impacted CDO prices. As these two groups didn't communicate effectively, CDO prices were wildly inflated. (Kohlhagen also blames the ratings agencies for CDOs' overvaluation, noting they were in a position to know everything.)

With all due respect to Mr. Kohlhagen, this argument doesn't pass the straight-face test. However, I give the Commission credit for getting a diverse panel.

Deliberate Price Inflation

The argument fails in two ways -- on its own terms and by all it ignores. On its own terms, it assumes that all the players were trying in good faith to get accurate, rather than inflated, prices set on CDOs and their underlying mortgage-backed securities. While surely some, maybe even many, did, evidence shows the mortgage-backed securities and CDO market's overall prices were inflated deliberately.

For example, banks "ratings shopped" until they got AAA ratings on securities that didn't deserve them, and those ratings inflated the prices, as the price crashes that followed downgrades reveals. Similarly, Congressional investigations have revealed emails and documents showing the banks were making and selling "shitty"...er...worthless securities as if they had value.

Moreover, the claim suggests that the quants creating the models were smart enough to design them but too dumb to look at their inputs, even though the quality of inputs powerfully impacted the purpose of the model -- determining the CDO's price. Most CDOs were priced marked to model, since there was too little trading to mark to market easily. Similarly, traders and security originators who knew the mortgages were increasingly poor must have known that the low quality would impact prices, regardless of whether they understood the underlying math.

While it may be that CDO prices cannot be accurately determined even if the quants had perfect information, traders still ultimately controlled the prices by their decisions about whether to buy or sell at a given price -- and their refusal to sell at certain prices had less to do with pricing accuracy than with the trader's incentives to keep the price high.

Puzzling Claim

Kohlhagen's claim also fails because it ignores how CDSs and synthetic CDOs radically magnified the bursting of the housing bubble. It also ignores how the existence of CDOs and CDSs -- that is, the ability to shift the risks of the underlying, poorly underwritten mortgages -- inflated the bubble.

As Kohlhagen's performance at the hearing showed, he's very smart and knows a lot about the crisis, CDOs and CDSs. Why he claims that CDOs' overvaluation was a communication problem and that derivatives had no role in the financial crisis is inexplicable to me.