So, I’ve been pondering the market crash. (It seems like the only stuff on the news are it and the presidential campaign.) The mortgage failures which started it took down more than just the banks which unwisely made excessive subprime loans because these mortgages were bundled up and sold as securities, exposing other firms. Financial corporations then made derivative securities on them, instruments which would provide a payment if some fraction of the mortgage holders did (a “CDO”) or didn’t (a “CDS”) make their payments. They even took bunches of CDOs and made “secondary CDOs” from them.

The theory behind the secondary CDOs was that mortgages fail now and then, so the high-risk CDOs will fail now and then when they do. But, just by chance, a more-than-usual number of mortgage failures will cluster in one CDO and make it fail, while other seemingly identical CDOs continue to pay — sucks if you held the unlucky CDO. The secondary CDOs protect against the phenomenon of chance clustering, but as we saw, they’re completely vulnerable to coordinated failures. (The rating agencies foolishly assumed mortgage failures were mostly independent, but in fact they’re highly correlated with each other, and in the presence of correlation, secondary CDOs have more risk, because they also “protect” you from chance putting an atypical number of good mortgages in your pool, which saves some primary CDOs when the market-wide failure rate would have been enough to take them down.)

Everything came tumbling down because many firms were exposed to mortgage failures through these derivatives. But aren’t derivatives supposed to be good for markets? Because they let people buy and sell risk, they thicken the market by bringing in traders who want different risk profiles. If people start worrying, they can hedge; without derivatives, you can only sell off.

I think that derivatives did bolster the market here. But subprime mortgage instruments are a market that deserved to fail, and should have failed much sooner. Derivatives held the market up, spreading the risk wider and wider, until there was nobody left to underwrite hedges, and the collapse of the market pulled these exposed firms down with it. Without derivatives, the failure of the subprime market would have come sooner, and had less impact, taking down only the mortgage traders. It’s good to stabilize markets which shouldn’t fail. But some markets should fail, and spreading exposure to these markets far and wide is a bad thing indeed.