The abuse of unregulated derivatives by Wall Street caused the Great Recession. That is the conclusion reached in Republic, Lost, How Money Corrupts Congress–and a Plan to Stop It by Lawrence Lessig. The following quotation is the simple analogy he uses to explain what happened. The regulation of derivatives is compared to laws regulating automobile highway speeds.
“A speed limit that applies to black cars only will not only incentivize the sale of colorful vehicles, it will also be a boon to the paint departments of auto body shops everywhere. That’s the story of Wall Street in the 2000s. While some portion of the market for derivatives was no doubt driven by a genuine meed for the particular flexibility of a derivative, a huge proportion was simply black cars being painted red. The winners in this new market were the drivers of those freshly painted cars, and the firms that had done the paint jobs (aka Wall Street). The losers were–surprise, surprise–the rest of us.”
The derivatives in question were backed by US mortgages and rated AAA by Standard and Poor and others. Derivatives were exempt from regulation by act of Congress as urged by Alan Greenspan and others. Financial instruments still regulated by law were recast as derivatives to escape regulation. And without the discipline of regulation, Wall Street took on excessive risk. And it came tumbling down in 2007-8 birthing the Great Recession.
- Revisiting the Greenspan Legacy (circa 2008) (ritholtz.com)