From a recent review in the Gulf News – “How derivatives Work”;
"It's called financial engineering for a reason," says Joseph Mason, an economist at Drexel University in Philadelphia.
"Engineering with space-age materials leads to great performance when it performs well." But a rocket ship can also explode, he adds.
In this case, it didn't help that credit-rating firms gave many CDO products top grades. Each CDO spawns a range of bond-like products defined by "tranches" - segments that carry varying risk and return potential.
That’s pretty much how they do work – like spaceships in a market full of Hyundais. However, the article’s second point is more prescient still. Derivatives themselves are not all to blame for the collapse of financial markets this summer, and before that in the early 90’s.
It’s the ratings agencies that grade them. By grading a derivative “A”, risk conservative pension funds, private investors and mutual funds can all assume that the asset class is safe – in the sense that it is relatively unlikely to “blow up” – and even legally take quite substantial positions in them.
When this happens, pretty much all market actors get involved, grossly inflating the price and creating the incentive among brokerages to create even more of these volatile grade “A” investment products.
The ratings agencies have to take a substantial portion of the blame when things go awry, like they did in the sub prime scenario.