Derivatives
Were thought up in ancient Babylon. The king wrote what were effectively wheat futures to guarantee a set price for the crops his farmers grew. Derivatives are a smoothing mechanism to help businesses plan future expenditure, but in order for them to work you have to have speculators to take opposing positions. Like knives they are not inherently a bad thing and can do much good, but if you don't control how you use them you can get a nasty cut.

While MrHappy's post makes him sound like a stereotypical City banker, his comments about the ratings agencies hint at how that control breaks down.

These agencies are trusted entities and a key part of the regulatory system. Their role depends on their reputation for absolute impartialality, probity and competence. Unfortunately they failed by massively overstating the quality of certain credit derivatives. This allowed and encouraged the banks to take up lots and lots of them while thinking that the risk was far less than it actually was. For example, one agency's system for mortgage derivatives was not capable of modelling a fall in house prices; it assumed they would always rise. When house prices fell, the mortgage backed securities performed in a way totally contrary to the expectations set by the rating agencies and the banks began to lose far more money than their risk budgets - built on the agencies' ratings - predicted.

The agencies' failure was one of the largest and most important links in the very complex chain that led to the 'massive fuck up' or 'credit crunch' or whatever you want to call it.

Edit: Changed "unpleasant individual" to "stereotypical banker"; it's not right to make a call on one post by MrHappy even though this is the internet.
( Scrumper, Mon 20 Jul 2009, 11:31, Reply)