it wasnt the airplane, beauty killed the beast

patient renter argued that flippers and people buying more house than they could afford caused the financial crisis...

i argued that in a healthy financial - economic system even several million defaults wouldnt crash the us and the world economic and financial systems

for that to happen the loans had to be securitized, tanched and swapped, with leverage sprinkled liberally across the process at every opportunity

i appreciate his point that people buying what they could not afford and or going into debt over their heads was the first domino or the striking of the match

but securitization, leverage and derivatives were the tinder dry forest

i recall on the day the tarp bailout was passed, the 700 billion was enough to buy outright every defaulted mortgage with almost half a trillion left over assuming average home price of 225k

today with all the cascading events there might be couple trillion in res RE defaults, just guessing

BUT

the fed has laid off more than 10 trillion in mark to model toxic securities by letting banks and other financial institutions bringing, in some cases, garbage to the fed window and get AAA treasuries etc in exchange

leverage, securitization, and derivatives took a manageable crisis like what we had in the late 80s during the S&L crisis, and turned it into a financial system meltdown

many institutions took the senior tranches of the collateralized debt obligations so that they could get interest rates over prevailing market levels

this involved leverage

furthermore some creative quant types fabricated instruments with greater leverage and diversity including synthetic CDOs and CDOs squared

again this levered up profits when the investors "won"

but the leverage also multiplied losses

there are other examples...CDSs enabled institutions to "write checks with their mouths that their bodies couldnt cash"...so to speak

i generally accept your argument that the theoretically,derivatives are a zero sum game but when a major player like aig, an insurer (writer of protection ) failed, then huge numbers of securities “underwritten by the failing firm lost their AAA rating

zero sum game or not, i have to argue that the gross dollar amount of outstanding derivatives contracts, which was over 500 trillion prior to the crisis, does matter in that it is an indication of the complexity of the web of interconnectedness between all players and the amounts of money that have been cross wagered

theoretically after all the chips pass back and forth across the table the total... of winner and looser deals... will equal out but not every individual nor institution wrote an equal number of winner or looser contracts so some individuals and institutions stood to collapse as the crisis developed

additionally there was counterparty risk...everybody was afraid that the music would stop and they wouldnt have a chair

so as the system strained it began to seize up and institutions began to grab at liquidity available to them and refuse credit to all comers

i think derivatives contributed substantially to the system meltdown

from your example above the following question...when is a 100% loss of a 1$ investment not a 1$ loss

answer when the securitized investment has been "insured" by a credit default swap

how? ... not only do you suffer the loss in principle, but you have been paying premiums to an individual or company which is unable to compensate you for your loss because they have written, by a factor of many times their net worth more policies than they can cover in losses...so your premium bought nothing

further more it was not an uncommon practice for the holder of a securitized portfolio to take out a CDO on the counterparty that they bought the primary CDO from to cover the initial investment

adding insult to injury in the derivatives market individuals and institutions could take out "bets" ie enter into CDS with counter parties who had no insurable interest in the underlying security

it would be as if you and i could buy and sell life insurance on people we didnt know and were neither our employees nor members of our family...it was a casino