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SECURITIZATION AND DERIVATIVES
market when Congress discussed regulating derivatives in the s—“did create
problems” during the financial crisis. Rubin testified that when the CFMA passed
he was “not opposed to the regulation of derivatives” and had personally agreed with
Born’s views, but that “very strongly held views in the financial services industry in
opposition to regulation” were insurmountable. Summers told the FCIC that while
risks could not necessarily have been foreseen years ago, “by our regulatory
framework with respect to derivatives was manifestly inadequate,” and that “the de-
rivatives that proved to be by far the most serious, those associated with credit default
swaps, increased fold between and .”
One reason for the rapid growth of the derivatives market was the capital require-
ments advantage that many financial institutions could obtain through hedging with
derivatives. As discussed above, financial firms may use derivatives to hedge their
risks. Such use of derivatives can lower a firm’s Value at Risk as determined by com-
puter models. In addition to gaining this advantage in risk management, such hedges
can lower the amount of capital that banks are required to hold, thanks to a
amendment to the regulatory regime known as the Basel International Capital Ac-
cord, or “Basel I.”
Meeting in Basel, Switzerland, in , the world’s central banks and bank super-
visors adopted principles for banks’ capital standards, and U.S. banking regulators
made adjustments to implement them. Among the most important was the require-
ment that banks hold more capital against riskier assets. Fatefully, the Basel rules
made capital requirements for mortgages and mortgage-backed securities looser
than for all other assets related to corporate and consumer loans. Indeed, capital re-
quirements for banks’ holdings of Fannie’s and Freddie’s securities were less than for
all other assets except those explicitly backed by the U.S. government.
These international capital standards accommodated the shift to increased lever-
age. In , large banks sought more favorable capital treatment for their trading,
and the Basel Committee on Banking Supervision adopted the Market Risk Amend-
ment to Basel I. This provided that if banks hedged their credit or market risks using
derivatives, they could hold less capital against their exposures from trading and
other activities.
OTC derivatives let derivatives traders—including the large banks and investment
banks—increase their leverage. For example, entering into an equity swap that mim-
icked the returns of someone who owned the actual stock may have had some up-
front costs, but the amount of collateral posted was much smaller than the upfront
cost of purchasing the stock directly. Often no collateral was required at all. Traders
could use derivatives to receive the same gains—or losses—as if they had bought the
actual security, and with only a fraction of a buyer’s initial financial outlay. Warren
Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., testified
to the FCIC about the unique characteristics of the derivatives market, saying, “they
accentuated enormously, in my view, the leverage in the system.” He went on to call
derivatives “very dangerous stuff,” difficult for market participants, regulators, audi-
tors, and investors to understand—indeed, he concluded, “I don’t think I could man-
age” a complex derivatives book. 
