Reply To: Glass Steagall as a cause of the financial crisis


Yes, the credit creation stimulated derivative use. Banks created mortgages out of thin air and lent them to subprime borrowers. They then sold the mortgages to Fannie Mae and Freddie Mac who securitized them. Because Fannie and Freddie had implicit government guarantees, banks bought MBS and used derivatives to hedge their downside potential. As the credit expansion extended to riskier and riskier projects, Credit Default Swaps use expanded.

The growth in derivatives began after the tighter regulation of the Monetary Control Act of 1980. The volatility during the period called the “Great Moderation” from the early 1980s through the 1990s was reduced in part because of the continuing expansion of derivative markets on the basis of rapid and steady monetary inflation and credit expansion.

Commercial banks have more stringent regulations on the securities they can hold and underwrite.