Credit derivatives, such as asset securitization and credit default swaps, allow investors to separate the credit risk exposure from the lending process itself. That is, banks can assess the creditworthiness of loan applicants, originate loans, fund loans, and even monitor and service loans without retaining exposure to loss from credit events, such as default or missed payments. This decoupling of the risk from the lending activity allows the market to efficiently transfer risk across counterparties. However, it also loosens the incentives to carefully perform each of the steps in the lending process. This loosening of incentives has been an important factor leading to the global financial crisis of 2007-2009, which has witnessed the aftereffects of poor loan underwriting, shoddy documentation and due diligence, failure to monitor borrower activity, and fraudulent activity on the part of both lenders and borrowers.
Warren Buffett has termed derivatives “financial weapons of mass destruction.”1
He has decried the “daisy chain of risk” that is facilitated by derivatives that require little payment up front but can represent large and uncertain obligations in the future. This point of view has led some to call for a ban on certain derivatives, although Warren Buffett admits that “the derivatives genie is out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity ...