Financial commentators have likened Japan's earthquake, tsunami and nuclear catastrophe to derivatives' role in the 2008 financial meltdown. The resemblance is clear enough: Each activity yields big benefits and carries a tiny but explosive risk. But the similarity between the two types of crisis ends where preventing their recurrence begins.
For the Fukushima No. 1 nuclear-power plant, a 1,000-year flood and ordinarily innocuous design defects combined to deprive the reactors of circulating water coolant and cause serious radiation leaks. In financial markets, an unexpected collapse in real-estate securities and design defects in the derivatives and repo markets combined to damage core financial institutions' ability make good on their payment obligations.
While the basic risks originated outside the systems — a tsunami for Fukushima, over-investment in real-estate mortgages for financial institutions — design defects and bad luck meant that the system couldn't contain the damage. In the U.S., AIG, Bear Stearns, and Lehman Brothers — all with large derivatives and/or repo investments — failed, freezing up credit markets for a scary few weeks.
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