Everyone in "the system" thought that by having all of these derivatives, risks could be reduced for themselves because they could be offloaded to other parties within the system. What this means is that the individual players in the system felt safe, thereby increasing their appetite for risk. This lead to lower risk premiums to the point of absurdity - just look at some of the terms in favor of the debtors in the leveraged buy out craze. Thus, by having all the individual players in the system feel safe, the entire system acted as though risk had been reduced but really it hadn't.
This is absolutely no surprise to me. If the individuals within a system have a low perception of risk but this perception is based on the structure of the system as opposed to the actual risks external to the system (that is, the ability of the debtors to pay back), then if all individuals act accordingly, the entire system will undervalue risk which at some stage will come back to take down the entire system instead of some of the individuals within it. It is my belief that this is what we are witnessing now.
Thus, the system itself is fundamentally broken. It is time to get back to basics where the people that lend the money feel like they are on the hook for the actions of their debtors. When this is the case, creditors will pay particular attention to debtors and price the debtors external risks appropriately. This whole crisis is due to the systemic undervaluing of risk due to the internal structure of the financial system promoting it. Of course the derivative market isn't entirely to blame, but it certainly has not helped.
