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Derivatives were used less to hedge risk than to restructure it into a form that escaped the relevant rule. A swap or structured note could reproduce the economics of a prohibited position, such as leveraged currency bets, disguised loans or off-balance-sheet debt, while carrying a legal label that regulators and accounting standards treated differently. Each new rule therefore became a design specification for the next product that got around it.
When the Federal Reserve raised rates through 1994, the pool lost about $1.7 billion and the county filed for bankruptcy in December 1994, the largest municipal bankruptcy in US history at that time. Wall Street firms, notably Merrill Lynch, had sold him the instruments, and voters had rewarded his earlier high returns.
Control over markets eroded because the instruments became too complex for managers, boards, auditors and regulators to value or understand, while deregulation removed the backstops that might have compensated. Traders who understood the products gained informational power over everyone meant to supervise them. That let them book fictitious gains, such as mark-to-model profits at Enron, and hide losses, such as Nick Leeson's hidden error account at Barings, until the losses became catastrophic.
Reported earnings should be read as something produced by choices about structure, timing and valuation, not as a measurement of economic reality. Special-purpose entities, prepaid swaps and fair-value models let firms like Enron manufacture smooth, rising profits that matched analysts' expectations while the underlying cash flows deteriorated. Once executive pay was tied to stock options, managers had a direct incentive to produce the numbers rather than the business performance behind them.