Geithner: Derivatives Blindsided Government

Derivatives are financial instruments whose value are derived from something else, such as a mortgage-backed security or a commodity like oil.

In one infamous example, AIG (AIG Quote) sold so-called credit-default swaps to protect investors against potential losses on mortgage-backed securities. When the housing market collapsed, AIG was unable to make good on its promises and took a $182 billion government bailout to keep from collapsing.

The allure of the over-the-counter derivative, as opposed to those swapped on exchanges, is that it can be individually negotiated and tailored to meet the specific needs of the buyer.

But Geithner said many investors used the instruments to evade regulation, exploit regulatory loopholes or minimize taxes.

Over-the-counter derivatives "grew explosively" in the past decade, with the face value of outstanding transactions rising sixfold to almost $700 trillion in 2008, he added.

"The apparent ease with which derivatives permitted risk to be transferred and managed during a period of global expansion and ample liquidity led financial institutions and investors to take on larger amounts of risk than was prudent," he said.