from MITWorld LINK Video, 1h30m... Merton uses deceptively simple graphs to show how risk propagated rapidly across financial networks, bringing down financial institutions. While he admits the crisis “is very big and complicated,” Merton boils a piece of it down to the use of put options, a derivative contract that’s been around since the 17th century. This asset-value insurance contract, a guarantee of debt, is the basis for the credit default swaps widely adopted by financial giants in the last few years -- now widely regarded as a primary cause of the meltdown. It turns out, says Merton, that the put “makes risky debt very complicated, and treacherous…”

The money quote (min. 34 to 36):"Each same size shock creates losses that are even larger [than the previous shock]"[Because Delta and Implied Vol of the embedded put option are bigger as a result of the previous shock]."Things are not conceptually out of control. This is not some mystery black swan event that we don't understand how it can be happening, and so we have to recast all the paradigms because all the modelling up to now was wrong"