There were a number of factors that contributed the crisis, swaps being one of them, but ultimately it was all our own greed that made the situation go out of control. The swaps were good instruments in the sense that it created money transactions, i.e., it got money and the economy moving. The swaps are based on real estate assets, which were booming for some time now. Everyone knew that it was at least on the high cycle, if not an actual bubble, but no one did anything about it, thinking that they could get out when things got bad. In essence, people were timing the market. When the bubble burst, people lost confidence in these assets rapidly, so fast that institutions couldn’t get out of them unless they wanted to through a fire sale.
How did then everything get so bad? I argue that Fannie Mae and Freddie Mac, while not the sole cause, were huge enough to distort the unregulated market and exasperate the problem. They were either buying up paper, or they were guaranteeing the loans. The market saw what they were doing, knowing full well that the government would not let them fail (or gambling on that knowledge). So, they continued the practice of either buying and selling to each other, or to the GSEs or to both. Little did they know that the GSEs were also selling to each other, thus also further distorting the market.
People knew that these things were risky, in some sense. The government tried to regulate it, but who wants to kill the golden goose? People were getting home ownership, politicians had feathers in their caps, the market was moving, and people were making money. My feelings are that even if they tried to regulate, the damage would already have been done, because people started defaulting on these loans. The regulation would have stopped the GSEs from their market distorting behavior, and might have provided transparency in the markets, but they probably wouldn’t have done nothing to stop the real estate bubble from popping. Bubbles are artificial by nature, and without an extraneous component they will pop – too quickly for most people to do anything about it (see e.g. tulips, silver, tech stocks, real estate).
Now, the current problem is that markets aren’t moving because there is a lack of faith in these instruments because no one knows how to value them. Banks, people, institutions already have too much money tied up into these things and might be content to let it play out, but in the meantime markets slow down and possibly freeze (or recession comes into play). If these swaps as well as the CDOs/MBSs/derivatives/whathaveyou can get moving, the market can start to return to normal.