Impact of Financial Innovations on the Subprime Mortgage Crisis

Causalities of the Financial Crisis

Essay, 2009

15 Pages, Grade: First


Table of Contents


The Blow of the Housing Bubble

Rating Agencies

Structured Investment Vehicles

Absolution of Financial Innovation

The Blame Game



Previous financial crises were generally macroeconomic nature, frequently caused by mismanagement of governments. In contrast, the current financial crisis is the result of microeconomic misbehaviour of many market participants. The macroeconomic conditions played rather a by-product of the subprime crisis (Park, 2009); which resulted in a collateral crisis, liquidity crisis and finally in a central banking crisis (The Economist, 2007). This paper investigates the correlation between financial innovations and the credit crunch, how financial innovations developed and which other factors contributed to the credit crunch. The first part deals with the price bubble and their creation through high financial leverage and securitization. In the next step, the focus is on involved financial institutions like rating agencies and structured investment vehicles and their impact and eventually, how the price-bubble burst as well as absolution arguments of financial innovations.

Ex-ante clarifications; according to Allen et al. (2008); a financial crisis is a rapid financial disintermediation due to financial panic. Characteristics are a flight to quality where savers liquidate assets in financial institutions due to a sudden increase in their perceived risk, moving their savings to safer assets like foreign currencies and foreign bonds in open economies or to currency, gold and government bonds in closed economies. This results finally in bank failures, stock market crashes and currency crises; which occasionally leading to deep recessions. Regarding the set out question Tufano (2002) defines financial innovations as, “the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets.”

The Blow of the Housing Bubble

Research on historical price bubbles point out that bubbles consist of a combination of three phenomena (Kindleberger & Aliber, 2005; Eichengreen & Mitchener, 2003). The ingredients are an excessive liquidity surplus, credit boom leading to unsustainable leverage and financial innovations. In the case of the current financial crisis these factors were evident in form of:

Liquidity surplus America’s current account deficit reasoned by high consumption and an active trade balance; which caused an immediate reinvestment into the USA from Asia and oil-exporting countries (Park, 2009). Furthermore, the FED kept the interest rate low to overcome the dot-com price bubble shock, the 9-11 disaster and the immense foreign demand for US treasury bills. Under these circumstances the interest rate fell below the inflation rate in 2003-04 (Visco, 2009) and this was already a mismatch between asset supply and demand (Gros, 2009).

Credit Boom The saving rate in America declined over the past years combined with cheap credits for households throughout the 90s and 2000s caused increasing domestic consumption (Visco, 2009). Moreover, the Government promoted home ownership through tax subsidies on interest payments and through the US Community Reinvestment Act; which enforced banks to give mortgage loans to lower income households (Park, 2009). The Federal National Mortgage Association (FannieMae) and the Federal Home Loan Mortgage Corporation (FreddieMac) are government-sponsored-enterprises “...with the mission to provide liquidity, stability and affordability to the U.S. housing and mortgage markets” (FannieMae). Among the duties of these financial institutions was the securitization; which included a guarantee feature for payments until maturity and supported the international expansion of mortgage backed securities (MBS) as investors relied on their guarantees (Morgenson & Duhig, 2008). Furthermore, banks lent households up to the full value of their property and increased the credit as soon as the property price increased and kept accordingly the default rate low (Carmassi & Micossi, 2009).

Financial Innovations Among the most significant innovations for the credit crunch is securitization. Securitization describes the process of pooling, bundling and standardising of loans to make them tradable like any other security and almost all American home mortgages are securitized (Bodie et al., 2008). Key securities were:

- ABS, Asset Backed Securities; which include mortgages, car loans, credit card debts and student loans
- CDO, Collateralized Debt Obligations; whose collaterals are mortgages and existing ABSs or other CDOs
- CDS, Credit Default Swaps; which are guarantees against credit default but can also be used for speculations (Brown & Reilly; 2009)

These pools of loans promised high returns with relatively low risk by using complex pooling and channelling techniques of underlying financial instruments and complex mathematical models of valuation (FSA, 2009). Securitization supplies liquidity to the markets as investment banks resell the loans to international investors; mainly to institutional investors. The fresh cash can be used to provide new mortgages; which will be sold to investors as well. Through the high property and CDO demand and the excessive use of CDOs as collaterals for synthetic CDOs, the American home-price-index rose by 124% from 1997 to 2006 (The Economist, 2007). This resulted in self-reinforcing asset prices and credit cycles which caused ultimately the price bubble (Allen et al., 2008).

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An inherent withdrawal of securitization is the ‘originate to distribution’ process; where risk of default is separated from originators and passed on to investors. This resulted in a continuous quality decrease of mortgages, since the mortgage agents and securing institutions are compensated by the volume they produce and not by the quality of returning cash flows (Jaffe et al., 2008). Actually, by 2006 a fifth of all new mortgages were subprime mortgages (The Economist, 2007). The majority of mortgages were Adjustable Rate of Mortgage (ARM) which are usually index related interest rates. They consist of indexes, margins, discounts, caps on rates, negative amortization, payment options, and recasting (FED) and forced individuals to refinance or to default after the rate increased from the initial low teaser rate (Dodd, 2007). Another innovative mortgage type is the Ninja loan ‘No Income, No Job and No Assets’ (Blackburn, 2008). These mortgage types caused finally the high default rate in the financial crises, since households did not understand the loan terms and spent over their budgets. Therefore Jaffe et al. (2008) require that debt originators should hold a portion of the loans and that their commission is paid over a certain time period to hold quality standards.

Prior to the crisis financial insurance companies were in excessive search for superior returns; which resulted in overstretching their capital base by CDSs issue (Blackburn, 2008). CDOs and CDSs are usually traded over the counter; which makes them more flexible but also more opaque. During the financial crisis CDOs and CDSs turned out to be excessively risky since nobody knew who will be the counterparty and CDS issuers are exposed to unlimited downside risk. The useful innovation of CDS for hedging turned into a hazardous financial weapon via speculation during the crisis. As Lehman-Brothers faced liquidity problems many speculators bought CDSs even though they had no credit exposures to Lehman-Brothers. This speculative demand raised the CDS price from 150 to 700 basis points and made it impossible for Lehman to get anywhere credit (Park, 2009). Consequently, interbank lending stopped because banks were not sure about their own and other banks liquidity and credit markets froze (Stiglitz, 2009; The Economist, 2007). The risk transfer feature of securitization failed in the financial crisis because banks were extremely interconnected through their financing, investment strategies and hedging procedures and too many banks were warehousing mortgage securities for sale but as financial markets started to froze they were stuck with it (Hoare, 2008). According to Achary et al. (2008) 50% of all CDOs and CDSs were in the banking and shadow-banking system -nonbank financial institutions like investment banks, hedge funds and pension funds.

The main reason for the crisis was the excessive use of monetary liabilities to bet on ever growing asset prices. Under such conditions investors speculate on ever growing prices, increase their leverage and the intrinsic risk is ignored. Financial institutions such as FannieMae and financial insurance companies transformed risky instruments into high rated CDOs via their guarantees and allowed the creation of new synthetic CDOs. However, with speculative growing prices the real underpinning assets lie on a decreasing value base just like an inverse pyramid.


Excerpt out of 15 pages


Impact of Financial Innovations on the Subprime Mortgage Crisis
Causalities of the Financial Crisis
University of the West of England, Bristol
Financial Instruments; Course: MSc Finance
Catalog Number
ISBN (eBook)
ISBN (Book)
File size
697 KB
Finance, Banking, Finzwesen, Credit Crunch, Subprime Mortage Crisis, Financial Innovations, Finanzinnovationen, Financial Crisis, Finanzkrise, CDS, ABS, SPV, Rating Agencies, Rating Agenturen, Preisblase, Price bubbles, Special Purpose Vehicle
Quote paper
Karime Mimoun (Author), 2009, Impact of Financial Innovations on the Subprime Mortgage Crisis, Munich, GRIN Verlag,


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