Essay Writing Service

Economic Causes of the Financial Crash

Economic Causes of the Financial Crash

After almost five decades of strict financial regulation following the 1929 crisis, the Reagan administration started a movement of financial deregulation in the 1980’s. Previously solely used by government-backed agencies, this new environment allowed financial institutions – especially commercial banks, to use securitization as a Credit Risk Transfer tool, transferring risk from the originator (of the loan) to investors on the financial market. We define securitization as the conversion of an asset, especially an aggregate of loans, into a marketable security. The financial deregulation has been followed by the United-Kingdom under the Thatcher administration leading to a generalized financial deregulation of the Western economy. This period has witnessed several financial crises of various scales, but the last one of 2007-2008 is known for being the most important financial crisis undergone by Western economies since 1929. This crisis is different from the previous ones because of its systemic importance, not only impacting financial institutions from all over the world, but also hurting global real economy by reducing global international trade and output, and increasing unemployment. This crisis – called subprime crisis, has been caused by the burst of a housing market bubble in the United States which has led to important losses suffered by all kind of investors because of the high interconnection between agents due to massive investment on securities and derivatives backed by risky housing related assets – such as subprime loans. This essay will discuss how the increasingly popular process of securitization contributed to the build-up of systemic risk and which role it played in the contagion effect following the break out of the crisis.

Get Help With Your Essay

If you need assistance with writing your essay, our professional essay writing service is here to help!

Find out more

The amount of worldwide securitization was of $200 billion in 1995 and around $500 billion in 2000, which represents an increase of only $300 billion in 5 years, as compared to the soar of $2,200 billion between 2001 and 2006. This exponential increase of use of securitization happened in a specific context giving the incentive to American banks to resort to this process. Thanks to modified rules at the SEC (Securities and Exchange Commission), the creation of SPV (Special Purpose Vehicle) by commercial banks was authorized and allowed banks to package assets and to transfer them to these SPVs as off-balance sheet assets. This process provided banks with regulatory capital relief, important liquidity entry thanks to the sale of these pooled assets on financial market after being securitized, as well as credit risk transfer. From 1992 to 2001, the interest rates of the Federal Reserve of the United States (Fed) have constantly remained under 6% and exceeded that threshold by 0.5% in May 2000 to pressure down the dotcom bubble. After the beginning of the recession starting in March 2001, the interest rates have been lowered to 1.75% at the end of the year and remained under 4.5% until 2006. The low interest rate environment created an appetite for higher yields by investors. Already incentivized to use securitization, American commercial banks responded to the demand of higher yielded securities by including subprime loans (alongside with car loans and credit cards) into the collateral pool of their ABS (Asset Backed Securities). Therefore, the number of subprime loans has soared between the end of the dotcom crisis and 2007. These loans were principally used to issue MBS (Mortgage Backed Securities) and CDO (Collateral Debt Obligation) containing an increasing proportion of this type of loans (from an average of 5% of a representative CDO in 2002 to 80% in 2007). The credit risk transfer obtained by the banks thanks to securitization created a moral hazard issue on the lending market, as the regulation on lending loosened and the bear of the risk was transferred to investors, bank did not have the incentive to correctly monitor borrowers, which eventually led to massive default once interest rates rose. Although including an increasing amount of bad loans into asset pools for securitization should have led to a downgrade of the securities issued by the SPVs, the credit rating agencies played a crucial role by rating these CDOs and MBSs senior tranches as AAA even though their quality kept deteriorating. Indeed, the rating of ABS is pro-cyclical since it mainly depends on forecasts of economic conditions, where a worsen of the economic environment should lead to a higher probability of default on mortgages. The way credit rating agencies were rating ABS was based on a quantitative approach and not on a qualitative one. Thus, not taking into account deterioration of the solvability of borrowers coupled with a positive expectation of economic outcome driven by an ever-growing housing market, led the credit rating agencies to overrate CDOs and MBSs – as well as their derivatives. The high standing of the use of mortgages as a collateral led banks to concentrate activities in the issuance of ABS containing almost exclusively mortgages – with a growing proportion of subprime loans. This behavior created a growing correlation between investors’ portfolios since they were mainly composed of MBSs, CDOs, but also of derivatives related to these securities such as Synthetic CDOs or CDS (Credit Default Swap). By securitizing pools of less and less diversified assets of decreasing quality, featuring ‘incompatible’ characteristics (safe with high returns), the American commercial banks creating an ever-growing interconnection between investors, building-up systemic risk.

The level of household indebtment dramatically increased from 70% of the US GDP (Gross Domestic Product) in 2001 to 98% in 2008. It is the result of a credit access that has been eased thanks to a period of low interest rates and the loosen of quality criteria used by banks to grant loans to borrowers. Therefore, subprime mortgages sharply expanded during this period, indebting barely solvable people with variable interest rates loans, who relied on the growth of the housing market prices to obtain a new mortgage by using their house as a collateral to pay the first one. Observing the overinvestment in the American housing market, the Fed chose to raise interest rates to calm down the growth of the bubble ending the year 2006 with a 5.25% interest rate. As a result of this decision, default rates on mortgages started to increase which had a direct negative impact on portfolios holding housing market related ABS. Indeed, agents heavily invested in CDOs and MBSs because of the revenue flow they generate thanks to the reimbursement of interests and principal of the underlying loans. The massive default on these mortgages deprived these securities from generating cash flow and led to foreclosure on mortgages leaving investors with decreasing value houses as a collateral – for those who had a claim on the underlying collateral. Even senior tranches owners of CDOs started to suffer loss which eventually led to a downgrading of these securities by credit rate agencies. Once downgraded, the market got an insight of the actual risk of these financial products and the demand for these products collapsed causing a massive fall of their prices. Investors, such as hedge funds, investment banks, pension funds, mutual funds of even commercial banks, who heavily bought these securities endured massive loss caused by the collapse of the market value of the underlying assets (mainly houses for MBS and simple CDOs, and MBSs and CDOs for derivatives). Commercial banks that were holding a large amount of subprime loans that they did not securitize and sell before the degradation of the market, were detaining these bad assets almost systematically defaulting, inflicting heavy losses. SPVs – particularly SIVs (Special Investment Vehicles), were suffering losses, causing great damage to their mother institutions because of a non-explicit link between them, where the mother institution (most likely an American commercial bank, or a European or Asian universal bank) has a commitment to its SIV preventing them to file for bankruptcy. The contagion even spread to investors not holding this type of securities because, according to S&P (Standards and Poor’s), the monoline insurance insured $127 billion of CDOs relying on subprime home loans. When default rate rose, these insurances had to pay important sums to insured investors holding CDOs. This resulted in a general downgrading of these insurances – such as MBIA of AMBAC. At a systemic level, the downgrading of these insurances implies a downgrading of everything insured by them – such as municipal bonds. Therefore, even investors who were not holding assets related to the housing market, suffered loss because of “fair value” accounting imposing to write down the loss of market value of securities held – such as (municipal) bonds, as a loss. Although these phenomena took place almost solely on the US market, the Lehman Brothers bankruptcy of the 15th of September 2008 was the critical event that spread the crisis worldwide. It froze the global interbank lending market which prevented banks to roll over their short-term debt. Banks and other types of investors (even outside the USA) who held subprime related securities were then cashing losses and suffering from a lack of liquidity. Stakeholders of institutions negatively affected by the crisis were then impacted even though they were not holding subprime related assets. A chain reaction which threatened the global financial system to collapse was triggered, and governments had no choice but to intervene by injecting capital, providing liquidity and/or guarantees to prevent other major financial institution to file for bankruptcy.

The process of securitization grew in popularity during the 1990’s in the United States and included an increasing number of subprime loans starting from the year 2001 because of a research of high yields in a period of generalized low interest rates (facilitating access to credit). The features of securities using subprime mortgages were unbeatable and led to a generalized overinvestment in it by private investors such as hedge funds, public ones such as municipalities or pension funds, and mostly by banks (commercial, investment or universal ones). Once the economic conditions were not favorable anymore, all types of investors got hurt (more or less severely), turning the financial crisis into a systemic crisis because of its negative effects not only on the financial markets, but also on the broader economy. Although banks could appear safe at a microprudential level, off-balance sheets operations and high correlation of investments between different agents participated to the build-up and the spread of a systemic risk. This crisis should teach us that the process of securitization can lead to severe financial imbalances threatening financial stability if it is not observed and regulated with appropriated tools, such as a macroprudential approach.


  • Ashcraft, Adam B. and Schuermann, Til, Understanding the Securitization of Subprime Mortgage Credit (March 2008). Wharton Financial Institutions Center Working Paper No. 07-43; FRB of New York Staff Report, No. 318. Available at SSRN:
  • Turnbull, Stuart M. and Crouhy, Michel and Jarrow, Robert A., The Subprime Credit Crisis of 07 (July 9, 2008). Available at SSRN:
  • Gorton, Gary B., The Subprime Panic (September 30, 2008). Yale ICF Working Paper No. 08-25. Available at SSRN:
  • IMF website:
  • Freixas, Xavier and Laeven, Luc and Peydro, José-Luis, Systemic Risk, Crises, and Macroprudential Regulation (2015). The MIT Press Cambridge, Massachusetts.


Most Used Categories

I order from this writer for quite a while, so we are having the chemistry going on between us. Great job as always!
Laura C., March 2018
Wow, ordering from EssayHub was one of the most pleasant experiences I have ever had. Not only was my work sent to me hours before the deadline, but the content was absolutely fantastic! Would order from them again!
Daniel L., March 2018
Professional Custom
Professional Custom Essay Writing Services
In need of qualified essay help online or professional assistance with your research paper?
Browsing the web for a reliable custom writing service to give you a hand with college assignment?
Out of time and require quick and moreover effective support with your term paper or dissertation?