What is Financial Crisis? A financial crisis is when the value of a financial institutions or assets declines suddenly, where investors sell off assets or withdraw their money due to the fear that the value of the assets would drop. E.g. Of a financial crisis are: * Banking Panics
* Stock market crashes
* Bursting of financial bubbles
* Currency crisis.
(http://provimet.weebly.com/uploads/2/4/3/4/2434228/global_financial_crisis.pdf) What is Financial Innovations? Financial innovations are ongoing development of financial instruments designed to achieve a specific objectives, such as offsetting a risk exposure (i.e. default of a borrower) or to assist with obtaining financing. Financial innovation can either be product or process. Process are developments demonstrated by new means of distributing securities, processing transactions or pricing transactions, while product innovations embodied by new derivative contracts, new corporate securities or new form of pooled investment products. Examples that relate to the crisis include the adjustable rate mortgage .i.e. the packing of subprime mortgages into Mortgage Backed Securities (MBS) or Collateralized Debt Obligations (CDO) for sale to investors, a type of securitization and a form of credit insurance called Credit Default Swaps (CDS), Collateralized Mortgage Obligation (CMO) The use of these products extended radically in the years prime to the crisis. These products differ in complexity and the simplicity with which they can be valued on the books of financial institutions. (http://www3.weforum.org/docs/WEF_FS_RethinkingFinancialInnovation_Report_2012.pdf)(http://www.scribd.com/doc/47101947/Financial-Crisis-of-2007-2010). The purpose of this assignment is to discuss how the innovations in the financial products contributed to the current financial crisis. In this paper I also examine what these financial innovations are and how they contribute to the current financial crisis. Some of these financial innovations I will look at are CDO’s, CDS, and MBS. Financial Innovation and the Financial Crisis
These are many factors played a part in the financial crisis and financial innovation was one of the factors but it did not only cause the financial crisis but to some degree it did contribute to the crisis due to it misuse and lack of information and the under pricing of the risk involve in some of the financial product. Collateralized Debt Obligations (CDO)
Collateralized debt obligations are asset backed security that is package together in a different range of debt obligations or bank loans package into a financial security that is divided up into various tranches, each level having a different maturity and risk. The greater the risk, the more the CDO pays. The type of CDO tranches include; Equity, Junior, Mezzanine, and Senior tranche. The equity tranche been the riskiest level and while senior tranche is the safest of the CDO. The development of CDOs resulted in more liquidity in the economy. They permit banks to sell their debt, and freed up more capital to invest or loan. Due to the additional liquidity this eventual lead to an asset bubbles in the housing market and credits crisis. So how did the CDO play a role in the financial crisis? During the early part of the crisis CDO assets started to decrease in value due to the rise in subprime mortgage default. CDO products began to underperform, the opacity of the products with view to the character and quality of the assets that underlined their value; leading to the discouragement in the investors and also led to panic in market about exposed institutions and CDO underwriters. As a result, CDO had lets banks and other financial institutions to increase their leveraged bet on the housing market, increasing returns in the short run escalating the damage once suspicions were...