Financial crisis of 2007/8 reviewed as the worst crisis after depression, one of the main reason of financial crisis is because of different issues occurred during the period. One of the factor is financial innovation and subprime mortgage markets. The function of financial innovation is creating new financial instruments, technologies, institutions and markets.
The outcome of financial innovations are mortgage-backed securities products and collateralised debt obligations (CDOs) in mortgage markets during the financial crisis. Subprime mortgage in US market was estimated at $ 1.3 trillion and over 7.5 million subprime mortgage is outstanding.
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Collateralized Debt Obligations (CDOs) did a big effect on the crisis, its special purpose vehicle (SPV) had created to buy assets, create securities from those assets, and then sell those securities to investors. Many subprime mortgage bundle together sold and dependent on US federal government support and guarantees led to a moral hazard to happen when one party intentions to behave inappropriately after the financial transaction has happened while another party need to bears for the costs if moral hazard happened. Banking crisis is another main factor that led to the financial crisis. For instance, bank runs occur is when large number of bank customers withdraw their deposits because they believe the bank might fail and it could affect the banking activity. Besides that, banking crisis include banking panics and systemic banking crisis, which could led many banks and a country happened a large number of defaults.
Many of financial institution and the government try to assist during the crisis to prevent the financial system collapse. On September 2008, Lehman Brother filed for bankruptcy, Merrill Lynch had sold to Bank of America at a low sale prices and AIG had faced the liquidity crisis. In addition, one of the factor contributed to the financial crisis is agency problems and asymmetric information.
Agency problems happened when mortgage originators did not hold the actual mortgage but they sold the notes on the secondary market and they gained the commissions from the amount of the loans produced. During the financial crisis, originators had sold number of loans to banks and they got information that many of borrowers from these loans about to default. Asymmetric information mean the parties engage in a transaction do not have same quantity and same standard of the information. In order to measure the accurate of risk, banks need considerable and accurate information to do a rational decision. Asymmetric information could exist between investors and companies or investors and investment firms. There is a risk for any investor or analyst because when evaluating companies, companies have good or bad information while investors and analyst is lack that information. The risk exist between investment firms and investors is the investment firm may suggest a customer to buy a company’s stock while they knew the stock’s price is going down.