Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 17 - Financial Innovation and the Credit Crunch

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter seventeen.

Chapter Introduction

In this chapter you will learn about: financial innovations such as CDOs and CDSs, the causes of the credit crunch, the failure of Lehman Brothers and AIG, the financial cost of the credit crunch, the measures taken by the authorities in response to the crisis and the policy lessons and implications of the credit crunch.

A number of financial innovations have been developed since the 1990s through to the present. These new financial instruments such as collateralized debt obligations and credit derivatives including credit default swaps played a significant role in the so-called credit crunch which is generally considered to have started on 9 August 2007. On that date when BNP Paribas warned investors that they would not be able to withdraw money from two of its funds due to a ‘complete evaporation of liquidity’ in the market. In addition, the European Central Bank pumped €95 billion of liquidity into the markets, followed a few days later by a further €108.7 billion. Up until the outbreak of the credit crunch financial innovation had generally been viewed as a good thing for financial markets and the economy. It was believed that risk could be divided up into various tranches and transferred from market participants wishing to reduce their risk exposure to other participants prepared to take on greater risk exposure. However, the credit crunch showed that rather than reduce risk exposure much of the financial innovation had in fact built up the level of risk to such a high level that there was a major breakdown in the banking and financial systems. In April 2009, the International Monetary Fund (IMF) estimated that there would be close to $4.1 trillion dollars of losses in financial institutions worldwide. The scale of the financial crisis was unprecedented in modern times and comparisons were made with the global depression of the 1930s. The chapter begins with a look at two of the key financial instruments linked to the credit crisis, (i) collateralized debt obligations (CDOs) and (ii) credit derivatives with a particular emphasis on credit default swaps (CDSs). As we shall see, these two financial securities played a pivotal role in the crisis, so an understanding of these instruments is essential to understanding how the credit crunch impacted so heavily upon the banking sector and, in the case of credit default swaps, was directly related to the failure of American International Group (AIG). Prior to the outbreak of the crisis AIG was the world’s largest insurance fi rm, but it had to be bailed out to the tune of approximately $180 billion by the US taxpayer in September 2008. We then proceed to look at the credit crunch, analyzing the role played by the financial innovations and the responsibilities of the different players involved in the crisis. These players include individuals such as the former chairman of the Federal Reserve, Alan Greenspan, heads of banks and financial companies such as Freddie Mac, Fannie Mae and Citigroup, and organizations including financial regulators such as the Securities Exchange Commission (SEC) and the Financial Services Authority (FSA), the rating agencies, Governments, financial institutions, and ultimately households and companies that took on unserviceable debt levels.

Revision Questions

  1. ​Discuss what is meant by a collateralized debt obligation and the role of CDOs in the credit crunch.
  2. Explain what is meant by a credit default swap and how the writing of CDSs contributed to the fall of American International Group.
  3. Discuss the role played by the credit rating agencies in causing the credit crunch.
  4. What is meant by quantitative easing? How is it likely to affect bond prices in the short and the long term?
  5. Who was most responsible for the credit crunch – the bankers or the regulators?
  6. Discuss five of the measures implemented by the US authorities to mitigate the effects of the credit crunch.

Multiple Choice Questions

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