Innovation in the financial market leads to current downturn across the world

Innovations like,

• Non-banks made home loans and let them offer creative, more affordable mortgages to prospective homeowners, which was lacking in conventional banks
• Then these loans pooled and packaged into securities that can be sold to investors, reducing risk in the process.
• Then makes call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in.
• And in case, still nervous, created derivatives that allow investors to purchase the insurance against default by issuers of those securities.

Thanks to these innovations, millions of poorer and hitherto excluded families became homeowners, investors made high returns and financial intermediaries pocketed the fees and commissions. It might have worked like a dream.

Then it all came crashing down.
Now, the near $1 trillion bailout of troubled financial institutions that the US Treasury has had to mount makes emerging-market meltdowns.

But where did it all went wrong?
Were the problem unscrupulous mortgage lenders who devised credit terms—such as ‘teaser’ interest rates and prepayment penalties—that led unsuspecting borrowers into the debt trap? Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise.
So maybe the culprit is the housing bubble that developed in late 1990s, and the reluctance of Alan Greenspan’s Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations (CDO) and similar securities went far beyond what was needed to sustain mortgage lending. That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume.
So not only these made the downturn of this huge havoc, many financial institutions acted as a catalyst to pursuit huge returns.

But what the credit rating agencies doing? Had they done their work properly and issued timely warnings about the risks, these markets would not have sucked in nearly as many investors as they eventually did.

So all the above mentioned are the crux of the matter?
Perhaps….

Maybe the true culprits lie halfway around the world.
High-saving Asian households and dollar-hoarding foreign central banks produced real interest rates into ‘glut’, which pushed real interest rates into negative territory, in turn stoking the US housing bubble while sending financiers on ever-riskier ventures with borrowed money.
Policy-makers could have acted in-time to unwind those large and unsustainable current-account imbalances.

But what really got us into the mess is the then US Treasury played its hand poorly as the crisis unfolded. Like the then Treasury secretary Henry Paulson’s refusal to bailout Lehman brothers. Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional. If Bear Stearns has been provided the bailout package then Lehman Brothers too can and AIG in the next few days should have saved them with taxpayer money. Wall Street might have survived, and US taxpayers might have been spared even larger bills.

So it is futile to look for the single cause.
And what will the post-mortem on Wall Street show? Was it a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure?

In short: ----
· Due to bad mortgage securities
· Collateralized Debt Obligation (CDO)
· Bursting housing bubble
· Excess leverage in the system
· Build-up of huge trade deficits in the US
· Securitization
· Derivatives
· Mark-to-market
· Short-selling