How Did These Instruments Contribute To The Large Credit Bubble Before The Credit Crunch

Explain the process of secutitization and credit default swaps. How did these instruments contribute to the large credit bubble before the Credit Crunch? What is the role of credit rating agencies in this process?

Credit default swaps is a form of insurance policy on investments to insure the issuer of a bond in case of a default/bust. There are two risks with bonds/share/investement: default risk/catastrophe and price risk (can go up and down). When the investor of the bond decides to hold on to its bonds it can decide to want a insurance policy. The investor pays a non refundable premium to the insurance company/investment bank can be upfront or over pay as you go installment and in return the nsurance company offers a protection if there is a credit event. A credit event triggers a playout by the investement bank that sold the insurance policy. The investement bank can guarantee a price for those bonds at a nominal value. The ideal situation of most insurance policies would be to collect the premium and prevent or avoid a credit event payout. A credit event is usually scene as a default of somesort, restructuring.

A credit default

Subprime mortgages are usually characterised with high interest rates and have a notorious association with a high credit risk primarily due to the poor credit of the majority of subprime borrowers. The securitisation of these subprime mortgages into mortgage backed securities meant that subprime MBS became increasingly desirable to investors; the security was liquid, and therefore tradeble as opposed to the mortgage loans, therefore, investors viewed this security as a guaranteed rate of return because subprime lenders would be paying higher premiums. This is often seen as the prime reason for the subprime mortgage crisis which led to the large credit