The Role of Adjustable-Rate Subprime Mortgages and Credit Default Swaps in the Global Financial Crisis

Abstract

This study focuses on three key areas where excessive risk taking created systemic vulnerabilities and thus contributed to the current crisis. The first was the awarding of high-risk adjustable-rate subprime mortgages to people with limited abilities to pay them back. The second was using the same high-risk mortgages as collateral for new borrowings in the form of mortgage-backed securities (MBSs) and ‘collateralised debt obligations’ (CDOs). If the subprime mortgages defaulted, the securities funded by those mortgages would also default. The third area where excessive risk taking took place was in the trading in credit default swaps, essentially unregulated insurance on debt. Trading in ‘naked’ credit default swaps, in particular, added considerably more risk to an overleveraged system by significantly magnifying potential liabilities especially for providers of insurance who did not hedge their sales.