Financial

innovations instability factors at the

heart of the subprime and euro zone crises
FALLOUL Moulay El Mehdi
Hassan II University of Mohammedia Morocco

Financial innovation, creative destruction or devastating destruction?

In our analysis, we will try to understand the role of financial innovation, in the
development of the financial crisis 2007. The question that arises is: "how financial
innovation which is susceptible to build a sound international financial system was about
to destroy it."
To resolve this problem will begin by doing a historical analysis of financial innovation, in
other words we will try to study it since its creation to its current development which no doubt
contributed to financial globalization and therefore the spread of systemic risk which we
believe was at the heart of the financial crisis 2007. Thus, we will try first to do a historical
analysis of the birth of financial innovation, its development, and the role that has played in
the development of financial globalization and financial crises, and then we will try to analyze
the mechanism of securitization which is at the heart of the Subprime crisis.
Innovation and its relation to globalization is not a new phenomenon. In fact, there were two
periods of financial globalization. First, from the second half of the 19th century until the first
World War and second since the abandonment of the Bretton Woods system in 1971 onwards.
Both of these two periods are characterized by a low correlation between domestic investment
and domestic savings.
In fact, several methods have been proposed to measure the degree of capital mobility. In our
study, we will consider the method initiated by Feldstein and Horioka that directly tests the
relationship between savings and investments in an open economy.
In their seminal paper, Feldstein and Horioka (1980) showed that in a situation of perfect
capital mobility, it should not be a strong link between domestic savings and domestic
investment rate. The allocation of savings in each country should be based on international
investment opportunities, and

conversely, domestic investment should be funded from abroad. Also a strong correlation
between these two variables would be evidence of a low degree of capital mobility and
therefore a low degree of financial integration.
The first globalization is the result of a long process of synergy between the geographical
extension of trade and the deepening of market regulation (Norel, 2004, p. 32-34). Before the
industrial revolution, big trade, geographic expansion in exchanges had stimulated the
creation of "national market system," in effect; it is the creation of markets for sophisticated
products, allowing a more rational allocation of resources. The first product markets worthy
of the name appear in Europe in the Netherlands and England which were leading countries in
trade expansion after the Golden Age.
At the late nineteenth century, the vast majority of capital flows was used to finance
infrastructures (in particular the railways) and buy government bonds. These capital flows
were thus mainly long-term flows and involved relatively few loans to financial institutions or
for short-term portfolio investments. The situation today is completely reversed: short term
capital flows dominate much long-term capital flows. Accordingly on the foreign exchange
market, the net positions of most of the stakeholders are on average kept open about 20
minutes: it is difficult to consider a shorter horizon. The degree of integration of financial
markets for short-term capital flows is now without precedent.
Financial globalization has therefore two dimensions, one temporal and one spatial. The time
is shortened, not only for stakeholders on the markets who must continually respond to new
information but also for policy makers, for whom the period available to respond to a crisis is
also becoming increasingly short. This is due to the strong development of Information
technology, an aspect that did not exist during the first phase of globalization.
The second aspect of contemporary globalization is that it eliminated the significance of
physical geography for financial processes: a crisis can start in a region of the world and
spread to the rest of the world without regard to distance and borders. For instance, the Asian
crisis began in July 1997 in Thailand, then it quickly reached South Korea, after that, it set off
a wave of panic on the foreign exchange markets and stock markets in the countries of the
region, then in 1998 reached Latin America and the Russia. The near-bankruptcy of the
American hedge fund Long-Term Capital Management (LTCM) is an indirect consequence of
the wave of panic on Russian markets. These events show that

the financial markets of the rich countries were not spared from a problem that had started in a
small Asian country.
In the contemporary globalization fund managers, insurers and bankers have transformed
the investment practices by creating financial instruments known as derivatives, whose value
is derived from the price of another underlying asset. The original idea of derivatives was to
help actors in the real economy, such as farmers and manufacturers, insure against risk. A
company may want, for example, to guard against increases in the prices of steel, wheat or
other commodities. Price stabilization and risk mitigation are worthwhile objectives, but many
derivatives trades have crossed the line into speculation rather than risk management.
Most derivatives are sold over the counter through private trades rather than on public stock
or commodity exchanges. This gives investment banks flexibility to propose to their
customers whatever deal they want, rather than being bound by the trades sanctioned by
exchange supervisors. As the deals are secret they do not help other investors price risk, and
often investors, regulators and other analysts do not know what liabilities a company has
taken on.
There are several types of derivative, including financial futures, forwards, swaps and
options. In the last twenty years traders have invented a series of ever more complicated deals
that they have sold to manufacturers, but primarily to investors. An example is a paper
company hedging on interest rates through a deal whereby it would receive a fixed rate of 5.5
per cent and pay a floating rate, squared and then divided by 6 per cent. One type of derivate
instrument is a credit default swap. In these deals, which were valued at $62 trillion in
December 2007, the buyer makes periodic payments to the seller in exchange for the right to a
payoff if there is a default or credit write-down in respect of a mortgage or other debt
securities they hold. The uncertainties about this huge market are a major factor in the 20072008 credit crunch, resulting in serious difficulties for many families and small businesses.
Financial engineers have also developed collateralized debt obligations (CDOs) through
which a financial institution combines assets of various types (for example prime mortgages
with subprime ones). The packaged debt is then sold to a special purpose vehicle, generally
registered offshore in a low tax jurisdiction. The new entity then issues its own equity or
bonds to resell the debt to other investors, carving it up into different tranches with different
risk ratings using complex mathematical models. The most actively traded CDOs are those
made up of credit default swaps. CDOs are also themselves being repackaged into other
CDOs, further obscuring the actual risk and ownership of the

underlining assets. The interlinked complexity of these deals feeds volatility rather than
reduces it.
Financial innovation in the derivatives market has largely aimed to disguise risk, avoid
regulations and generate higher short-term profits. Hedge funds, private equity corporations,
investment banks and pension funds have used derivatives to evade regulations. They have
devised elaborate and opaque financial vehicles through which they have dumped risks onto
the state or onto less informed investors including pension holders. Many companies,
including Enron and Parmalat, showed that this strategy works only in the short-term, but may
prove disastrous after that. Parmalat abused the capital markets for years by raising money
under false pretences. Money was siphoned off for family purposes and the whole mess
hidden in a complex structure of 200-plus subsidiaries and special purpose vehicles scattered
across the globe, including tax havens such as the Cayman Islands, the Dutch Antilles and
Cyprus.
To understand the relationship between financial innovation and the recent global financial
crisis it is necessary to study the evolution of financial innovations. Hence the first chapter
will be devoted to discuss the link between financial globalization and the development of
financial derivatives particularly, credit derivatives. Is the the second chapter we will first
analyze securitization as a sophisticated financial engineering product at the heart of the
recent global financial crisis And we will analyze three factors of convergence who acted as
amplifiers of the outburst of this crisis which are the rating agencies, Basel II prudential
regulation and international accounting standards IFRS. And Finally In The third chapter will
try to assess the role that has got the CDS on the recent Euro zone financial crisis.

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