Financial innovation tends to reduce transaction cost and risk and as a result bring the capital market into widening, deepening and integration. The sources of financial innovation came from financial innovation, public policies toward credit market and technology advance. For example, credit card is a financial innovation product come from technology advance including improvements in communications, data management, and credit scoring. Other examples of financial innovation included securitization and credit default swaps. Securitization is the process by which financial assets such as mortgages or car loans are bundled together and used as collateral to back new securities issued to investors, sometimes called asset backed securities (ABS) whereas Credit default swaps are credit insurance. Like other modern invention, financial innovations become a good thing when you used it properly and become a bad thing when you abused it. Due to abuse the financial innovation, it seems fallen at a hard time. The willingness by the lenders to take excessive risks, low interest rate and the greed of investors for ever to yield a higher return coupled with their belief allowed complex investment product to be sold to extremely wide range of investors. It leads to increase innovation in structured finance products. As a result, it created the premises for a potential devastating financial crisis. Investors demand for the security that higher return and no extra risk as a result come out the new securities that are believed by investors. The new securities called subprime securities. Then, something bad happen. This new product showed its flaws. The market cracks because no one really understood this product. Other than that, financial complexity led to loss of information. In principle, financial innovation is meant to increase efficiency. But, in financial markets, efficiency depends on the availability of information. Hence, the nature of innovation that occurred in effect destroyed information. The most important was complexity lead to increase the risk of uncertainty. Complex system exhibited well-known features such as path dependency and sensitivity to initial condition made the system truly unpredictable and uncertain. Hence, the spectacular failures of models during the crisis were constructed on the assumption that stable and predictable distribution probabilities could be used to describe the different states of the financial system and the economy. They collapsed when extreme events occurred with a frequency that no one ever thought would be possible.
Incorrect pricing of risk
Financial risk is any risk associated with any form of financing. Typically, in finance, risk is synonymous with downside risk and is intimately related to the shortfall or the difference between the actual return and the expected return when the actual return is less. The pricing of risk mean that the required return of the investors to compensation the additional risk measured by using interest rate or fees. The increasing complex of the securities process allowed the reallocation of the risk between market participant according to their preference, expectation and risk aversion. As a result, securitization had fuelled a strong demand for credit risk. This demand made valuation and risk assessment more difficulty. Consequently, this led to a certain mis-pricing of credit risk. For example, the level of risk of CDOs failed to price when they introduce into the system. In the late 2005 to the middle 2007, the bank estimated that $450bn of CDOs were sold. However, among the $120bn of those that had been liquidated. Thereafter, JPMorgan estimated there had approximately 32 percent on dollar of average recovery rate for CDOs while the average recovery rate of the CDOs only 5 percent for every dollar. Apart from this , there had a critic argued involved with mortgage-related financial products failed to accurately priced by credit rating agencies and investors failed to accurately priced the risk, and that governments did not adjust their regulatory practices to address 21st century financial markets in the economic crisis 2008. Credit rating agencies badly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble. Credit rating agencies lowered the perception of credit risk by giving AAA ratings to the senior tranches of structured finance products like collateralized debt obligations (CDOs), the same rating they gave to government and corporate bonds yielding systematically lower returns. Flaws in rating methodologies were the major reason for underestimating the credit default risks of instruments collateralized by subprime mortgages. In addition, the lack of historical data relating to the US subprime market also was one of reason that caused incorrect pricing the risk.
Boom and collapse of the shadow banking system
Shadow banking systems typically are intermediaries between investors and borrowers. Shadow banking systems are a system of non-financial institutions that borrow money in a short term then take the money to invest in long-term assets. Before collapsed, shadow banking system was bigger than all the economies except US. It included hedge funds, investment banks and structured investment vehicles such as the Lehman Brothers mini bonds which turned into junk in the economic crisis. They did so by raising fund in the non-deposit market, notably unsecured debt such as interbank borrowing and commercial paper and secured borrowing such as reserve repo and asset-backed commercial paper. Shadow banking systems are not regulated like commercial banks. They offer bigger returns but are more risky. Shadow banking systems used the credit derivatives to avoid standard banking regulations. During boom periods, towering leverage intensifies profits as well as losses during downturns. Among several cases, the purchased of long term assets were included in the mortgage supported securities that are regarded as "toxic assets". These classifications of assets diminished importantly in value since prices of housing declined as well as foreclosures augmented from 2007 until 2009. The unexpected loss incurred by assets backed by US sub-prime mortgage has highlighted the potential high cost investor face. As a result, the markets in these instruments have become extremely illiquid. Vehicles financed by short term commercial paper, namely the SPVs find themselves unable to issue more debt. This forced more and more bank losses on their balance sheet. Apart from that, there was not liquidity backstop for the shadow banking system also became one of the important cause of collapsed of shadow banking system. Hence, depositors refused to roll over their repo agreement that mean they refused to lend new cash for the new repo or they lend less cash for the same amount of collateral when they got nervous about investment bank like Lehman Brother and Bear Stearns. The result is a bank run - only this time the run is on the shadow bank. The refusal of investor or incapacity to offer funds through the short term markets was an initial cause of the Lehman Brothers and Bear Stearns' collapse in 2008. The deflationary argument depends on the collapse of both the shadow and the real (deposit taking) banking system. Hence, the shadow banking system can be say is the murky world of credit, securitization, and derivatives which currently supports and/or holds some $600 trillion in assets.
Commodity bubble
The build-up and eruption of crisis in the financial system was paralleled by an unusually sharp increase and subsequent strong reversal of the prices of internationally traded primary commodities. The collapsed in the housing bubble followed by the rapid increased in the number of commodity price. The oil price rose nearly tripled from $50 to $147 from early 2007 to 2008. Beside the oil price, copper prices increased at the same time as the oil prices. Copper traded reaching $7,040 per ton in 2008 from the $1600 in 1999. The bubble in crude oil, natural gas, copper and other commodities cost at the U.S. more than $110 billion in 2008 which translates to over every American household about $846. The effect was to take an already weak and frail economy and push it down the stairs. The commodities bubble amplified the effects of the housing bubble and financial crisis, making them much worse. The housing bubble and commodity bubble burst caused the situation that the people had to find a new thing to invest in before they realized that there was actually too much money in the system and this brings them to a very big danger because their new investment target will be gold. However, the issue banks were not able to cover the banknotes they printed anymore when the gold price will achieves to $2000-3000 per ounce. Finally the people will lose their trust in money and a super inflation coupled with a deep recession would lead into a financial failure. Commodity bubble brought a lot of drawback to the country. The commodity bubble brought badly effect on American business. High energy cost caused everything included daily expenses in American more expensive. Petroleum is the basis for petrochemicals such as plastic, so the cost of packaging for most goods increased. In addition, most of business takes energy to produce goods and takes energy to transport them through the supply chain. Hence, high energy cost caused suffered of the business in a country. The commodity bubble also caused the increasing the unemployment rate. Oil price, copper price and other commodity cost forced many company into bankruptcy and lay-off their employees. The employees who were lay-off were in hot water because they were force to spend dramatically more on food and energy. Apart from this, banking crisis also became more crises on the commodity bubble. As the consumers spent dramatically more on the food and energy, they were unable to pay their debt to bank. This cause the bank became illiquid. Commodity bubble also caused the housing crisis more severe than before. This was because the price on food and energy rose caused the people difficulty to make their mortgage payment and how some of those lost their house to foreclosure.
Systemic crisis
Systemic crisis was a crisis that troubles affect the whole financial and monetary system. It can cause a meltdown of most financial instruments and institution. It brings also dire consequence on the whole economic system. So, systemic crisis was also a crisis of capitalism itself. The financial crisis began with the sub-prime mortgage crisis in the US in mid-2007. The financial crisis was not strictly a financial crisis which only affects banks, stock markets and currency markets. The crisis was affect widely. The impacts of crisis on real economy are becoming clear day by day. Many European countries have witnessed several episodes of social unrest in the streets. The crisis has also led to overthrow of governments in Czech Republic, Latvia and Hungary. Many more governments fear spurt in social and political unrest in the future. Hence, this financial crisis is essentially a crisis of capitalism, which was systemic crisis. The crisis has shown that capitalism is inherently unstable and prone to failure. It has shown that capitalism can destroy itself. It can not merely destroy financial wealth such as paper money; it can also destroy jobs, social security, real economy, productive assets and ecological wealth. It was the real threat for the future for humankind and the planet. Systemic failure was driven by the financial deregulation, large-scale financial investments on commodity futures markets, and widespread currency speculation. Financial deregulation was driven by an ideological belief in the virtues of the market. It has allowed "innovation" of financial instruments that are completely detached from productive activities in the real economy. This instrument favors speculative activities that build on apparently convincing information, which in reality is nothing other than an extrapolation of trends into the future. Besides this, speculation of currency and financial market were leaded to considerable misalignments of exchange rates and to overspending in capital-receiving countries. This was one of the important reasons that caused growing imbalance between countries. The consequences of the price and exchange rate speculation were the build-up and eruption of crisis in the financial system was paralleled by an unusually sharp increase and subsequent strong reversal of the prices of internationally traded primary commodities. It put a very heavy burden to developing countries on import of food and energy.
Role of economic forecasting
Economic forecasting is a process of making prediction about the future economic as a whole. The role of economic forecasting is a "top-down" investment process. In the commercial field, almost all the financial service firm put their effort on economic forecasting. It is start with an outlook for the economy and monetary condition, continues to the strongest industries, follows with detailed company study for stock selection and may include an overlay of technical analysis to provide a timing dimension. Some would add analysis of social and political conditions even before economic studies. Typically, economists mostly failed to predict the worst international economic crisis. General public believed that the majority of economists have failed in their obligation to predict the financial crisis though popular articles published in the mass media. Due to the bad images of the economists to predict the financial crisis, it was caused the severe financial crisis during 2008. This is because most people did not believe the professional prediction of economists. For example, Nouriel Roubini who was a economic professor in New York University. Most of the people call him as Dr. Doom. Three years ago, he stood in front of the International Monetary Fund and predicted that the crisis was brewing. He warned that the United State was likely to face an once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession in the coming months and years. Then and there, the audiences seem skeptical, dismissive, even roundly ridiculed for it. However, the time proved the prediction of the Dr. Doom. In the year that followed, subprime lender began entering bankruptcy, hedge funds began going under and the stock market plunged. There was declining employment, a deteriorating dollar, ever-increasing evidence of a huge housing bust and a growing air of panic in financial markets as the credit crisis deepened. After that, whenever most of the optimists have declared that the crisis had passed behind us, Dr. Doom has countered with steadfast pessimism. He declared that one or more of the large institution would go into collapsed. After six week later, Bear Stearns collapsed. Due to the government and most of the people misdoubt with the economic forecasting and unplanned for the emergency measures, the severe economic crisis occurred and most of the financial institution collapsed.
