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occurs when an increase in asymmetric information from a disruption in the financial system causes severe adverse selection and moral hazard problems that render financial markets incapable of channeling funds efficiently from savers to household and firms with productive investment opportunites
the elimination of restrictions on financial markets and institutions, or when major financial innovations are introduced to the marketplace ,as occurred recently with subprime residential mortgages.
With restrictions lifted or new financial products introduced, financial institutions frequently go on a lending spree. Expand their lending at a rapid pace
increases in asset prices in the stock and real estate markets that are driven well above their fundamental economic values by investor psychology
substantial unanticipated decline in athe price level sets in, leading to a further deterioration in firms net worth because of the increased burden of indebtedness
mortgages for borrowers with higher expected default rates than prime, but with better credut records than subprime borrowers
By lowering the transactions costs, computer technology enabled the bundling together of smaller loans like mortgages into standard debt securites
Mortgage backed securities
The ability to cheaply bundle and quantify the default risk of the underlying high risk mortgages in a standardized debt security
structured credit products
derived from cash flows of underlying assets and can be tailored to have particular risk characteristics that appeal to investors with differing preferences
collateralized debt obligations (CDOs)
paid out the cash flows from subprime mortgage backed securites in different tranches, with the highest rated tranch paying out first, while lower ones paid out less itf there were losses on the mortgage backed securites
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