To what extent was the Global Financial Crisis the result of the subprime mortgage Crisis?

It is often argued that the subprime mortgage crisis is the main cause of the Global Financial Crisis; yet we must not forget to take into account other long-term and short-term causes, such as financial assets were riskier than they seemed, increasingly complex securitization, greater interconnectedness across institutions and countries and heightened leveraging. The Global Financial crisis became as big as it did, not only because of the initial conditions, which laid the seeds, but more importantly it was the amplification mechanisms that magnified the effects so dramatically. (Blanchard) One contributing factor to the Global Financial crisis is the illusion painted of subprime mortgages to be riskless. The reason for the underestimation of the true risk may have been the large savings by Chinese household which led to low world interest rate. (Blanchard and Quah) This in turn leads to a search for yield by investors sought the return of assets. This was further heightened by the common feeling of optimism amongst borrowers and lenders about future returns. US trade deficit continued to spiral down due to securitization; securitization led to complex and hard to value assets on the balance sheets of financial institutions. Investors sought out these securitised products because they appeared to be relatively safe while providing higher returns in a world of low interest rates. This reduced the value of their balance sheets and also reduced their liquidity which further led to distrust in the economy, and thus further fuelled the financial crisis. As a result of globalization and industrialization, the interconnectedness of financial institutions meant that what happened in one would have an impact on the others; this is known as the spillover effect. Increasing interconnectedness can be seen as a catalyst in bringing about the Global Financial Crisis; it leads to effects such as dynamic spillovers which means what happens in one county is going to effect countries all over the world, and thus further fuelled the Global Financial Crisis. The years leading towards the Global Financial crisis, there was a common feeling of optimism and underestimation of risk which meant that there was an increase in leverage. If the value of the assets became lower, then the higher the leverage, the higher the probability that capital would be wiped out, the higher the probability that institutions would become insolvent. In summary, it can be said the risk of insolvency rises with leverage, thus causing instability and distrust in the economy. Having said that, the aforementioned initial conditions only laid down the seeds for the Global Financial Crisis, it was the amplification mechanism which really defined the extent of the Global Financial Crisis. When the probability of default on some assets increases, both the expected loss and the uncertainty associated with the asset side of the balance sheet increases. The value of capital becomes both lower and more uncertain, increasing the probability of insolvency. As institutions are increasingly at risk of no longer being able to fund themselves, institutions are forced to sell assets at fire sale prices. This further contributes to decreasing value of assets and in turn

reduces their capital forcing them to sell more assets. Furthermore, assets are more opaque and thus difficult to value, the increase in uncertainty will be larger. Another amplification mechanism comes from the need by financial institutions to maintain an adequate capital ratio. Due to a decrease in the value of assets and thus lower capital, financial institutions must either get funds from outside investors or deleverage in order to decrease the risk of insolvency. Therefore, opacity, connectedness and leverage all imply more amplification. To conclude, it is obvious that that the subprime mortgage crisis was a significant contributing factor in the Global Financial Crisis. However, the initial conditions on themselves would not have made the Global Financial as big as it became, but more importantly, it was the amplifying mechanism which determined the extent of the Global Financial Crisis.