Final answer:
The sale of credit default swaps during the financial crisis exacerbated the situation as they acted as insurance on risky mortgage-backed securities. These risky assets defaulted en masse when the housing bubble burst. Securitization practices separated banks from lending risks, contributing to the crisis as banks sold mortgage loans bundled into bonds.
Step-by-step explanation:
The sale of many credit default swaps significantly worsened the financial crisis of 2008-2009. Financial institutions sold these products as a form of insurance against the default of mortgage-backed securities (MBS). However, when the housing bubble burst, there was a massive rate of loan defaults which strained the financial institutions responsible for paying out under these swaps. This destabilizing sequence was further accelerated by securitization, where banks bundled mortgage loans into CDOs and sold them as safe investments, despite the underlying assets being often composed of subprime mortgages.
The process of securitization made it possible for banks to distance themselves from the risks associated with the loans they originated. By selling these loans, which were then securitized and transformed into bonds, banks could quickly offload potential risks onto investors. However, what initially allowed banks to profit and expand the housing market eventually led to a cascade of defaults and a loss of trust in financial systems around the globe when those subprime borrowers began to default.
As part of the explanation, consider a pool of mortgages totaling $1,000,000 with an interest rate of 5% and amortized over three years with yearly payments. This pool can be converted into a series of annual coupon bonds with maturities of one, two, and three years, which would be sold to investors looking for returns based on mortgage payments from homeowners.