However, when interest rates began to rise and housing prices started to decline, refinancing became more difficult and subprime borrowers were unable to make their mortgage payments, which resulted in a continuous subprime cycle throughout all markets in the United States.
Subprime borrowers were unable to pay their mortgage payments, so several financial institutions made the effective financing approach by issuing financial agreements called Collaterized Debt Obligation (CDO), mortgaged-backed securities (MBS) and a form of credit insurance called Credit Default Swaps (CDS) to sell to investors across the world to invest in the U.S. Graph 1 illustrates that the growth of CDOs issued increased dramatically from 2004 to 2006, then dropped slightly in 2007. These types of financial innovations derived value from increasing in mortgage payments and housing prices, becoming popular. The usages of the product expanded dramatically. The financial innovation was carried out by firms whose activities were not regulated. The transactions became too complex and the policies were inclined to support deregulation of the financial market, sometimes being loose of supervision. The subprime mortgage crisis thus became a full-fledged financial crisis, and turned to a collapse in financial markets.
As the subprime crisis intensified, financial institutions faced difficulties in raising capital forced default protection, and sellers (such as Northern Rock and American International Group (AIG) were reducing credit ratings. This left depositors with no confidence in the stability of financial institutions and they began to withdraw their deposits, which was the main cause of bankruptcy of financial institutions. For example, due to the bankruptcy of one major institution like the AIG, it brought down the whole financial system. In the beginning of 2008, “The Bear Stearns Companies,