Financial Risk Manager Part 1

Explanation

The global financial crisis of 2007-2008 spread rapidly worldwide primarily because:

Key Mechanism:

• Foreign banks in Asia, Europe and other regions had purchased substantial amounts of collateralized US debt (primarily mortgage-backed securities and CDOs)
• When US mortgage defaults rose dramatically, the value of these collateralized debt instruments plummeted
• This caused massive losses for international banks that held these assets
• Consequently, global lending froze as banks became risk-averse and faced solvency issues

Why Other Options Are Incorrect:

Choice A: While US banks did finance foreign banks, this was not the primary transmission mechanism. The crisis was fundamentally a solvency issue related to toxic assets, not just a liquidity problem.

Choice B: The crisis spread was not primarily due to emerging market instability concerns. The core issue was direct exposure to US housing market through complex financial instruments.

Choice C: While declining US demand for exports did contribute to the global recession, this was a secondary effect that occurred after the financial contagion had already spread through the banking system.

The correct transmission mechanism was the global interconnectedness of financial institutions through complex US mortgage-backed securities, which created a domino effect when the underlying mortgages defaulted.