The financial system not only in the US but of the whole world was greatly affected due to the

Subprime Mortgage Crisis that took place in 2007. Several explanations for the crisis that happened coming from different people of various professions and expertise exist. For the purpose of analyzing the mentioned failure in the financial system, the focus of the paper would be on financial instruments specifically securitization which proved to be the major contributor. Banks began turning their loans into sellable assets to earn money as they are securitized and off-loading the risks to the buyers at the same time. It is said that the subprime mortgages are a representation of extreme version of credit risk transfer process of banks. The creation of loans is initiated by banks with the intention of passing on the underlying risks to several outside investors. However, the transfer of risks from banks to market unexpectedly returned where it came from. The risks landed back to the banks leading to the crisis. It becomes evident here that banks exposure to risk is high. It should be clear that it is credit risk that we are referring here which is defined as the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligations. Credit exposure and default as drivers of credit risk largely affected the subprime failure. As banks turned to loans and mortgages, engaging in financial instrument-reducing risks, they began taking higher risks which lead to their further exposure. Their over-confidence resulted to their missing the right strategy to take and right management of funds. The increase in interest rates and dropping of value of homes at the same time caused inability for borrowers under financial constraints to pay which became a payment shock to them. Following this event was the increasing number of default rates on subprime mortgages. Investments in these mortgages became huge losses for various investors. The formulation of the Black-Scholes Model to price an option (a type of a derivative that gives the buyer a right to buy something in the future at a fixed price) became the obsession of many. The use of derivatives during this time was not so much of reducing the risk but even taking more of it for the sake of making money. During 2007 and even before that, credit default swaps were soaring high and most of these swaps were on mortgages which went into a big drop. Because investments were interconnected, the sudden drop led to failure of several investments: a domino effect. Derivatives, in this case the credit default swaps, are not to be mistaken as the reason for crisis in the financial system although it contributed to the acceleration of the breakdown. The crisis was so severe that its effects were felt not only by financial institutions but also by ordinary consumers. It is not a point of debate to say that banks are highly necessary and essential in the current market system. When banks, universal as their services are, are in predicament, almost everyone suffers including both the wealthy and the commoners. Businesses are left to struggle and ordinary people cut off their consumption to reduce their expenses.