Miscellaneous Essay

1837 WordsFeb 5, 20138 Pages
Derivatives: How They Played a Part in the Housing Market Crash Derivatives are securities whose value results from the price of something else (currency, stocks, bonds, credit card debt, mortgage, etc). It’s an imaginary security that has no tangible value of its own. It is essentially a “bet” on the value of future risk or securities. Initially, these bets were made to hedge risk, but today the derivatives market is nothing more than speculation. Not only is this market complex and difficult to value, it is unregulated by the Securities and Exchange Commission which means that there were no policies to insure that the corporations had funding to back up their agreements. In the world financial system, bets have been made on just about anything, and several banks have made a massive amount of money from it. Derivatives played a major part in the downfall of the housing market. The housing market experienced growth during 1995 – 2006. There was plenty of money available for new loans as the banks were issuing new types of lending such as adjustable rate loans, interest only loans and zero down loans. People were buying like crazy as the prices of housing increased. They were “flipping” houses to make a quick profit. With every loan issued, banks would promptly securitize the loan and pass the risk off to someone else. The amount of derivatives held by the financial institutions burst and the total percent of cash reserves declined. During 2003 – 2007 subprime loans had increased 292% from 332 billion to 1.3 trillion. (DeGrace, 2011) In mid-2006, the housing market reached its peak and shortly after began to decline. Security-backed mortgages such as subprime loans lost most of their value, worldwide investors decreased purchases of security-backed mortgages, and refinancing became much more difficult. Adjustable rate loans (ARM) interest rates

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