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Tuesday, September 11, 2007

Subprime contagion fueled by derivatives

September 10 2007
Complex derivatives, such as mortgage-backed securities and collateralized debt obligations, have probably helped subprime problems spread across much of the financial sector, possibly affecting economic activity, Federal Reserve official Janet Yellen said on Monday. Mortgage-backed securities (MBS) are packages of home loans that are sliced up into different bits and sold to institutional investors. Collateralized debt obligations repackage MBS and other asset-backed securities into yet more securities for sale. These relatively new derivatives and other financial innovations helped fuel the housing boom. They were hailed as beneficial instruments because they encouraged the wider spread of risk among a more diverse set of investors. Other examples include collateralized loan obligations and credit default swaps. By spreading and diversifying risks, instruments like MBS and CDOs may have increased the chances that disruptions in small parts of the financial world have a broader impact.


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