Derivatives the Line Between the Essay

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Interest rates are set at the national level, and the state of the economy is also national. Additionally, trends in investment flows (particularly into real estate) also proved to be national. As a result, the level of market risk remained high even when the level of asset-specific risk was reduced through the securitization process.

It is not inevitable that this had to happen this way. Banks, however, overinvested in the mortgage-backed securities, believing them to be safe. This reflected a lack of understanding of the true risks associated with mortgage markets, and in general the risks associated with the underlying assets of many MBSs. There are two reasons for this. Securitization created a false sense of security, that diversification would lead to these products having low risk levels. AAA ratings from ratings agencies confirmed this view, despite it being false.

The second reason is that the securitization process was complex. A simple form of securitization, such as a basic equity mutual fund, is easy to understand in terms of its underlying assets and therefore its risk. With mortgage-backed securities, the securitization process was complex and to some extent this obfuscated the true risks associated with the products, and made it nearly impossible to analyze the security in terms of its underlying assets.

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As a result, investors had little ability to determine the true risk levels of these securities. This is a risk that is specifically introduced in a complex securitization process.

The securitization process adds value to securities because it allows them to be bundled in a manner that encourages investors to take on risky assets, if they are packaged with low-risk assets. This was the appeal of mortgage-backed securities. However, the process also made it difficult to ascertain the risks associated with these assets. The result of this was a financial crisis, as banks in particular overinvested in this asset class, believing it to be safe.

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