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Supplemental Resource Lesson 6

Supplemental Resource Lesson 6

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Supplemental Resource Lesson 6

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  1. Supplemental Resource Lesson 6

  2. 1950-1997 Housing Price Trend?

  3. Increasing demand would increase housing prices and increase housing quantity. Real Home Price Index Supply of houses P2 P1 D’ Demand for houses Q1 Q2 Quantity of housing

  4. Declining supply also would cause prices to rise but would result in a decrease in housing quantity. S’ Supply Price P2 P1 Demand Q2 Q1 Quantity

  5. Rising Building Costs?

  6. Growing Population?

  7. Long-term Interest Rates?

  8. Short-term Interest Rates?

  9. Short-term Interest Rates?

  10. Potential Returns: Old System Place $100,000 in savings account: Deposit earns 1% interest $ 1,000 profit Home loan, owner does not default: principal $100,000 interest $ 20,000 Total payments $120,000 $20,000 profit Home loan, owner defaults: Sell property $ 40,000 $60,000 loss

  11. Strong Incentive to Check Creditworthiness If you do not pay for a credit check: Borrower is not a good risk; you do make the loan: −$60,000 Borrower is a good risk; you do make the loan: +$20,000 If you do pay for credit check ($5,000) Borrower is not a good risk; loan is not made: −$ 5,000 Borrower is a good risk; you do make the loan: $20,000 profit – $5,000 credit check +$15,000

  12. Purchased mortgage, no default without credit check: with credit check : Purchased mortgage without credit check, default: $120,000 $120,000 $40,000 $100,000 $100,000 $100,000 $0 $0 $5,000 $15,000 $20,000 −$60,000

  13. The Mortgage–Backed Security • Mortgages are bundled together and then pieces are sold off to investors. • Why do this? • Spreads risk • Increases liquidity • Allows small investors to participate • More money flows into the housing sector

  14. Securitization Split into 10 shares $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 Mortgage #1 Mortgage #2 Mortgage #3 Mortgage #4 Mortgage #5 $500,000

  15. If no homeowners default: principal $100,000 interest $ 20,000 Total payments $120,000 X 5 = $600,000 ÷ 10 $60,000 ‒$50,000 cost / share $10,000 profit / share If one homeowner defaults: 4 X $120,000= $480,000 Home sale $ 40,000 $520,000 ÷ 10 $ 52,000 ‒$50,000 cost / share $2,000 profit / share Consequences of default are spread across all 10 investors

  16. Old System: Concentrated Risk Strong incentive to check creditworthiness because the negative consequences of default to any single investor were large. New System: Dispersed Risk Less incentive to check creditworthiness because the negative consequences of default to any single investor are small.

  17. Pros and Cons of MBS