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Supplemental Resource Lesson 6 1950-1997 Housing Price Trend? 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 Declining supply also would cause prices to rise but would result in a decrease in housing quantity. S’ Price Supply P2 P1 Demand Q2 Q1 Quantity Rising Building Costs? Growing Population? Long-term Interest Rates? Short-term Interest Rates? Short-term Interest Rates? Potential Returns: Old System Place $100,000 in savings account: Deposit earns 1% interest $ 1,000 profit Home loan, owner does not default: principal interest Total payments $100,000 $ 20,000 $120,000 $20,000 profit Home loan, owner defaults: Sell property $ 40,000 $60,000 loss 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 Purchased mortgage, no default without credit check: with credit check : Purchased mortgage without credit check, default: $120,000 $120,000 $100,000 $100,000 $5,000 $15,000 $0 $20,000 $40,000 $100,000 $0 −$60,000 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 Securitization Split into 10 shares Mortgage #1 Mortgage #2 Mortgage #3 Mortgage #4 Mortgage #5 $500,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 If no homeowners default: principal interest Total payments $100,000 $ 20,000 $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= Home sale Consequences of default are spread across all 10 investors $480,000 $ 40,000 $520,000 ÷ 10 $ 52,000 ‒$50,000 cost / share $2,000 profit / share 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. Pros and Cons of MBS Positives Negatives Spreads risk Reduced incentive for credit check Banks less concerned about creditworthiness Global effects Liquidity Smaller investors More money in housing sector