Transcript Understanding the Role of the Federal Reserve in Today`s Economy

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