In the early 2000s, as a way to diversify risk, financial institutions bundled mortgages from many people into one investment. The underlying concept was that, if one person defaulted on a mortgage, the effect on the overall investment-the value of real estate-would be small, since the other mortgages would continue to provide returns.
(a) If this approach succeeded in reducing risk, would the interest rate for mortgages go higher or lower? Why?
(b) If the interest rate for mortgages did as you said in (a), would the number of people seeking to buy houses increase or decrease? Why?
(c) What would you expect to happen to housing prices in response to your answer to (b)? Why?
(d) There were many reasons why housing prices increased across the 2001-2008 period, including government policies by both Presidents Clinton and Bush that made home ownership easier. Given that people observed this upward trend in prices, would people want to buy a house in the present or wait until the future when they expected houses would be more expensive? Can an increasing price lead to more buyers? Why?
(e) What happens when the market runs out of buyers? By 2007 there weren't many new buyers left: They already had houses. Would prices continue to increase then?
(f) In 2008 and 2009, many people found themselves holding mortgages requiring them to pay far more than they could recover if they sold the houses. A number of people, as a result, defaulted on their mortgages. What happens to prices? And what happens to the desire to buy a house as a "good investment"?
(g) Was risk in fact diversified? That is, was the likelihood of default by one borrower unrelated to the likelihood of default by others?