To evaluate: The interest rate on the mortgage-backed security.
Answer to Problem 1TY
The interest rate on a mortgage-backed security is higher than the treasury securities.
Explanation of Solution
With the help of given information, it is clear that the expected default rate on a mortgage-backed security is 4% per year and the corresponding Treasury Security annual interest rate is 3%. Investments in houses or securities depend on the interest rate. If the home mortgage interest rates are less, then the prices of the houses will increase. Therefore, as the purchase of houses is more profitable, investors would prefer doing it then investing in the securities. So, here, in this case, the interest rate on a mortgage-backed security is higher than the treasury securities and is a suitable situation to encourage investment in houses.
Further, if the expected default rate is 8% then the house prices will fall as people won’t be in a position to invest in the purchase of houses. A higher interest rate on a home loan will not attract the customers.
A low mortgage interest rate will always increase house prices.
Introduction:
Mortgage-backed security: A mortgage-backed security is supposed to be an investment similar to a bond. The only difference is that this represents a bunch of home loans taken from a bank.
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