Assume that professional experience secures you employment at a well-known, large investment bank that trades in securities of many types, including mortgage-backed securities. This large bank is unlike a small community bank (a "Main Street" financial institution, such as the one you worked at while serving Jucheng and Dave in the Module 2 Discussion: The Big Picture), which typically holds loans after origination. Larger banks purchase loans from Main Street financial institutions and sell these to Wall Street firms, packaging and selling mortgage-backed securities to investors and financial intermediaries. Mutual funds, retirement funds, financial institutions, and large investors typically hold these securities as investment goods.

Noticing that home prices nationally have been rising at seemingly high rates while wages do not appear to be rising as quickly, you wonder how so many borrowers can qualify for home loans given this mismatch in price versus ability to pay. Your colleague Loren explains that most home loans are packaged and sold, so banks issuing mortgages frequently lend to "sub-prime" borrowers who may not necessarily be expected to meet loan demands in the longer term. She notes that few investors worry about default since home prices historically only move upward, on average, and loans are sold and packaged with many others, lowering the risk that the whole package, versus a few underlying assets, will fail. You wonder if managers at your firm fully understand the risks of holding mortgage-backed securities. Your colleague does not believe that your worries are valid, based on the structure of these large packages backed by homes and land. Loren asks you to consider two facts. First, large numbers of mortgages, packaged together, are low risk because the numbers or underlying mortgages reduce the risk of default. Second, most financial institutions, particularly large ones, hold these securities as investments, and these securities are reasonably liquid because so many entities purchase them regularly. In other words, asset-backed securities are easily sold if they appear troubled. She concludes that many large financial institutions probably hold substantial amounts of these securities, so she hopes she is correct.

Section 1

• Based upon this module's required reading, explain briefly how interest rate movements affect the valuation of any one debt or equity asset traded in financial markets. You may want to review pp. 202-204 of our textbook.

Section 2

• For the purchaser of mortgage-backed securities (e.g., financial institutions, intermediaries, or investors) or any other security that has an increased risk of default, identify one risk that you think is possible and explain your conclusion. You may want to review pp. 201-210 and 253 of our textbook.

Section 3

• Comment on any one aspect of the connection between Wall Street and Main Street that you learned about in reflecting on sections 1-3.