Suppose there are two mortgage bankers. Banker 1 has two $700,000 mortgages to sell.

Suppose there are two mortgage bankers. Banker 1 has two $700,000 mortgages to sell. The borrowers live on opposite sides of the country and face an independent probability of default of 6%, with the banker able to salvage 41% of the mortgage value in case of default. Banker 2 also has two $700,000 mortgages to sell, but Banker 2’s borrowers live on the same street, have the same job security and income. Put differently, the fates and thus solvency of Banker 2’s borrowers move in lock step. They have a probability of defaulting of 6%, with the banker able to salvage 41% of the mortgage value in case of default. Both Bankers plan to sell their respective mortgages as a bundle in a mortgage-backed security (MBS) (i.e., as a portfolio). Which of the following is correct?

Banker 2’s MBS has more risk but the expected returns on both MBS are the same.

Banker 1’s MBS has less risk and lower expected return.

Banker 1’s MBS has more risk and lower expected return.

Banker 2’s MBS has less risk but the expected returns on both MBS are the same.

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