Three characteristics for risk are that risks are interdependent, they evolve over the business cycle, and their appearance can be very uneven over the cycle. These characteristics continue to appear business cycle after business cycle, yet we are constantly surprised. The latest version of this was the housing boom and bust.
a. Liquidity, marketability, and the value of the underlying asset (housing) were assumed to be independent risks. Yet, during the housing correction everything appeared to fall apart. Explain why.
b. How did the success of the early home buyers and mortgage lenders give rise to the increase in risks over the cycle and why might such risks be overlooked by the market?
c. Early in the cycle the perceptions of risk were minimal. Over time, the delinquency rates on subprime lending kept rising with little apparent concern until, all of a sudden, risk perceptions skyrocketed. This pattern repeated earlier cycles most recently seen in the dot-com and high-yield bond corrections. Why might such a process of uneven risk perceptions and then a sudden break be so regular in the behavior of investors?