See: Mortgage.
You may have heard of a mortgage-backed security. They became famous during the financial crisis of 2007-2008. They were debt instruments (similar to bonds) that were backed by a group of home mortgages. Watch The Big Short if you haven't.
Wall Street banks bought tons of them during a housing boom of the early part of the 2000s, thinking they were safe investments. They were then stuck holding a bunch of them when the market collapsed, leading to a financial crisis and an eventual government bailout.
Mortgage pools provide the basis of mortgage-backed securities...like how batter provides the basis of a cake, or how water provides the basis of a wet t-shirt contest. A mortgage pool consists of a group of similar mortgages...borrowers with similar credit scores buying houses of similar values. These get bundled together (or pooled, if you'd rather). Then this big pile of mortgage debt becomes the basis of securities (those mortgage-backed securities we mentioned before), which can then be sold on the open market.
Having a mortgage pool provides some diversification, in that a single default by one of the associated homeowners doesn't cause a major threat to securities issued based on the pool. However, this diversification is limited.
All the mortgages in a pool are similar...that's part of the plan. They likely have the same risk, duration, geographic area, size, type of collateral (a house), color of paper used to sign the documents, etc. This means that all the mortgages will react in a similar way to market forces. An economic downturn that increases the number of home defaults will impact all the homeowners that contribute to the pool in the same way. It's like a school of sardines when a shark enters the area...they all turn the same direction at once.
Since everything reacts in a similar way to market influences, when things go bad, they go bad for all the pool contributors. In that case, it's not diversification. It's more like...gasoline on a fire.
Hence the issues that came up in the mortgage meltdown that led up to the 2007-2008 financial crisis. When the market turned, it turned for everyone in the same way. Many pools became completely toxic, because they weren't filled with completely independent actors. They were filled with a bunch of situations likely to react exactly the same to a bad housing market...i.e. with people who stopped paying their mortgages.
Related or Semi-related Video
Finance: What is Adjustable-Rate Mortgag...17 Views
Finance allah shmoop What is adjustable rate mortgage or arm
Well here's an arm and here's a leg and that's
What Renting the money to buy a home costs you
Yeah Okay Eight r m stands for adjustable rate mortgage
The rate well that's The interest cost of the money
or the cost of renting that money to buy the
home Well the rate isn't it fixed in this case
like five point seven percent for thirty years Where you
know in advance that your monthly payments going to be
nine hundred forty three bucks a month or whatever it
is that would be a fixed mortgage a fixed number
You can count on it for all three hundred sixty
payments And then the house is all yours So that's
fixed then what's adjustable like yes the interest rate changes
But how does it change Well in a standard arm
there is some global standard on which the rates are
often price like lie bore the london interbank borrowing offering
rate It's one of the key things that price is
the cost of renting money all around the world with
the actual rate of libel or is generally reserved for
banks like super cheap cost of renting money to banks
who are very likely to pay back the money with
no hassle that rate is more or less what banks
pay for running the money along with blue chip customers
in real life The banks then mark up a premium
on top of the rate that they're paying to rent
the money to themselves And then they resell or re
rent that money teo their prized customers So the pricing
of bank my views in renting money to joe six
pack could be something like lie boer plus three percent
or three hundred basis points So if libel or is
it didn't say two and a half percent today the
adjustable rate might be five and a half percent and
all that's great honor given alone It might mean that
for a while you're paying seven hundred twelve dollars a
month for your house payment wonderfully cheap and in fact
banks market these low rates initially to help people be
able to afford tto by that new home and live
of the dream You know the american dream usually with
an arm there's a teaser rate that starts really low
Like at live or live or plus ten basis points
or something like ridiculously cheap for six months or a
year something like that Then it has an incremental set
of step ups in interest costs and venit adjust with
the markets usually upward maybe upward by a lot Remember
there's a reason it's called a teaser rate but then
if we get inflation or a you know just bank
nervousness for there are weird effects from brexit or the
volume of transactions going through london or something weird happens
Well then the liquidity drops and interest rates rise So
now lie board goes up and up and up to
four and a half percent and wealth contractually in your
mortgage paperwork you have to pay live or plus three
hundred basis points no matter what So now that's seven
and a half percent interest on the dough you borrowed
and well we're that toe happen It's likely that your
monthly payment has skyrocketed from seven hundred twelve dollars a
month is something more like twelve hundred dollars a month
or more Can you handle that big of a payment
Well have you done a fixed rate loan at nine
Hundred forty three dollars a month Well you'd still be
paying on that number but you rolled the dice with
an arm and now you owe big bills There go
that arm and a leg thing we warned you about 00:03:26.033 --> [endTime] eh
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