ECON 3303 Test 2 Study Guide
ECON 3303 Test 2 Study Guide Econ 3303-001
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This 19 page Study Guide was uploaded by Josh Radcliff on Wednesday October 28, 2015. The Study Guide belongs to Econ 3303-001 at University of Texas at Arlington taught by Kathy Kelly in Summer 2015. Since its upload, it has received 300 views. For similar materials see The Economics of Money and Banking in Economcs at University of Texas at Arlington.
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Date Created: 10/28/15
Josh Radcliff Test 2 Study Guide Econ Money and Banking Prof Kathy Kelly Chapter 6 The Risk and Term Structure of Interest Rates Book Notes 0 The reason why bonds with the same term to maturity have different interest rates is because of the risk associated with each bond Risk Structure of Interest Rate why do interest rates change o You default when the issuer of the bond can39t make the interest payments or pay off the face value in time or at all 0 0 Corporations who suffer losses are likely to default or suspend payments on bonds they issue The US Treasury is because they have the ability to either print more money or collect more taxes How much additional interest a person will accept to buy a bond with risk of default over a default free bond Risker bonds always have a positive premium 0 O 0 O O When default risk on corporate bonds increases demand for corporate bonds shifts to the left and demand for defaultfree US Treasury bonds shifts right ceteris paribus all other things equal Since the price for T bonds US Treasury Bonds goes up the interest rate goes down and since the price for C bonds corporate bonds goes down interest rates go up The difference in the new interest rates is the risk premium for C bonds Pg 118 Figure 2 is a great explanation of risk premium in graph form A bond with default risk ALWAYS has a positive risk premium and they are positively related so when default risk increases so will the risk premium placesbusinesspeople who determine how likely it is for a corporation to default Bondssecurities with a low risk of default BBB or Baa and higher bonds with a higher default risk than investment grade securities o When liquidity decreases the result is the same as when default risk increases 0 Therefore when C bonds become less liquid the shifts of the curves for both T and C bonds and the resulting risk premium is the same as when default risk on a C bond increase Demand for T bonds shifts right Demand for C bonds shifts left lncome Tax Considerations 0 state and local government bonds they do have default risk whose interest rates are lower than T Bonds So if they have default risk why are the interest rates lower than the defaultfree T bond These bonds are exempt from federal income taxes In other words the demand for these increases because the expected return would increase since you don39t have to expect tax withdraws Your return is higher because you don39t have to pay taxes on it 0 Compare M and T bond graphs with Figure 3 on pg 123 When tax exemption is applied demand for M bonds increases causing the price to increase and interest rate to decrease When demand shifts right demand for T bonds goes left causing price to decrease and interest rates to increase 0 The relationship among interest rates on bonds with different terms to maturity Graphs change in interest rates depending on their term to maturity the yield curve shows how the interest rate changes over time The term structure of interest rates must consider the following facts 1 The interest rates of bonds of different maturities move together over time 2 When shortterm interest rates start low it is likely to slope upward the longer the term and vice versa 3 The yield curves almost always slope upward So how are interest rates on bonds of different maturities related There is no exact answer but there are 3 theories about it The most precise answer would be a theory that includes all 3 facts listed above Theory 2 Theory 1 The interest rate on a longterm bond equals the average of the short term interest rates that people expect to occur over the life of the longterm bond 0 Ex you have a twelve year bond with an interest rate of 5 Leading up to the maturity of that bond there are 6 two year bonds with interest rates of 3 4 5 5 6 and 7 You should be able to take the average of those percentages to give you the same interest rate of the one 12 year bond 0 Assumption for this theory People must only want to hold one type of bond over the other 0 Problem with this theory It doesn39t explain why yield curves typically slope upward The markets for different maturity bonds are separate and segmented and therefore not related at all o The interest rate is determined by a supply and demand for the bond and is not affected by the returns on other bonds with different maturity dates 0 Assumption for this theory Bonds with different maturities are NOT substitutes 0 Problem with this theory It can39t explain why interest rates of bonds with different maturity dates move together in the same direction Theory 3 Liquidity Premium and Preferred Habitat Theories The most used and most accurate theory a combination of theories 1amp2 o The interest rates of a longterm bond equals the average of short term interest rates expected to occur over the life of a long term bond PLUS a liquidityterm premium that responds to supply and demand conditions for that bond o Investors prefer short term bonds because there is less interest rate risk so the liquidity premium offered to longterm bonds gives the investor incentive to buy the longer term bond with the higher interest rate risk 0 Assumption for this theory bonds of different maturities are substitutes o What can you determine from this theory A steeply rising yield curve means that short term interest rates are expected to rise in the future A moderately steep yield curve means that short term interest rates are not expected to rise much A at yield curve means that shortterm rates are expected to fall moderately in the future because the added liquidity premium to the long term bond still equals the current interest rate An inverted negatively sloped yield curve means that short term interest rates are expected to fall sharply in the future Chapter 7 Stock Market Theorv of Rational Expectations and Ef cient Markev Hvoothesis Book Notes Computing the Price of Common Stock 0 someone who owns stocksharesa percentage of a company Stockholders are meaning you get dividends at the end once the company computes net earnings o The value of an investment is determined by using the present value to predict future earnings In other words How much will it cost me today to earn X amount of pro t in the future 0 Different models for computing price of common stock If you buy the stock and hold it for one period you get X amount paid to you in dividends P D1 P1 0 Formula 0 16 16 P0 is the Current Price of the Stock it39s actual value not necessarily what it is selling for D1 is the Dividend paid at the end of the one period per share of stock owned Ke is the required return on investments in equity a percentage pro t you are willing to earn P1 is the predicted sale price of the stock at the end of the pe od lf P0 is greater than the price that the stock is offered you can buy it because in the end you are predicted to pro t by the difference of the two plus the dividend Same as the one period Dn valuation model except you keep adding K n for however many periods you are receiving dividends Official Formula 0 D P P quot f 0 20quot 1Kef f the nal period n Period 1 2 3 etc Keeps going up with each period and you add them together The sigma 2 means that for every value of n between 1 and in nity the following equation is applied and added to the previous tota Problem This assumes that the dividends will be the same each year Since dividends are bound to change from year to year this model is tough to compute so other formulas are available P0 How the market sets security prices 0 1 The price is set by the buyer who is willing to pay the highest price o 2 OR the market price is set by the buyer who can take the best advantage of the asset AKA they can judge the risk better than others so they know how valuable it really is o 3 OR you have superior information about an asset meaning you know a lot about it so you are reducing your risk on buying the object If you know more you will discount these with a lower interest rate than someone who is unsure about the asset aka that asset is more risky to the person who doesn39t know as much People who bid against each other set the market price When new information comes out it can change peoples expectations so the price will change 0 Theory of Rational Expectations Using past experiences to predict the future Ex looking at how the stock market has changed in the past helps us predict how it will change in the futurenot always a good idea because the society could have changed so much where what happened then isn39t likely to happen now 0 Uses all information from the past and the present to predict the future market price This is the most accurate but it is not perfect Peope39s of the market price are not rational because 1 You ignore some available information OR you don39t know about some information that is available 0 1 If a variable changes expectations will change with the variable 0 2 If you average your errors over time the average will be zero because you will forecast prices to be both high and low Using rational expectations to set prices for securitiesstock O O O The prices of the stocks re ect all available information Ex a stock prices is set at X because the company predicts a 7 growth rate Over time the expected growth rate changes to 8 so the stock price will go up because of the new information Stock prices are not predictable Like a random walk in the park they can go wherever they feel like going There is no pattern When you buy a stock and never sell it even when it drops a ton because you believe that in the longrun it will be lots better When you hold it you avoid paying the brokerage commissions each time of buying and selling stock Rational Expectations in Financial Markets 0 IO 390 0 390 390 It39s the same exact thing as the rational expectations theory but applied speci cally to forecasting nancial markets aka predicting stock prices and prices of other securities In sum of both Peoples39 expectations about the future are formed using all available information and expectations will adjust when new information is available resulting in the Stock prices will shift accordingly to supply and demand Prices will shift toward the Supply and Demand equilibrium which is equivalent to peoples expected rate of return from a given stocksecurity Stock prices are not predictable The best guess for tomorrow is to just use the price at the end of today It s like a random walk you never know where you39re going to end up or what the price is going to be Hot tips are only good if you can get them ahead of the pricing of the stocks But that would make the market inef cient because the whole point of an ef cient market is that all information available to any one person is publicly available to all So really the ef cient market hypothesis can39t be 100 accurate but it is close Stock Prices will rise if there is good news as long as this good news wasn39t expected If the market predicted this good news the prices will already be adjusted for it But if it were unexpected prices would go up Even if good news is announced stock prices may not go up IF the good news wasn t as good as what was expected Applying concepts from other elds of study such as psychology and sociology to explain the prices of securities 0 People may think that the way to be the most successful is to buy and sell stocks constantly keeping up with the uctuation of the market sell when prices are high buy when prices are low Psychoogy suggests that loss aversion makes this a bad idea o study that the pain of a dollar lost is worse than the joy of a dollar gained 0 This is why is not common it is too stressful for people to buy and sell the same exact stock every time it rises and falls 0 We believe we are better than the other investors out there and we believe we have a system to understand the stock market Leads us to buy and sell based on beliefs rather than facts 0 Everyone else is buying and selling X stock at this time so maybe I should too 0 Overcon dence and Social Contagion help explain stock market bubbles Chapter 9 Banking and the Management of Financial Institutions Book Notes 0 The Bank Balance Sheet A bank s assets and liabilities o A list of sources of funds and uses of those funds assets 0 Sources of bank funds are liabilities such as deposits 0 They use these funds to get assets like securities and loans that charge a higher interest rate than what they promised to pay the people who are the source of their nds o Liabilities source of bank funds 1 Your normal everyday check that you depos Bank must pay these people interest on their deposits 2 different from checkable deposits because when you deposit the money you can39t write a check that takes money out of these accountstwo types 0 A People can deposit or withdraw at anytime B o A person deposits money and the bank promises to hold it for a certain period of time and pay that person interest If a person wants to withdraw this money before the maturity period they forgo all interest that bank previously offered 0 lt1000 Less liquid for depositors but offers a higher interest so it39s more costly for banks 0 Large denomination time deposits gt1ooo 3 Borrowings AKA Advances Getting loans from the Federal Reserve 0 Interest rate the bank owes the Fed on borrowwings o Bank to bank loans Loans by Bank Holding Companies AKA Parent companies 0 Loans by corporations 0 Loaning US dollars in banks located in other countries 4 Bank Capital AKA Equity Capital The bank s net worth Difference between assets and liabilities Gain capital by selling stock or increasing retained earnings A backup source of if their assets can39t pay the liabilities o The Bank39s Use of Assets funds 1 Reserves Consist of all the checkable deposits made by loaners Includes deposits from the Fed and all physical cash in the bank Banks don39t use these funds to make money Rather there is a law requiring banks to hold a certain amount of these reserves called for when depositors want to withdraw money 0 Percentage of reserves the bank is required to hold Those reserves held by the bank that aren39t required 0 Good to have so when depositors come and withdraw money there is still enough money in reserves to ful ll the required reserve ratio 2 Cash Items In Process of Collection Literally the couple days it takes for a check to process and actually get into the bank s account 3 Deposits at Other Banks Correspondent Banking Smaller banks put funds in bigger banks for various unimportant reasons 4 Securities excluding stock Government securities State and local government securities Other securities These are highly liquid and make up much of the bank s revenue 5 Loans The main source of revenue for banks bc of the interest earned when people who borrow the bank s money pay the bank back 0 Not liquid because the bank can t get their money back until the maturity date of the loan when the borrower pays back 0 Although it makes the most money loans the banks give out have the highest chance to default in case the borrower can39t pay back the bank 6 Other Assets physical property like the building artwork land etc 0 Basic Banking Use TAccounts to track bank assets and liabilities When a bank gains deposits it records an equal amount of checkable deposits liability as reserves asset Bank often uses excess reserves and turns them into loans or securities to make them more money 0 General Principles of Bank Management 1 and Role of Reserves Make sure the bank has cash when investors withdraw money deposit out ows by obtaining very liquid assets o If the bank has excess reserves a deposit out ow may only change the quotreservesquot asset to go along with the decreased quotDepositsquot liability If a deposit out ow occurs and the bank has insufficient required reserves after the withdraw the bank can 0 1 Borrow from the fed other banks or corporations Requires a new tab quotBorrowings fromquot under Liabilities o 2 Sell securities decrease this asset and add it to the quotreservesquot asset but will face transaction costs 0 3 Reduce loans decrease this asset and add to quotreservesquot Do this by short term loans which will piss off a customer who won39t get a loan renewed when his loan ends and he39ll take his business elsewhere Could sell the loans to a different bank which has the same effect because the other banks can buy the loan for a lesser value because they know the bank selling is desperate 0 Because all of these three have a cost to the bank the bank will try and hold excess reserves to replenish the required reserves when funds become insuf cient 2 Pursue low level of risk via low rates of default on assets and diversifying assets o 1 Find borrowers who pay a high interest rate and won t default on the loan Banks normally play conservative and will take lower interest rates as long as the person won39t default 0 2 Buy Securities that have a high return and a low risk obviously ideal but dif cult to nd 0 3 Diversity assets to lower risk and approve loans to lots of people 0 4 Keep enough liquid assets for when deposit out ows cause reserves to become insufficient 3 Acquiring funds assets at low cost 0 Goal is to acquire funds quickly in the least costly method 0 Ex borrowing or issuing CDstime deposits 4 Deciding how much capital the bank needs then getting that capital and making sure that assets minus liabilities equals that number 0 1 It prevents bank failure 0 Bc bank capital assets liabilities you need to manage your assets and liabilities so capital is always positive If it becomes negative that39s when a bank fails because it does not have enough assets to pay back all of its liabilities 2 It affects the return the owners get 0 Measuring the Return on Assets ROA tests how much pro t per asset a bank is making net pro ta er taxes ROA Formula assets Want ROA to be high 0 Measuring Return on Equity ROE investments measures how much pro t per capital a bank is making net pro t after taxes ROE F0 rm Ula39 Equity Capital o ROA and ROE are directly related measured by the Assets EM 2 F0 rm Ula39 Equity Capital 0 ROE ROA x EM 0 Given a xed ROA the lower the bank capital the higher the ROE 3 It39s law to hold a certain amount of capital In the T Account if assets are greater than liabilities the bank capital AKA equity capital is recorded under the Liability side so the two sides will balance each other out TradeOffs between safety and returns to equity holders 0 The safer a bank is from avoiding being insolvent the more capital it has HOWEVER the more capital it has the lower the ROE will be for owners 0 Managing Credit Risk Ways a bank reduces adverse selection people who default on their loans often and moral hazard once is loaned people will take on more risk and still make a pro t 1 Screen and Monitor to reduce adverse selection 0 Put people through tests to get credit scores and decide if the bank thinks they will pay back a loan Just like a job application Specialization in Lending to reduce adverse selection 0 Stay local or within a company because it39s easier to get to know them and get information on them if they are close and you39ve done successful business with them before 0 Monitoring and Enforcement of Restrictive Covenants to prevent moral hazard 0 Banks write restrictive covenants contracts so people won39t take the loan and engage in rislq business 2 LongTerm Customer Relationships 0 The more the bank has dealt with a customer the easier it is to get information on them and build trust to give a loan 3 Loan Commitments Reduce costs of collecting information by striking an agreement with companies to give them loans with a certain interest rate for a set period of time so it builds a long term relationship and reduces risk 4 Collateral and Compensating Balances Property a bank gets if a borrower doesn39t pay Lowers adverse selection because rislq people will have less incentive to invest The rm gets a loan but must keep X in a checking account with the bank works the same as collateral so if a person defaults the bank can take this money in the checking account as payment 5 Credit Rationing Refusing a loan even when a borrower says he will pay the stated interest or even more interest also could be just loaning a smaller amount 0 Why Reduces adverse selection Don39t accept giving loans to those who may take too many risks regardless of how much they promise to pay back 0 Also reduces moral hazard because a person could get too risky once they receive the money 0 Managing Interest Rate Risk If a bank has more ratesensitive liabilities than ratesensitive assets a rise in interest rates will decrease pro ts Vice versa If a bank has more ratesensitive assets then rate sensitive liabilities a rise in interest rates will increase pro ts Subtract the dollar amount of ratesensitive liabilities from the dollar amount of ratesensitive assets and multiply the difference by the change in the interest rates to show the dollar amount gained or lost from the interest rate change 0 Same as the gap but broken down into changing interest rates for subintervals AKA maturity buckets throughout the date to maturity Standardized Gap Analysis Accounts for the different degrees of rate sensitivity given to us by man named Macaulay It uses the weighted average duration of assets and liabilities to see how the net worth responds to a change in the interest rates 0 Ex You have an average duration of assets of 3 years and an average duration of liabilities of 2 years You have 100m in assets 90m in liabilities and 10m in capital AKA 10 of assets are capital If interest rates go up by 5 current assets will be worth 15 less compared to the new market value 5 x 3 15 so assets will be 10015 85m Same concept for liabilities 5 x 2 10 so liabilities are 909 81m 0 Result in net worth change is a 4m or 4 decline 85814 0 Off Balance Sheet Activities They impact a bank s pro ts but don39t appear on the balance sheet 1 Selling a loan at more than what you loaned it out for so it goes off your assets but you make money 0 2 Income from special services like exchanging international currency guaranteeing securities loan commitments and overdraft p vHeges o All lead to higher risk 0 3 Trading Activities and Risk Management Techniques 0 When you take risk calculate and prepare for the worst possible outcome Chapter 10 Economic Analysis of Financial Regulations Book Notes Before the FDIC existed bank failures or a bad turn in the economy would cause and people would literally run to be rst in line at the bank to withdraw all their money so they beat the other depositors before the bank ran out of money Federal Deposit Insurance Corporation FDIC o A government safety net that guarantees depositors will get back up to 250000 of their funds if the bank fails o 2 ways the FDIC handles a failing bank 1 FDIC will straight pay the depositors what39s in their account and the bank itself will fail 2 FDIC nds another bank to merge with the failing bank so the depositor s money is safe but the bank just changes names FDIC offers mergers subsidized loans or offers to buy the old bank s weak loans as incentive to merge 0 Bad part of FDIC is it increases the likelihood of moral hazard and adverse selection Big banks and business became too big to fail because of the FDIC will always use purchase and assumption method because it would be too bad for the economy if they let these huge business and banks fail This gives big banks a reason to take on more risk because depositors aren39t incentivized to monitor their actions since they know they are guaranteed they will not lose money in case of a bank failure Types of Financial Regulation 0 1 Restrictions on Asset Holding to reduce moral hazard Banks can39t own stock they can only engage in so many risky assets they must also diversity 0 2 Capital Requirements to reduce moral hazard By being forced to maintain a leverage ratio certain amount of equity capital AKA certain amount of assets minus liabilities they are incentivized to take on less risk 0 3 Prompt Corrective Action to help moral hazard problem Must have X amount of capital and if not they must nd a way to get it o 4 Financial Supervision Chartering and Examination to reduce adverse selection and moral hazard Basically get paperwork to be approached and become an of cial bank National banks Get certi cation from Comptroller of the Currency State Banks Get certi cation from State bank agencies Once chartered they are checked and examined periodically Receive a rating a score that says how good the bank is doing 0 5 Assessment of Risk Management to reduce moral hazard Must have suf cient oversight by management Good limits and rules on risky business Good measurements for determining risk Good internal controls to prevent fraud Calculates losses in worst possible scenarios 0 6 Disclosure Requirements to reduce moral hazard The more they are required to reveal to the public about their operations the less risk they will take because they have eyes watching their activities 0 7 Consumer Protection to reduce moral hazard Banks must provide information on costs of borrowing standardized interest rate APR and method of assessing nance charges Banks can39t discriminate on age race gender marital status etc o 8 Restrictions on Competition to reduce moral hazard Tried to not allow branching by banks but it was repealed in 1994 McFadden Act Tried to not let nonbanks compete against banks but it was repealed in 1999 GlassSteagall Act Still working on current restrictions on competition to reduce moral hazard Chapter 12 Financial Crises Book Notes 0 A major disruption in the nancial market characterized by sharp declines in asset prices and rm failures 0 Dynamics of Financial Crises 0 Stage One Initial Phase Begins with either a credit boom and bust or a general increase in uncertainty caused by failures of major nancial institutions Credit Boom and Bust When nancial institutions go on a lending spree due to elimination of restrictions on nancial markets and new types of loans or nancial products 0 Bad because lenders may get greedy and start lending to too many people who won t pay back the lenders 0 Moral hazard arises and banks begin taking on more risk and losing more on their loans causing their net worth capital to decrease because the value of their loans are decreasing This leads to when banks cut back on their lending to borrowers Less capital means it39s more risky for investors to put their money in the banks so they will take their money out causing more trouble for the bank Fewer funds means fewer loans and fewer investments for the bank so the lending boom turns into a lending Asset Price BoomBust 0 When prices of assets go well above what they are expected to be this creates an Ex tech stock market in the 905 and the housing market back in 20072008 Bubbles created by credit booms when people purchase the asset due to an increase in credit this jacks up the price of the asset 0 When the bubble burst prices come back down to what their economic value should be companies involved lose lots of their value and net worth and they will make riskier choices because they have less to lose Because it they become more risky nancial institutions tighten lending standards leading to a decline Increase in Uncertainty Financial Crises come about usually after a major company fails or the stock market declines This is because people become a little more scared and therefore won39t invest as much thus leading to a decline in economic activity 0 Stage Two Banking Crisis When banks become unable to pay off depositors they may fail When one bank fails people with money in a different bank begin to get worried that their bank will fail too so they take out their money causing a in which several banks fail at the same time o This all happens because of asymmetric information Depositors feel in the dark and don39t know enough information on how the bank is using their money so they pull out just to be safe When the bank starts to go downward they try to sell lots of their assets quickly called to make back some money but often they have to sell them at a very low price because they are so desperate and they end up not making enough money and failing anyway 0 After banks fail the information about all of their customers goes away and the existing banks have to operate more on adverse selection Once authorities decide to shut down insolvent rms and liquidate them sell off everything uncertainty starts to fade away and the market begins to recover 0 Stage 3 Debt De ation occurs when the price level drops dramatically because then people owe the same amount of money but the money they have is worth less making it even harder to pay off what they owe Ex I have 100m in assets and 90m in liabilities leaving me with 10m of capital The price level increases by 10 and l have not acquired any new assets This means that the value of my liabilities increases by 10 from 90m to 99m leaving me with capital of only 1m This is no Bueno Best Example of a nancial Crisis The Great Depression 0 Stage 1 Initial Phase Stock market crash in October 1929 This was a major credit bust in the economy getting the ball rolling for the crisis 0 Stage 2 Banking Crisis Bank panics begin in 1930 resulting in a failure of 13 of all US banks Panics started when droughts in the Midwest caused farmers to not be able to produce much thus not make much money thus not be able to pay their mortgages thus default on the banks thus leading other people to withdraw their money resulting in a panic 0 Stage 3 Debt In ation Price level decline of 25 Because of the stock market crash and the bank failures economic activity went down sharply which resulted in the major decline in the price level The decline in net worth resulted in more people participating in adverse selection and moral hazard With that employment rose to 35 o The Global Financial Crisis of 20072009 0 Cause of the Crisis Financial innovation in the Mortgage Markets The invention of the subprime mortgage which allowed people with low credit scores to get a loan and the invention of which created risk characteristics that appealed to all sorts of different investors and led them to invest both resulted in a sharp increase in loans Agency Problem in the Mortgage Markets The mortgage brokers didn39t care who they gave mortgages to because they just made money off of broker fees each time they gave out a mortgage They gave mortgages to people who could not pay them off and the result was this crisis o caused people to take excessive risk 0 Financial instruments whose payoffs are derived from previously issued securities 0 contracts led insurance companies to spend millions of dollars on these contracts 0 A nancial derivative that provides payments to holders of bonds if they default Asymmetric Information and CreditRating Agencies Creditrating agencies gave advice to people about the probabilities of default on products and advice on how to structure nancial instruments that they themselves rated So they didn39t ever give truly accurate information They just led you to putting your money in places that they were in charge of rating 0 Effects of the 20072009 Financial Crisis 0 1 Housing boom and bust Subprime mortgages giving mortgages to those with bad credit led to the astronomical growth and boom of the market At this time there were also residential mortgages offered with very low interest rates for investors leading to an even bigger boom People were able to get second and even third mortgages on top of their rst mortgage to help pay and buy them more time to get money to pay Prices rose so far away from the norm that eventually the market busted and prices came back down The value of the houses people were buying became lower than the cost of their mortgages Defaults began and so did the crisis 0 Deterioration of Financial Institutions39 Balance Sheets The value mortgagebacked securities that banks held tanked when the housing market busted so the banks39 assets decreased sharply and so did their net worth Banks began deleveraging and selling off their other assets to try and bring their net worth back up by paying off some of their liabilities They also stopped making loans to people tanking economic activity and worsening the market 0 Run on the Shadow Banking System hedge funds investment banks and other nondepository nancial rms not necessarily considered banks People got funds from these shadow banks through reIDOS Loans where the borrower uses assets as collateral in case they fail to pay in order to get the loan o Borrowers typically have to offer up collateral with a slightly higher value than the loan they are receiving The percentage difference between the value of the loan and the value of the collateral Ex If a bank offers a loan for 100m and says you have to offer up collateral worth 105m the 5m difference is a 5 haircut Got funds from shadow banks because banks wouldn39t give out loans because of their crash Same result happened to the shadow banks as the real banks 0 People weren39t able to pay off their loans to the shadow banks and the haircuts that the shadow banks claimed weren39t worth much at all once the market declined so the shadow banks suffered too 0 Global Financial Markets A French investment rm heard of the huge collapse in America and then suspended some of its shares in the money market Other European banks started hoarding their funds and not loaning to other banks because they were afraid and it resulted in the failure of several banks who depended on those short term borrowings 0 Failure of HighPro le Firms Bear Stearns sells out to JP Morgan for only 10 of what it was worth the year prior Frannie Mae and Freddie Mac insured over 5trillion of the subprime mortgages and when people defaulted they didn39t have enough to insure that much The US Treasury and Federal Reserve helped them survive and then took over them completely Lehman Brothers led for bankruptcy Merrill Lynch suffered losses from subprime holdings and sold to Bank of America AlG suffered major asset losses when its credit rating went down and it had to pay millions to those insured for subprime holdings The Federal Reserve stepped in to keep them going 0 Government Intervention and the Recovery Trouble Asset Relief Program TARP authorized the Treasury to spend 700billion in purchasing subprime mortgage assets from large rms like AlG Raised insured limit in the bank from 100000 to 250000 so people would keep their money in the banks and not withdraw it One time tax rebates sending 600 checks to individual taxpayers Pumped 787 billion into the economyvery controversial Response of Financial Regulation 0 Started Analyzes individual companies to make sure they are operating well and have a good capital ratio If it does not they enforce corrective action or shut it down 0 Started as well Analyzes the safety and soundness of the nancial system as a whole and makes sure the nancial system has enough liquidity DoddFrank Wall Street Reform and Consumer Protection Act of 2010 0 Consumer Protection Created a Consumer Financial Protection Bureau in charge of more strictly regulating who is allowed to receive loans and making sure there are more rules that nancial institutions must follow to grant people loans Resolution Authority Lets the government takeover nancial institutions other than banks with big impacts on the nancial markets when they are failing similar to the Too Big to Fail idea Systematic Risk Regulation Institution that monitors the market for bubbles that are forming and risks that are increasing and can regulate them to prevent them from getting out of hand Volcker Rule Limits banks to only owning a small percentage of hedge and private equity funds Derivatives derivative products need to be traded on exchanges and cleared through clearinghouses to reduce risk
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