Chapter 9 Questions
Why is the originate-to-distribute business model subject to the principal-agent problem?
-Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk.
Why do credit spreads rise significantly during a financial crisis?
-Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. -The rise of credit spreads during a financial crisis reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.
How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?
-Fewer resources to lend, and lending will decline. -The contraction in lending then leads to a decline in investment spending, which slows economic activity.
How did a decline in housing prices help trigger the subprime financial crisis starting in 2007?
-Many subprime borrowers finding that their mortgages were "underwater" because they owed more on them than their houses were worth. -When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. -Defaults on mortgages shot up sharply, causing losses to financial institutions which then deleveraged, causing a collapse in lending.
What is the shadow banking system, and why is it an important part of the 2007-2009 financial crisis?
-The shadow banking system is composed of hedge funds, investment banks, and other non-depository financial firms that are not subject to the tight regulatory frameworks of traditional banks. -Due to the light regulation, they had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial firms. -They are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fueled some of the housing bubble. -Because of their large presence in financial markets, when credit markets began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit.
What role does weak financial regulation and supervision play in causing financial crises?
-Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market discipline is weakened by the existence of a government safety net. -When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.
