Consumer econ chapter 13

What contributed to this?

-really nothing: fundamental like corporate productivity growth increased at their normal rate -The only reasonable answer is :excessive optimism on the part of the consumers, investors were caught by a wave of collective madness.

long-term reform back to narrow banking:

-suggestions have been made to go back to narrow banking -strict separation of commercial and investment banking -the classes of assets in which banks can invest must be limited. -no securitization anymore

Short-term interest rates

-the fed injected additional reserves and kept short-term interest rates at 2% or less throughout 2002-2004. -Due to rising inflation in 2005, the fed pushed interest rates upward -Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly

CAMEL RATINGS

Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk

cosigner

agrees to repay the loan is the borrower defaults.

Automated Banking Machine

combine ATMs, the internet and telephone technology to provide complete service

bankruptcy

form of legal recourse open to insolvent debtors.

Financial counselor

helps those who dont have money

tax evasion

illegal because of the methods involved, such as not paying taxes or not reporting all income

Credit score

includes all information plus assets, length of employment, and length of living in one place.

financial planner

looks at a persons or a family's total financial picture, helps that person or family define and prioritize goals, then works out a plan to achieve those goals

Money MArket accounts

offers higher rate of interest than most checking or savings accounts.Many require a min balance to be maintained

Electronic money

or stored cash, only exists in electronic form. It is accessed via a stored value card or smart card

taxes

payments of money to federal, state, and local govts.

Fair Debt Collection Practices Act (FDCPA)

prohibits debt collectors from using unfair, deceptive, or abusive practices while collecting debts.

collateral

property used to secure the loan -this is what you own at the end of the loan or this is what you lose if you cant pay the loan off

FICO scores

range from 300-850 -below 500 is considered subprime lending -median score is 623 -750 is high score and above 800 is unusual.

E-cash

refers to an account on the internet used to make purchases

Securitization

refers to the transformaiton of illiquid assets into marketable capital instruments -Today, almost any type of private debt can be securitized. This includes home mortgages, credit card debt, student loans, car loans, etc.

Truth in lending act

requires financial institutions to reveal annual percentage yield/rate, fees charges, information about the loan balance, payment due, total amount charged.

Federal Deposit Insurance

- US congress created FDIC in 1933, after the bank failures in the great depression -today, FDIC guarantees each bank depositor up to a max of $250,000 -FDIC insurance is funded by a small fee paid by banks based on their deposits.

Changes in the Market Environment:

-As a result of financial innovations in the 1960s and 70sL -banks and S&Ls faced more competition from other financial firms (such as mutual funds) -New financial assets made it possible for investors (including banks and S &Ls to take on more risk) to take on more risk

Primary bank regulators in the US:

-Office of the Comptroller of the Currency (OCC) -part of US department of treasury -Federal Reserve system- the US central bank -FDIC (insures up to $250,000, used to be $100,00 0before Obama) -State Bank regulators

Changes in Regulation:

-Partially deregulated in the early 1980s -S&Ls had mostly been restricted to home MORTGAGES lending before, but now they were allows to invest in commercial real estate and stocks -As a result, S& Ls held more risky assets, resulting in huge loan losses -Since S&L deposits (up to $100,000) were protected by federal deposit insurance, depositors had little incentives to monitor S&L risks.

21st century and degregulation of banking

-This allowed commercial banks to take on all the activities investment banks had been taking (underwriting and holding of securities stocks/bonds) -Thus banks were allowed to take on same RISKY ACTIVITIES that they had prior to the great depression -lessons of history forgotten

Capital REquirements

-also known as REGULATORY CAPITAL -When theres deposit insurance, banks have an incentive to hold too little capital. -Therefore the government imposes capital requirements to ensure the banks hold sufficient capital. -Also considered the ratio of the bank's equity to its debt.

Unemployment in Recent severe recessions

-at the end of jan 2009, UR was 7.6%. -The UR rose to 9.6% during the 1974-75 recession and to 10.8 % during the 80-82 recession -Even during the relatively short recession of 1990-1991, the UR rose to nearly 8% and it remained at, or near, 7% for almost two years.

Banks are less stable than other businesses because:

-bank debts tend to be short term-many depositors could withdraw their funds with little notice. -The behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken.

CDs

-banks and brokerage firms offer CDs with a maturity of at least 7 days, with penalties on early withdrawals. -it is a type of time deposit, are usually safe ways to store money from 7 days to several years.

Why is separation important?

-banks are the center of payment system -this creates strong links of COMPLEMENTARITY when one bank fails, other banks are in trouble. -Contrast with non-bank firms (automobile) where SUBSTITUTABILITY prevails; who one firm fails this is good news for the others. -investment banks can do all the sophisticated asset creation and management they want, but no funding through commercial banks.

Bank examinations:

-banks are visited on a regular schedule by bank examiners from the OCC, the federal reserve system, the FDIC and other agencies. -Bank examiners review the bank;s financial statements and its confidential accounts -The results are summarized in a "CAMELS" rating given to the bank

Restrictions on asset holdings:

-banks cannot invest too large a share of their deposits in a single loan or in loans or businesses in a single industry. -banks cannot lend funds to bank directors, managers, or principal shareholders at below market rates

Banking Crisis of 1930s:

-banks loans out more than they had coming in -this created inherent fragility -no problem in normal times -problem with confidence disappears

Banks Ride on bubbles

-because of deregulation banks became fully exposed to the economic occurrence of bubbles and crashes in asset markets. -they now hold the full panoply of assets that regularly are impacted by bubbles and crashes -their balance sheets became extremely sensitive to these bubbles (hi-tech bubble, housing bubble, general stock market bubble)

Bank's Troubles:

-by 1984 bank's nonperforming loans (loans on which payments were late) rose to $5.2 billion (over 10% of total loans) -May 1984: an electronic "Bank run"- depositors withdrew billions of dollars in deposits.

Bank examinations:

-camel ratings are disclosed to bank management, but not to the public -If the CAMELS ratings are unfavorable, regulators can take these actions: -require banks to disclose unfavorable information in their public financial statements. -Issue a "cease and desist" order requiring the bank to stop doing things that cause financial troubles and to correct problems -Impose fines (up to 1 million per day)

Financial intermediaries

-commercial banks (B of A) -Savings and loan associations (S& Ls) (also called "thrifts" or "thrift institutions" -Credit unions

Foreclosure rates on subprime:

-compared to their prime borrower counterparts, the foreclosure rate for subprime borrowers is app 10 times higher for fixed mortgages and 7 time higher for ARMs. -there was not trend in the foreclosure rate prior to 2006 for Adjustable rate of fixed rate mortgages -Starting in 2006, there was a sharp increase in ARM foreclosure rate.

Incentive effects of deposit insurance:

-deposit insurance increases the supply of deposits from consumers (within the insurance coverage limits) -banks attract deposits pay lower interest rates on their deposits even as they pursue risky strategies that increase the risk of bank failure -As a result, deposit insurance reduces banks' incentives to avoid risk.

Factor 2: the fed's MANIPULATION of interest rates during 2002-2006.

-fed;s prolonged low-interest rate policy of 2002-2004 increased demand for, and price of, housing. -the low short-term interest rates made adjustable rate loans with low down payments highly attractive -as the Fed pushed short term interest rates upward in 2005-2006, adjustable rates were soon to reset, monthly payment on these loans increased, housing prices began to fall and defaults soared

Return of an old philosophy:

-financial markets can regulate themselves thereby making regulation by authorities unnecessary -Alan Greenspan (former Federal Reserve chairman):"authorities should not interfere with pollinating bees of Wall Street. Regulation is harmful" -Philosophy encourage bankers to lobby for deregulation -bankers achieved their objective -banks were progressively deregulated in US an in Europe -we saw different rules and more players in the financial market. -New forms of banking emerged (banks without main offices or branches)

ARM loans outstanding

-following the fed's low interest rate policy of 2002-2004. ARms increased sharply. -measured as a share of total mortgages outstanding, ARMs increased from 10% in 2000 to 21% in 2005.

Gramm-Leach-Billey Act of 1999

-legislation to eliminate Glass-Steagall -states retain insurance regulation, while SEC oversees securities activities -Fed still oversees bank holding companies.

Banks' Reponse

-loss of customers and in making loans causes reduction in profitability in traditional banking (expand lending into riskier areas-real estate) -creates problems for US regulatory system -similar problems for banking industry in other countries.

Default rate

-mortgage default rate fluctuated, within a narrow range. around 2% prior to 2006. -It increased only slightly during the recessions of 1982, 1990, and 2001 -The rate began increasing sharply during the second half of 2006. -It reached 5.2 percent during the 3rd quarter of 2008.

Ownership of banks

-most banks are privately owned, in most cases a bank's stock is held by a large number of investors, so a bank has many "owners".

other factors: financial innovations

-process of deregulation of financial markets coincided with financial innovators -These made it possible to repackage assets into different risk classes and to price these risks differently -And to sell these:"securitizaiton: -In other words...Mortgage Backed Securities

House Price change

-relatively stable during the 90s, but they began to rise toward the end of the decade -between January 2002-mid year 2006, housing prices increased by 87%. -The boom had turned to a bust, and the housing price declines continued throughout 2007 and 2008. -By the 3rd quarter of 2008, housing prices were app. 25% below their 2006 peak.

Bank Products: savings

-savings provide a safety net are also helpful for putting together money for future needs such as a down payment on a house. -TRaditionally, an emergency fund of 3-6 months of salary set aside as savings is recommended as a financial goal. These funds should be kept in a liquid interest-bearing account such as a money market fund, short-term certificates of deposits (CDs) or a savings account

REgulatory Reforms following the 1980s crisis:

-some regulatory agencies that had not been effective were eliminated and their powers were given to other agencies. -Earlier restrictions on assets holding S& Ls were reinstated -Now bank examiners visit banks more frequently than before

Reserve requirements:

-the federal reserve system requires banks to hold reserves that are GREATER THAN OR EQUAL TO a specified percentage of their deposits.

Historical Development of the banking industry

-the modern commercial banking industry began when the B of A was chartered in Philadelphia in 1782.

in 2008...

-then came the downturn with the credit crisis -in one year's time stock prices drop 30%.

Consumer Credit Protection Act of 1968

-you cannot be denied credit card because you are a single woman. -you can limit your risk if a credit card is lost or stolen -you can resolve errors in your monthly bill without damage to your credit rating -you cannot have credit shut off just because you have reached age 62.

Credit and consumer rights

a good credit rating is important for a number of reasons, including the fact that potential employers may check your credit history before hiring you and landlords may check to see if they would be wise to give you a lease

Certified Divorce planner

a specialist who is trained to focus on who get the assets in divorces and who works alongside attorneys who handle legal documents and child custody issues -Help couples divvy up retirement accounts and stock options, divide up businesses, calculate alimony payments, and decide who keeps the primary house and vaction home

Chapter 13 bankruptcy

allows debtors to repay some of the debt they, and in return they get to keep most of their property; usually this type of debtor is a person with regular income. -have to be paid within 5-7 years

debts

are what is owed

interest

cost of using money -Rate of interest is determined by supply (amount of money lenders are willing to lend) and demand (amount of money borrowers are willing to pay) -rate are expressed as percentages (examples, 4 % per year)

Consumer Reporting Agencies (CRA)

credit bureaus. have files that contain information about your income, debt, and credit payment history as well as information on whether you have been sued or arrested or have filed for bankruptcy.

debtor

a person who owes money

Bank holding company

is a firm that owns one or more banking firms

Chapter 7 bankruptcy

known as straight liquidation chapter because in return for eliminating debts, the debtor agrees to turn over nonexempt assets and pay as much as possible to creditors.

tax avoidance

legal money management strategy to reduce one;s taxes through such investments as tax-deferred individual retirement accounts or charitable donations which are allowed under the tax code and should be properly documented.

lien

legal rights to take and hold property if the person does not pay the debt.When the loan is paid off, the lien is removed.

excise tax

which is collected from the manufacturer of a product. (gas)

smart cards (also called chip cars or store value cards)

which may be worth $20 or $50 and can be used for playing phone calls or buying sodas or snacks from vending machines.

What caused the crisis of 2008? Factor 1: Beginning in the mid 1990s, government regulation began to erode the CONVENTIONAL lending standards

- FANNIE MAE and FREDDIE MAC hold a huge share of American Mortgages. -Beginning in 1995, HUG regulations required fannie mae and freddie mac to increase their holdings of loans to low and moderate income borrowers. -HUD regulations imposed in 1999 required fannie mae and freddie to accept more loans with little or no down payment.

THe bank collapse of the 1930s and the ensuing Great Depression has introduced some institutional changes aimed at making the banking system less fragile. These were...

- central bank as lender of last resort -Deposit insurance -Separation of commercial banking and investment banking (Glass-Steagall Act of 1933)

Factor 3: doubling the debt-income ratio of households since the mid 1980s

- the debt-to-income ratio of households was generally between 45 and 60% for several decades prior to the mid 1980s. By 2007, the debt-to-income ratio of households had increased to 135%. -increase on credit card debt also increased substantially

According to FTC, under Fair Credit REporting Act, your right are as follows:

- you have right to receive a copy of your credit report -right to know the name of anyone who received your credit report in the last year for most purposes and in the last year for employment purposes. -right to a free copy of your credit report when your application has been denied -if you disagree with the accuracy of information, you can file a dispute with the CRA and the company that furnished the information.

Banks must be regulated because:

-A bank failure can be devastating to depositors. -Theres a risk of : the failure of one bank can make it more likely that other banks will fail. -Government assistance to a bank can be costly

Stock market return

-As of mid-december of 2008, stock returns were down by 37% since the beginning of the year. -This is nearly twice the magnitude of any year since 1950. -This collapse eroded the wealth and endangered the retirement savings of many Americans.

Who paid the cost?

-Bank and S&L stockholders -Some depositors who had large deposits that exceeded the deposit insurance limits -Taxpayers, who ultimately will pay higher taxes to pay off bonds that were issued to fund the costs of the crisis.

The Us govt regulates banks in many ways:

-Federal deposit insurance -Imposing capital requirements (min capital/asset ratios) - imposing reserve requirements (min reserve ratios) -restricting types of assets that banks may hold -performing bank examinations (periodic auditng reviews)

Magnitude of the crisis:

-From 1980 through 1994, over 2,900 banks and S &Ls failed -On average, a bank or S &L failed every 15 days from 1980-1994. -During this period, about one out of every 6 banks or S&Ls (holding a total of over 20% of the assets of the system) was closed or received government assistance.

At the same time: US stock market 2006-2008

-GDP measure of US output increased only 5% (650 billion) -yet stock market went up by about 35% or in other words: $3.5 trillion was added to the value of Us corporations in just one year.. What contributed to this?

moral hazard

-General insight: agents who are INSURED will tend to take fewer precautions to REDUCE the risk they are insured against. -The insurance provided by central bank and governments gave bankers strong incentives to rake more risks -To counter this, authorities have to supervise and regulate. -They did this for most of the post-war period

Key events leading up to the economic crisis of 2008

-Housing price INCREASES during 2000-2005 followed by a levelling off and price decline -increase in the default and foreclosure rates beginning in the second half of 2006 -collapse of major INVESTMENT banks in 2008 -2008 collapse of stock prices

Roles of banks in the economy:

1. Facilitate borrowing and lending 2. facilitate payments 3. risk management ( issue financial assets that allow firms to share risks, provide guarantees and lines of credit)

The history has one other significant outcome: multiple regulatory agencies:

1. Federal Reserve 2. FDIC 3. Office of the comptroller of the currency (National bank act of 1863) 4. State banking authorities

CAMEL ratings

1. sound in every respect 2. fundamentally sound, but with modest weaknesses that can be corrected 3. moderately severe to unsatisfactory weaknesses; vulnerable if theres a business downturn 4. many serious weaknesses that have not been address; failure is possible but not imminent. 5. High probability of failure in the short term

Two reasons for bank failure:

1.the value of bank assets/investments/holdings falls, so assets< liabilities. 2. Deposit CASHFLOW: a large number of depositors withdraw their funds from the bank, exhausting the bank's cash (reserves) and other liquid assets.

Managing the 1980s crisis:

In 1989, the government created the REsolution Trust Corporation (RTC) to handle S& Ls that were failing. -Took over assets of failing S & Ls and sold them to recover as much of their value as possible. -Issued bonds to fund the costs of covering S&Ls losses

Your credit rights are protected under the...

Fair Credit Reporting Act (FCRA), Equal Credit Opportunity Act (ECOA), Fair Credit Billing Act (FCBA)

Erosion of Glass-Steagall

Fed, OCC, FDIC allowed banks to engage in underwriting activities, under the section 20 loophole in the act.

Banking Act of 1933

Glass-Steagall -Glas-Steagall allowed commercial banks to sell on-the-run govt securities, but prohibited underwriting and brokerage services. -It also prohibited real estate and insurance business. But it did protect commercial banks by not allowing other financial intermediaries to offer commercial banking activities

Bank Secrecy Act (BSA)

requires all national banks to file a Suspicious Activity Report (SAP) when they detect certain known or suspected violations of federal law or suspicious transactions related to money-laundering activity or a violation of the BSA.