Money & Banking Exam II

10.1.7 [Related to the Chapter Opener on page 279] An article in the Wall Street Journal in early 2010 noted: "Some small business owners say they could expand if they could just get a loan." Over the past 35 years, has making loans to small business become a more important or a less important aspect of commercial banking? Briefly explain.

"C&I" loans are a much smaller share of commercial bank assets than they were 35 years ago.

10. 2.1 What is a T-account? Use a T-account to show the effect on Bank of America's balance sheet of your depositing $50 in currency in your checking account.

A T-account is an accounting tool used to show changes in balance sheet items. Bank of America Assets Liabilities Vault Cash +$50 Checkable deposits +$50

10.1.2 According to this chapter: "We can think of a bank's liabilities as the sources of its funds, and we can think of a bank's assets as the uses of its funds." Briefly explain what this means.

A bank's liabilities, principally deposits and borrowings, are the sources of the funds the bank invests. A bank's assets, principally loans and securities, are the bank's uses of those funds.

9.3.8 b. Does a market maker have different responsibilities than a financial firm that is providing investment advice for clients?

A market maker has a responsibility to provide an accurate description of the security being traded; a market trader does not reveal the intention of the buyers or the intention of the sellers.

9.3.8 a. What is a market maker?

A market maker is similar to a real estate agent. Goldman Sachs acts as a market maker by bringing together buyers and sellers.

9. 2.20 a. What is a Ponzi scheme?

A ponzi scheme is an operation that pays returns to investors from their own money or money paid by subsequent investors.

9.2.9 What is the difference between venture capital firms and private equity firms? What roles do they play in the financial system?

A venture capital firm is a firm that raises equity capital from investors to invest in start-up firms. Private equity firms raise equity capital to acquire shares in established firms with the intention of reducing moral hazard problems.

10.1.8 The following entries (in millions of dollars) are from the balance sheet of Rivendell National Bank (RNB): Use the entries to construct a balance sheet similar to the one in Table 10.1 on page 281, with assets on the left side of the balance sheet and liabilities and bank capital on the right side. U.S. Treasury bills $20 Demand deposits 40 Mortgage-backed securities 30 Loans from other banks 5 C&I loans 50 Discount loans 5 NOW accounts 40 Savings accounts 10 Reserve deposits with Federal Reserve 8 Cash items in the process of collection 5 Municipal bonds 5 Bank building 4

Assets U.S. Treasury Bills $20 MBS $30 C&I loans $50 Municipal bonds $5 Cash items in the process of collection $5 Bank Building $4 Reserve Deposits $8 Assets $122 Liabilities Savings Accounts $10 Now Accounts $40 Discount Loans $5 Demand Deposits $40 Loans from Other Banks $5 Liabilities $100 Capital $22

9.3.7 Describe some of the information problems in the financial system that lead firms to rely more heavily on internal funds than external funds to finance their growth. Do these information problems imply that firms are able to spend less on expansion than is economically optimal? Briefly explain.

Asymmetric information makes information costs for external funds higher than for internal funds. Information costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal. Information is costly. Firms need to answer the question, "Is the cost of eliminating the information problem less than the cost associated with less investment?"

10.1.3 Define the following terms from a bank's balance sheet: d. Bank capital

Bank Capital: The bank's net worth, or the difference between the value of a bank's assets and a bank's liabilities.

10. 1.9 b. Does a bank's capital appear on the left side of the bank's balance sheet?

Bank capital appears on the right side of the balance sheet.

10.4.3 Why did nationwide banking come relatively late to the United States compared with other countries?

Historically in America, there was a fear of banks having too much power and that banks should only fund loans in their local area; Hence, laws were created against large national banks.

10.2.9 [Related to the Making the Connection on page 289] An article in the Wall Street Journal notes that in response to the failure of some small community banks: [The] Federal Deposit Insurance Corp., Federal Reserve and other regulatory agencies are increasing their scrutiny of local lenders. . . . As part of the effort, the watchdogs are asking the banks to boost their capital and loan-loss reserves even further. . . . a. How would increasing loan loss reserves reduce the risk of bankruptcy for a smaller bank?

If the regulatory watchdogs consider the loans of the small community banks to be in worse shape than these banks think, then increasing loan loss reserves will better reflect the banks' current profitability and capital. Increasing the loan loss reserves could reduce the risk of bankruptcy because the banks' management and the regulatory watchdogs would have a better understanding of the condition of the banks. Help could possibly be available where needed and the banks would have a clearer picture of their needs for capital.

10.1.1 Asset

Something of value owned by the firm.

10.1.1 Liabilities

Something that the firm owes.

10.4.1 What are state banks? What are national banks? Why is the United States said to have a dual banking system?

State banks are banks that have charters only in specific states. National Banks are federally chartered banks. The United States has maintained this dual banking system since 1863, when the National Banking Act made it possible for a bank to obtain a federal charter.

9.2.19 a. Why would a company use stock options as part of a top manager's compensation?

Stock options provide an incentive for the managers to make decisions that increase the stock's value.

10. 2.7 Suppose that Lena, who has an account at SunTrust Bank writes a check for $100 to José, who has an account at National City Bank. Use T-accounts to show how the balance sheets of each bank will be affected after the check clears.

Suntrust Bank reduces checkable deposits by $100, and reduces reserves by $100. National City Bank's checkable deposits increase by $100, and reserves increase by $100. Sun Trust Bank Assets Liabilities Reserves -$100 Checkable deposits -$100 National City Bank Assets Liabilities Reserves +$100 Checkable deposits +$100

10.4.6 What is the TARP? When and why was it created?

TARP is the "Troubled Asset Relief Program," which is a government program under which the U.S. Treasury purchased stock in hundreds of banks to increase the banks' capital. TARP was created to allow banks the financial flexibility to keep their balance sheets solvent.

10.1.1 Shareholders' equity

The difference between the value of the firm's assets and firms liabilities.

9.3.2 What is the most important method of debt financing for corporations?

the bond market. moral hazard is less of a problem with debt contracts than equity contracts, so investors who may doubt managers will max profits may still believe that they will be able to make fixed payments due on bonds or loans.

9.2.18 Briefly explain in which of the following situations moral hazard is likely to be less of a problem. a. A manager is paid a flat salary of $150,000. b. A manager is paid a salary of $75,00 plus 10% of the firm's profits.

Moral hazard is less likely to be a problem in scenario (b). Note that you can use this question to explain why large companies often provide stock options as part of executives' compensation packages. Tying salary with profits provides an incentive for the managers to make decisions that are in the best interests of shareholders

10.3.9 Look again at Problem 1.8 on page 309. If RNB's assets have an average duration of five years and its liabilities have an average duration of three years, what is RNB's duration gap?

Duration gap = duration of assets-duration of liabilities = 5 years = 3 years = 2 years.

9.3.6 If everyone were perfectly honest, would there be a role for financial intermediaries?

Adverse selection does not necessarily occur because of dishonesty, it occurs because one side of a transaction does not have as much information as the other side to the transaction. Being honest would not eliminate the need for financial intermediaries. Financial intermediaries might have economies of scale in processing information.

9.2.12 An article in the Economist magazine observes: "Insurance companies often suspect the only people who buy insurance are the ones most likely to collect." a. What do economists call the problem being described here?

Adverse selection, we don't know if they may be high or low risk so there is a risk for high-risk people buying more insurance

10.3.7 Briefly explain whether you agree with the following statements: b. "A bank that expects interests to fall will want the duration of its assets to be greater than the duration of its liabilities—a positive duration gap."

Agree. A fall in interest rates with a positive duration gap will increase profits.

9.2.10 The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." a. Do you agree with this statement? If so, what do landlords know that potential renters might not?

Agree. Landlords know more about the quality of the property, and hence its true value, than renters.

9.2.17 Yves Smith runs the popular financial blog nakedcapitalism.com. In one of his postings, he noted: "Amex is offering very hefty balance reductions (20%) to business accounts who pay off balances early on credit line products that Amex has discontinued." Smith worried that Amex's offer would expose the credit card company to adverse selection. Briefly explain whether you agree.

Agree. Only the most financially sound firms would have the cash flow to take advantage of the offer, thus leaving American Express with a loan portfolio disproportionately filled with riskier borrowers

10.3.7 Briefly explain whether you agree with the following statements: a. "A bank that expects interest rates to increase in the future will want to hold more rate-sensitive assets and fewer rate-sensitive liabilities."

Agree. Rate-sensitive assets will increase in value thus holding more of them as assets, while reducing them as liabilities, will increase bank profits.

10.2.12 An article in the Wall Street Journal states that Royal Bank of Canada's ROE during the fourth quarter of 2009 was 14.5%, having fallen from 16.4% during the fourth quarter of 2008. Despite the decline in ROE, the article states that the total amount the bank had earned in profits was higher than it had been a year earlier. What is the most likely explanation of a bank experiencing rising total profits and a falling ROE?

Bank leverage (the ratio of bank assets to bank capital) fell, reducing the return on equity even though bank profits rose.

10. 2.4 What is bank leverage? How is it related to a bank's ROE?

Bank leverage is the ratio of the value of a bank's assets to the value of its capital. Leverage can magnify the return on equity (ROE).

10. 2.6 Suppose that Bank of America sells $10 million in Treasury bills to PNC Bank. Use T-accounts to show the effect of this transaction on the balance sheet of each bank.

Bank of America reduces securities by $10 million, and increases reserves by $10 million. PNC Bank increases securities by $10 million, and reduces reserves by $10 million. Bank of America Assets Liabilities Reserves +$10 million Securities -$10 million PNC Bank Assets Liabilities Reserves -$10 million Securities +$10 million

10.1.3 Define the following terms from a bank's balance sheet: b. Borrowings

Borrowings: Funds raised, including money borrowed in the federal funds market, as well as through reverse repurchase agreements, and discount loans.

9.2.12 An article in the Economist magazine observes: "Insurance companies often suspect the only people who buy insurance are the ones most likely to collect." b. If insurance companies are correct in their suspicion, what are the consequences for the market for insurance?

It will increase the price of insurance.

10.1.8 The following entries (in millions of dollars) are from the balance sheet of Rivendell National Bank (RNB): b. RNB's capital is what percentage of its assets?

Capital/asset ratio = 22/122 = 0.18

9.2.5 What is collateral? How do banks use collateral to reduce adverse selection in making car loans?

Collateral refers to assets that a borrower pledges to a lender that the lender may seize if the borrower defaults on the loan. When buying a car, the car serves as collateral because the bank can seize the car if the borrower does not make payments.

9.2.3 What is credit rationing? Why would a lender ration credit rather than raise the interest rate it charges on loans?

Credit rationing is the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate. Firms ration credit instead of raising interest rates because asymmetric information leads only the most risky borrowers to borrow at the higher rates.

10. 3.2 What is credit risk? How do banks manage credit risk?

Credit risk is the risk of credit default. Banks can manage credit risk by diversifying their assets, performing credit risk analysis, requiring borrowers to put up collateral, credit rationing, and creating long-term business relationships through which the bank would acquire information about a creditor.

10.3.7 Briefly explain whether you agree with the following statements: c. "If a bank manager expects interest rates to fall in the future, he should increase the duration of his bank's liabilities."

Disagree. Higher duration of its liabilities will reduce profitability.

9.2.15 Writing in the WSJ, Vincent Reinhart, the former director of the Federal Reserve's division of monetary affairs, argued: The problem with securitization is that it dilutes individual responsibility. The mortgage broker can easily become disconnected from the outcome of the initial lending decision. Federal regulation is needed to ensure that mortgage originators perform the appropriate due diligence in matching potential borrowers with loan products. c. What is due diligence? What does Reinhart mean when he says that federal regulation should require that mortgage originators perform due diligence in this context?

Due diligence is the research performed on a financial asset that closely evaluates its fundamentals. In this case, due diligence would be the research on the borrowers to determine the risk involved in the borrower paying back the loan. Federal regulation should force the originator to bear some of the risk of the loan. This is often referred to as having "skin in the game."

9.1.4 What are economies of scale? What role do economies of scale play in helping financial intermediaries to reduce transactions costs?

Economies of scale are the reduction in average costs that results from an increase in the volume of a good or service produced. Financial intermediaries reduce transaction costs because of their economies of scale in risk assessment

10.4.5 What is electronic banking?

Electronic banking refers to banking transactions done electronically, such as with ATMS and online banking services. Virtual banks conduct all banking transactions online.

9.1.5 What advantages do financial intermediaries have over small savers in dealing with the transactions costs involved in making loans?

Financial intermediaries are able to take advantage of economies of scale, such as standardized legal contracts, specialized loan officers, and sophisticated computer systems, to reduce transactions and information costs.

9.1.3 What are financial intermediaries? Why are financial intermediaries important to the financial system?

Financial intermediaries, such as commercial banks and mutual funds, channel funds from savers to borrowers. They are important to the financial system because they create a market for saving and lending, matching savers and borrowers. They reduce transactions and information costs.

10.3.4 What is the difference between gap analysis and duration analysis? What is the purpose of gap analysis and duration analysis?

Gap analysis is analysis of the difference between the dollar value of a bank's variable rate assets and the dollar value of its variable rate liabilities. Duration analysis is an analysis of how sensitive a bank's capital is to changes in market interest rates. The purpose of both is to determine the bank's sensitivity to interest rate movements.

10.4.8 [Related to the Making the Connection on page 303] In early 2010, an article in the Wall Street Journal described an increase in "vendor financing" to small businesses.With vendor financing, the suppliers, or vendors, to a small business make loans to the business beyond the usual short-term financing connected with the business's buying the vendor's product. For instance, a manufacturer of women's clothing might make a loan to a small boutique clothing store. In early 2010, why might small businesses have been trying to borrow from their vendors rather than from banks? What would be the advantages and disadvantages to a small business of borrowing from a vendor rather than from a bank? What would be the advantages and disadvantages to the vendor of making the loan?

In general, banks reduced their lending during the financial crisis. So as loans expired, banks built reserves. Small businesses had a difficult time finding sources of funds. One of the solutions was to borrow from suppliers (vendors). The advantages to the small business is the access to funds (a loan) and the disadvantages is typically a higher interest rate than the bank would charge. The advantage to the supplier is that the small business continues to operate and buy its product, and the disadvantage is that the supplier does not have economies of scale in risk assessment and the chance that the borrower will default.

10.2.9 [Related to the Making the Connection on page 289] An article in the Wall Street Journal notes that in response to the failure of some small community banks: [The] Federal Deposit Insurance Corp., Federal Reserve and other regulatory agencies are increasing their scrutiny of local lenders. . . . As part of the effort, the watchdogs are asking the banks to boost their capital and loan-loss reserves even further. . . . b. If a bank increases its loan loss reserves, will it have less money available to lend?

Increasing loan loss reserves will not reduce the amount of money the banks have available to lend, unless the bank falls below capital requirements.

10. 2.8 Suppose that National Bank of Guerneville has $34 million in checkable deposits, Commonwealth Bank has $47 million in checkable deposits, and the required reserve ratio for checkable deposits is 10%. If National Bank of Guerneville has $4 million in reserves and Commonwealth has $5 million in reserves, how much in excess reserves does each bank have? Now suppose that a customer of National Bank of Guerneville writes a check for $1 million to a real estate broker who deposits the check at Commonwealth. After the check clears, how much in excess reserves does each bank have?

Initially: $0.6 million in excess reserves for National Bank of Guerneville, $0.3 million for Commonwealth Bank. After the transaction: National Bank of Guerneville now has -0.3 million in excess reserves, and Commonwealth Bank has 1.2 in excess reserves.

10.3.3 What is interest-rate risk? How do banks manage interest-rate risk?

Interest-rate risk is the risk associated with the change in value of assets and liabilities because of an increase or decrease in interest rates. Banks can reduce interest-rate risk by making more floating rate loans, or ARMs, using interest rate swaps, and using futures and options contracts.

9.2.13 In discussing the Abacus CDO case, Alan Murray, deputy managing editor of the Wall Street Journal, observed: "Markets don't work if you don't have good information and you don't have transparency. And this [CDO] is terribly lacking in transparency." b. Why won't financial markets work without good information and transparency?

Lack of transparency creates moral hazard and adverse selection problems that increase the risk of the transaction.

9.2.10 The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." b. If the statement is correct, what are the implications for the market for rental apartments?

Landlords will attempt to charge a higher price than they otherwise would receive in the absence of this information asymmetry, and there is the possibility of the "lemons problem" of bad rental properties driving good rental properties out of the market.

9.1.7 What advantages might large banks have over small banks in making loans?

Large banks might be able to exploit economies of scale in a way that small banks cannot. Thus, large banks would have lower costs per transaction.

10.3.1 What is liquidity risk? How do banks manage liquidity risk?

Liquidity risk is the possibility that depositors may collectively decide to withdraw more funds than the bank has immediately on hand. Banks manage this risk by keeping some funds very liquid, such as in the federal funds market or a reverse repurchase agreement. Banks can also increase their borrowings to cover liquidity risk.

10.2.5 Why might the managers of a bank want the bank to be highly leveraged? Why might the bank's shareholders want the bank to be less highly leveraged?

Managers of the bank make bonuses on quarterly performance of the company and on its stock, which provides the incentive to take risk with leverage to increase ROE. Shareholders who have invested in the company often want the best return over 10-20 years, and want the bank to take less risk which would typically be associated with less leverage.

9.2.1 What is the difference between moral hazard and adverse selection? How does each contribute to making information asymmetric?

Moral hazard occurs in financial markets when borrowers use borrowed funds differently than they would have used their own funds. Adverse selection occurs when borrowers who are bad risks are more likely to accept a financial contract than are borrowers who are good risks. Each makes information asymmetric: The lender may not know what the borrower will do with the funds as a result of moral hazard, and the lender may not know the riskiness of the borrower as a result of adverse selection.

10. 2.2 What is a bank's net interest margin? How is it related to a bank's return on assets (ROA)?

Net interest margin is the difference between the interest a bank received on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets. Return on assets (ROA) equals the sum of the net interest margin plus the ratio of bank fee revenue net of the cost of providing its services to total bank assets.

9.2.6 What is net worth? What role does net worth play in lenders' attempts to reduce adverse selection problems?

Net worth is the difference between the value of a firm's assets and the value of its liabilities. Net worth provides the same assurance to lenders as collateral.

10. 1.9 In July 2010, Congress was considering having the federal government set up a "lending fund" for small banks. The U.S. Treasury would lend the funds to banks. The more of the funds the banks loaned to small businesses, the lower the interest rate the Treasury would charge the banks on the loans. Congressman Walt Minnick of Idaho was asked to comment on whether the bill would be helpful to small businesses. Here is part of his response: The bank that's struggling to write down their commercial real estate assets is having to take a hit to capital, and this provides replacement capital on very, very favorable terms. So it deals with the left side of the balance sheet... a. Would a loan from the Treasury be counted as part of a bank's capital?

No, a loan from the Treasury would not be counted as bank capital. It would be counted as borrowing and appear on the right hand side of the balance sheet.

10.1.3 Define the following terms from a bank's balance sheet: a. Nontransaction deposits

Nontransaction deposits: deposits that cannot be immediately withdrawn, and which typically pay a higher interest payment.

10.4.4 What are off-balance-sheet activities? List four off-balance-sheet activities and briefly explain what they are.

Off-balance-sheet activities are activities that generate fee income but do not affect a bank's balance sheet because they do not increase either the bank's assets or its liabilities. 1) Standby letters of credit: A promise by a bank to lend funds, if necessary, to the seller of commercial paper at the time that the commercial paper matures. 2) Loan commitment: A bank agrees to provide a borrower with a stated amount of funds during some specified time. 3) Loan sales: A financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party. 4) Trading activities: Trading in the futures, options, or swaps market.

10.1.5 If commercial banks were allowed to purchase significant amounts of stock in the companies to which they make loans, would this increase or decrease the extent of moral hazard in the financial system? Briefly explain.

On the one hand, banks might be better able to monitor the behavior of the companies they had made loans to, so moral hazard should decrease. On the other hand, the existence of deposit insurance generates moral hazard concerning which stocks a bank purchased. To the extent that equity investments are riskier than the usual commercial bank investments under the current system, moral hazard problems might increase

9. 2.20 b. How do the operators of a Ponzi scheme manage to keep it going? Are investors to blame for believing they can get rich quickly as this article indicates?

Ponzi schemes use money from new investors to pay current investors. Many "funds" do not reveal their investment strategies, which generates asymmetric information. This makes it difficult for investors to determine if a firm is honest.

10.2.10 Suppose that the value of a bank's assets is $40 billion and the value of its liabilities is $36 billion.If the bank has ROA = 2%, then what is its ROE?

ROE = 0.02 x ($40/$4) = .2 or 20%.

10.1.4 How have the types of loans banks make changed over time?

Real estate loans have become a much higher percentage of total loans since 1973, while commercial loans have declined.

9.2.7 What is relationship banking? How do banks and borrowers benefit from relationship banking?

Relationship banking is the ability of banks to assess credit risks on the basis of private information about borrowers. Banks have less risk because of the additional information they collect about the borrower. The borrower gets a lower interest rate because they are a lower risk to the bank.

10.1.3 Define the following terms from a bank's balance sheet: c. Reserves

Reserves: A bank asset consisting of vault cash plus bank deposits with the Federal Reserve.

10.2.3 What is the difference between a bank's return on assets (ROA) and its return on equity (ROE)? How are they related?

Return on Assets (ROA): The ratio of a bank's after-tax profit to the value of its assets. Return on equity (ROE): The ratio of the value of a bank's after-tax profit to the value of its capital. They are related because ROE is equal to ROA (Bank assets/Bank Capital).

9.1.1 Why do savers with small amounts to invest rarely make loans directly to individuals or firms?

Savers with small amounts to invest rarely make loans directly to individuals or firms because transaction costs and information costs make small transactions very expensive relative to the return.

9.2.15 a. What is securitization?

Securitization is the process of combining loans, such as mortgages, into securities that can be sold on financial markets.

10.4.9 [Related to the Making the Connection on page 302] Entrepreneurs in Somalia have managed to carry out a substantial amount of banking activity using cell phones. Are there certain banking activities that are difficult to carry out when relying exclusively on cell phones and Web sites?

Taking out cash from your bank would be difficult over the phone. Most banking activities can take place through e-banking.

9.2.2 Explain the "lemons problem." How does the lemons problem lead many firms to borrow from banks rather than from individual investors?

The "lemons problem" refers to the adverse selection problem that arises from asymmetric information. Because potential investors have difficulty in distinguishing good borrowers from bad borrowers, they offer good borrowers terms they are reluctant to accept. Because banks specialize in gathering information, they are able to overcome this problem.

10.4.2 What is the FDIC? Why was it established?

The FDIC stands for the Federal Deposit Insurance Corporation. The FDIC was established in 1934 after a series of bank failures. The FDIC was established to ameliorate bank runs.

10.4.10 The Capital Purchase Program carried out under TARP represented an attempt by the federal government to increase the capital of banks.Why would the federal government consider it important to increase bank capital? What might be some of the consequences of banks having insufficient capital?

The Federal government wanted bank capital to increase in order to keep banks with falling asset values solvent. A consequence of insufficient capital is insolvency.

9.1.6 How has the growth of the Internet affected the problem of transactions costs and information costs in the financial system?

The Internet has reduced information and transactions costs. The Internet reduces the drive time of shopping for consumers and reduces the difficulty of acquiring information to make smart investment decisions.

9.2.4 What is the Securities and Exchange Commission (SEC)? Why was it founded? What effect has the SEC had on the level of asymmetric information in the U.S. financial system?

The Securities and Exchange Commission (SEC) is a federal government agency that regulates U.S. stock and bond markets. The SEC's primary role is to reduce adverse selection by requiring the disclosure of financial and accounting information from all publically traded firms. The SEC was founded in 1934 in an attempt to alleviate the asymmetric information problem that became apparent following the stock market crash of 1929. The SEC has been successful in reducing the cost of asymmetric information, but it has not eliminated it completely.

9.3.3 The stock market is the most widely reported financial market and is what many people think of first when they think of "investing." Why, then, is the stock market not the most important source of financing for corporations?

The bond market is preferred to the stock market as the most important source of financing for corporations because bonds present less of a moral hazard risk than buying stock.

9.2.13 In discussing the Abacus CDO case, Alan Murray, deputy managing editor of the Wall Street Journal, observed: "Markets don't work if you don't have good information and you don't have transparency. And this [CDO] is terribly lacking in transparency." c. What information was lacking and who lacked it in the Abacus CDO case?

The buyers of the CDOs lacked information. Goldman Sachs neglected to inform the buyers that the hedge fund Paulson & Co. helped pick the mortgage-backed securities to be included in the Abacus CDOs and that Paulson & Co. intended to place bets that the CDOs would lose value.

9. 2.19 A news story reported that the former CEO of homebuilder KB Home was convicted "of four felony counts in a stock option backdating scam." The article goes on to note: A stock option allows an employee to purchase a company's stock at a preset price at a future date. [The CEO] retroactively tied the exercise price of his options to dates when the stock was selling for a low price. b. What is the "exercise price" in an options contract? Why would this manager have wanted his options backdated?

The exercise price is the price at which the buyer of an option has the right to buy or sell the underlying asset. In this case, the exercise price was the price that the KB Home CEO could buy stock By backdating the options to an earlier date when the stock price was lower, the CEO is able to purchase shares of the company at a cheaper price and then resell the stock at the current higher price

10. 2.13 Suppose that you are considering investing in a bank that is earning a higher ROE than most other banks. You learn that the bank has $300 million in capital and $5 billion in assets.Would you become an investor in this bank? Briefly explain.

The higher the ratio of assets to capital, the more money a bank can make but the more leveraged the bank becomes. Generally speaking, it would be unwise to invest in a bank with an asset/capital ratio that is this high.

9.2.19 A news story reported that the former CEO of homebuilder KB Home was convicted "of four felony counts in a stock option backdating scam." The article goes on to note: A stock option allows an employee to purchase a company's stock at a preset price at a future date. [The CEO] retroactively tied the exercise price of his options to dates when the stock was selling for a low price. c. From the point of view of investors in KB Home, which information problem is involved here?

The information problem involves the principal-agent problem-the moral hazard problem of managers pursuing their own interests rather than those of shareholders.

10.3.5 Before 1933, there was no federal deposit insurance.Was the liquidity risk faced by banks during those years likely to have been larger or smaller than it is today? Briefly explain.

The liquidity risk would have been larger because the absence of deposit insurance created the incentive for depositors to withdraw funds whenever they became concerned about the bank's viability, thus putting that viability at risk.

9.3.9 Commenting on the Abacus CDO case,WSJ columnist Brett Arends offered the opinion that "as a rule of thumb, the more complex a [financial] product is, the worse the deal." Do you agree? Why would a more complex financial product be likely to be a worse deal for an investor than a simpler product?

The more complex the product, the more difficult it is for an investor to assess the risk of the product. When investors buy simpler products, they typically have more information and can make more informed choices about the products. The more complex deal is often one for which information costs increase, which then reduces the resulting profit from the deal.

9.3.1 What is the most important source of funds to small- to medium-sized firms? What is the most important source of external funds to small- to medium-sized firms?

The owners' personal funds and profits are the primary source of funds for small- to medium-sized firms. Loans from financial intermediaries are the most important source of external funds to small- to medium-sized firms, because financial intermediaries can reduce transaction and info costs, they are able to provide a path by which funds can flow from savers to smaller firms. Smaller firms also rely on trade credit. Trade credit is the common situation where a supplier ships the firm goods ordered while agreeing to accept payment at a later date.

9.2.8 What is the principal-agent problem? How is the principal-agent problem related to the concept of moral hazard?

The principal-agent problem occurs when managers (agent) succumb to moral hazard and follow their own self interests rather than the interest of the shareholders (principal).

9.2.11 At a used car lot, a nearly new car with only 2,000 miles on the odometer is selling for half the car's original price. The salesperson tells you that the car was "driven by a little old lady from Pasadena" who had it for two months and then decided that she "didn't like the color." The sales-person assures you that the car is in great shape and has had no major problems.What type of asymmetric information problem is present here? How can you get around the problem?

The problem is adverse selection. It is likely that only a lemon would be sold so fast. A buyer could circumvent the problem by having a mechanic inspect the car or by getting a guarantee from the dealer (or trust the dealer's reputation).

10.3.8 A Congresswoman introduces a bill to outlaw credit rationing by banks. The bill would require that every applicant be granted a loan, no matter how high the risk that the applicant would not pay back the loan. She defends the bill by arguing: There is nothing in this bill that precludes banks from charging whatever interest rate they would like on their loans; they simply have to give a loan to everyone who applies. If the banks are smart, they will set their interest rates so that the expected return on each loan—after taking into account the probability that the applicant will default on the loan—is the same. Evaluate the Congresswoman's argument and the likely effects of the bill on the banking system.

The problem with this bill is that it creates adverse selection . With the high interest rates the low-risk borrowers in this group will drop out of the loan pool, leaving only the high-risk borrowers.

9. 3.5 Consider the possibility of income insurance. With income insurance, if a person loses his job or doesn't get as big a raise as anticipated, he would be compensated under his insurance coverage. Why don't insurance companies offer income insurance of this type?

The problems are moral hazard (once insured, you won't work as hard) and adverse selection (people who are more likely to be fired or get low raises would be more likely to buy such insurance)

9.2.10 The author of a newspaper article providing advice to renters observes that "landlords will always know more than you do." c. In what ways is the market for rental apartments like the market for used cars? In what ways is it different?

The rental property market and the used car market are similar in that the landlord and the current car owner know more about the property or the car than the potential renter or buyer. However, they differ in that the landlord is not selling the apartment, merely renting it. Thus, if a landlord wants the tenant to renew the lease, the landlord will be forced to keep the property in shape so its value approaches the rental rate. This would be similar to the car dealer offering a warranty.

9.2.16 Reinhart also argued: "Widespread home ownership was in part made possible by giving people a broad range of alternative ways to fund house purchases. The transfer of loans from banks to investors through asset securitization helped open up those opportunities." Explain more fully how securitization of mortgage loans may have contributed to "widespread home ownership" in the United States.

The securitization of mortgage loans allowed the issuer of loans (banks) to eliminate the risk involved in offering loans. If a bank had to hold a loan for 30 years, it would take more time to risk-assess the borrower and would turn down high-risk customers. Since banks simply sell these loans to investors on the secondary mortgage market, they have no incentive to accurately risk- assess customers.

9.3.4 List the three key features of the financial system and provide a brief explanation for each.

The three key features are: 1) Loans from financial intermediaries are the most important external source of funds for small to medium sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms. 2) The stock market is a less important source of external funds to corporations than is the bond market. This is because there is less moral hazard involved with bonds than with stocks. 3) Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard.

9.3.8 [Related to the Making the Connection on page 270] During a Congressional Committee hearing at which Goldman Sachs CEO Lloyd Blankfein testified, Senator David Pryor of Arkansas asked Blankfein, "Why would clients believe in Goldman Sachs?" Blankfein replied that Goldman Sachs was acting as a market maker for the Abacus CDOs and that a market maker shouldn't be responsible for determining whether the securities it buys and sells are appropriate for every investor: "The markets couldn't work if you had to make sure it was good for them." c. Do you agree with Blankfein that "the markets couldn't work if [market makers] had to make sure it was good for [investors]"? Briefly explain.

There is disagreement about the role of market makers. Some argue that market makers have the obligation to provide more information to the seller and buyer. Others argue that it is the job of the buyer and seller to collect that information.

10.4.7 Evaluate the following statement: "The United States has more than 6,000 banks, while Canada has only a few. Therefore, the U.S. banking industry must be more competitive than the Canadian banking industry.

This statement is misleading because branching restrictions in the United States give local banks more monopoly power than that possessed by branches of Canadian national banks.

10.1.6 [Related to the Making the Connection on page 283] In 1960, federal regulations prohibited banks from paying interest on checking accounts. Today, banks are legally allowed to pay interest on checking accounts, yet the value of checking accounts has shrunk from more than 50% of commercial bank liabilities in 1960 to about 10%. Because checking accounts now pay interest, shouldn't they have become more popular with households rather than less popular?

This would have increased the popularity of checking accounts, but at the same time banks have created several savings instruments that offer higher interest rates that savers can choose, including certificates of deposit and money market deposit accounts. Furthermore, as wealth has increased over time, households hold less in checking accounts relative to other financial assets

9.1.2 What are transaction costs? What are information costs?

Transactions costs are the costs of a trade. Information costs are the costs that savers incur in determining the creditworthiness of borrowers.

9.2.13 In discussing the Abacus CDO case, Alan Murray, deputy managing editor of the Wall Street Journal, observed: "Markets don't work if you don't have good information and you don't have transparency. And this [CDO] is terribly lacking in transparency." a. What is "transparency" in this instance?

Transparency refers to perfect information on both sides of the transaction, particularly in this case how the mortgage-backed securities for the Abacus CDOs were picked.

9.2.14 Brett Arends, a columnist for the Wall Street Journal, argues: "Today you should probably view [financial firms selling investments] the way you view someone selling a used car." How should you view someone selling a used car? Why might you want to view someone selling a financial investment the same way?

When buying a used car, buyers should always be aware of information asymmetry. The seller typically knows more about the car than the buyer. Sellers of financial instruments also have more information than the buyers of financial instruments. Because of this asymmetry, buyers should be cautious.

9.2.15 b. Why might securitization lead to a mortgage broker becoming disconnected from the outcome of a lending decision?

When the loans are bundled together and sold off, the bank that issued the loan doesn't bear the cost if the borrower fails to pay back the loan. The bank that issues the loan makes its money by originating and selling the loans on the secondary market. This creates a moral hazard problem.

10.3.6 Does the existence of reserve requirements make it easier for banks to deal with bank runs?

Yes, the existence of reserve requirements makes it easier for banks to deal with bank runs because they are required to hold money with the Federal Reserve

10.4.11 In September 2009,Wells Fargo indicated that it wanted to pay back $25 billion it had received under the Capital Purchase Program. John Stumpf,Wells Fargo's CEO, was quoted as saying: "We will pay back. . . .We are now earning capital so quickly . . . we don't want to dilute our existing shareholders." a. How can a bank "earn capital"? b. How would a failure by a bank to pay back the federal government's stock purchase under the Capital Purchase Program "dilute existing shareholders"?

a. Capital can increase as banks earn profits, and then, rather than pay them out in dividends, retain them as reserves or other assets. b. It dilutes the existing shareholder equity because the government would own shares. When Wells Fargo pays back the Federal Government, the bank is essentially buying the shares back.

10.2.11 Suppose First National Bank has $200 million in assets and $20 million in equity capital. a. If First National has a 2% ROA, what is its ROE? b. Suppose First National's equity capital declines to $10 million, while its assets and ROA are unchanged.What is First National's ROE now?

a. ROE = 0.02 = ($200/$20) = 0.2 or 20%. b. 0.4 or 40%.