Chapter 1

Subprime vs Alt-A borrowers

A subprime borrower is a borrower with a flawed credit history. Alt-A borrower is a borrower who states his or her income but does not document or prove the amount of income.

Why is a bubble more likely to occur in the housing market rather than in the market for automobiles or the market for​ refrigerators?

Because a house is likely to increase in price while automobiles and refrigerators are less likely to gain in value.

How does securitization result in mortgages being​ "sliced into numerous​ pieces"?

Because the loans have been bundled with other loans and resold to other investors.

Benefits of using​ peer-to-peer lending

Borrowers can apply for a loan online, interest rates are lower than those on credit cards, and it may be easier to qualify for a loan. NOT a benefit: the funds for the loans come directly from the bank.

How does the creation of a secondary market in mortgages help to promote home​ ownership?

By allowing banks to transfer the risk of holding a loan to firms that have economies of scale in risk assessment. By allowing banks to offer a lower interest rate than if they held the loan themselves.

What actions did the Federal Reserve and Treasury take in dealing with the financial​ crisis?

Congress passed the Troubled Asset Relief Program​ (TARP) and the Treasury actively worked with the Fed to ensure financial stability. The Federal Reserve and the Treasury worked together to find a buyout partner for Bear Stearns. The Fed aggressively lowered interest rates and created several new credit windows for distressed banks.

Direct vs Indirect Financing

Direct finance is a transaction between two parties where one party lends directly to the other​ party. Indirect finance involves three​ parties: the​ borrower, the​ lender, and a third party such as a bank.

Which involves financial​ intermediaries, and which involves financial​ markets?

Direct finance requires financial​ markets, while indirect finance involves financial intermediaries

Suppose financial intermediaries did not exist and only direct finance was possible. How would this affect the process of an individual buying a car or a​ house?

Direct financing would increase the price the lender charges and reduce the number of loans.

How do the​ Fed's current responsibilities compare with its responsibilities when it was first created by​ Congress?

In addition to its original role as a lender of last​ resort, the modern Fed is now responsible for monetary policy.

By the​ 2000s, what significant changes had taken place in the mortgage​ market?

Investment banks began buying​ mortgages, bundling large numbers of them together as​ mortgage-backed securities, and reselling them to investors. Lenders created new types of​ non-traditional loans, allowing borrowers to pay a very low interest rate for the first few years of the mortgage and then pay a higher rate in later years. Lenders loosened the standards for obtaining a mortgage loanlong dash—often lending to subprime borrowers and​ Alt-A borrowers.

Describe key services that the financial system provides to savers.

Liquidity, Economies of scale of information, Risk sharing

What problems did the decline in housing prices that began in 2006 cause for the financial​ system?

Many subprime and​ Alt-A borrowers, borrowers with adjustable rate​ mortgages, and borrowers who had made only small down payments defaulted on their mortgages. Banks began to restrict credit to all but the safest borrowers limiting the flow of funds from savers to borrowers. The value of​ mortgage-backed securities declined sharply causing heavy losses for the investment institutions owning these securities.

Five Key Financial Assets

Money is anything that people are willing to accept in payment for goods and services or to pay off debts. A stock is a financial security that represents partial ownership of a firm. A bond is a financial security issued by a corporation or government to borrow money in exchange for the rights to an interest payment. Foreign exchange is a unit of foreign currency. A securitized loan is a collection of loans packaged together that pays an interest payment to the owner of the loan. Every financial asset IS NOT a financial security.

What a saver would consider a financial asset a borrower would consider a financial liability. Is this statement true or​ false?

TRUE

What actions did the Federal Reserve and Treasury take in dealing with the financial crisis?

The Treasury passed the Troubled Asset Relief Program (TARP) and actively worked with the Fed to ensure financial stability The Federal Reserve and the Treasury worked together to find a buyout partner for Bear Stearns The Fed aggressively lowered interest rates and created several new credit windows for distressed banks

What is the Federal​ Reserve?

The central bank of the United States.

Why would securitization make renegotiating a loan more​ difficult?

The cost of negotiation with every investor holding the security may be prohibitively costly.

What is the moral hazard​ problem?

The problem that managers of a financial firm will take on riskier investments because they believe the federal government will save them from bankruptcy.

Who appoints the members of the Federal​ Reserve's Board of​ Governors?

They are appointed by the president and confirmed by the Senate.

Why might the federal government decide to intervene in the housing market to promote home​ ownership?

To make it easier for families to borrow money to purchase homes.

What challenges might exist in accurately measuring housing​ prices?

Whether the value accounts for quality improvements or declines if the index is based solely on selling prices. Whether to use the price sold as the value of the house or the appraised value. Whether there are other features of a home or neighborhood that are not easily identifiable from an index number.

In a talk at the White House in December​ 2009, President Barack Obama​ argued: "Ultimately in this country we rise and fall​ together: banks and small​ businesses, consumers and large​ corporations." Why in this​ statement, did the president single out​ banks? Aren't​ supermarkets, airlines, software​ companies, and many other businesses also important to the​ economy?

Without a healthy banking​ system, supermarkets,​ airlines, and other businesses would not be able to conduct business.

Economists classify a​ "bubble" as

as an unsustainable increase in the price of a class of​ assets, such as the purchase of a home.

Could the actions of the Federal Reserve and Treasury be viewed as a moral hazard​ problem?

​Yes, financial firms such as Bear Stearns may continue taking on riskier investments because they believe a federal bailout is likely.