ECO3223-Assignment 4

The collapse of the bubble in the housing market in the United States followed by the selloff in the stock market had a major effect on the U.S. economy in terms of economic growth and unemployment. Explain the linkage between them.

1. (Collapse of the bubble) Federal legislation that was designed to increase home ownership, historically low interest rates, growth of non-traditional lenders, and expansion of financial derivatives, which led to the spread of sub-prime mortgages. When the housing bubble collapsed, the sub-prime mortgages went into mass default. 2. (Sell-off in the stock market) When the sub-prime mortgages went into mass default, the mortgage backed securities lost their value. This led to a mass attempt to sell off the assets, but there was no demand for them (toxic assets). Thus the institutions and individuals that had invested in these assets saw a large reduction in their net worth.

Morgan Stanley and Goldman Sachs converted their charters to become commercial banks rather than investment banks as a result of the credit crisis. What were the advantages and disadvantages?

1. Converting attracted federally insured deposits and sure up their funding sources and gives the banks access to the federal reserve as a lender of last resort. Because of this, it prevented a bank run. 2. The disadvantage is that commercial banks are, in general, more heavily regulated. This led to them having had to reduce their current risk. The reduced risk also leads to a lower expected rate of return. The leverage ratios also had to be reduced. Finally they faced a stiffer capital requirement, which is one of the more important regulations they now needed to follow.

President Obama's plan for reform of financial market regulation included proposals to

1: create a Financial Services Oversight Council to identify sources of systemic risk 2. coordinate the activities of the various federal agencies that regulate the financial markets to head off systemic failures before they develop.

What is the objective of creating the Financial Stability Oversight Council (FSOC)? What authority does it have to carry out its mission?

1: creating the FSOC was to monitor development in the financial market and identify any potential systemic risk that can produce instability in the financial system. 2: Recommended for increasing strict rules for suspect firms, and can approve extending federal reserve regulation to non-bank financial firms. Authorizatized by the Fed.

Bank Run

A bank run is an event in which investors believe (whether true or not) a financial institution is failing, and rush to remove their investments, often causing the institution to fail regardless of whether the institution was doing well originally or not.

Too Big to Fail

A too big to fail firm is a firm that has many strategic relationship with other firms. The failure of the too big to fail firm will lead to the collapse of the other firms, which leads to a systematic failure and threaten a financial collapse.

Toxic Asset

A toxic asset is an asset in which a price cannot readily be determined and therefore there is no signficant market for the asset.

What role did AIG play in deepening the financial crisis?

AIG invested in mortgage related financial derivate during the boom years. They were also a principal supplier of CDSs to firms wishing to hedge their risk in financial derivatives. This lead to a downgrade on their debt, which caused creditors to withdraw their funds. Federal Reserve had to bail out AIG twice, and both times the stock market took a dive.

What was the origin of Fannie Mae and Freddie Mac? How did their mission change over time?

After world war II, Fannie Mae and Freddie Mac were founded with the goal of promoting the American dream of home ownership. They were authorized to issue government-backed bonds and use the proceeds to purchase mortgages. The mortgage payments were then used to retire the bonds. This created a more liquid national mortgage market to increase homeownership in the U.S. Fannie and Freddie were privatized in the 1970s, and got heavily involved in financial derivaties, which lead to bankruptcy during the credit crisis. This lead to a takeover by the government.

Explain the importance of Bank Capital in regulating the banking system.

Bank capital is the part of the bank's balance sheet that absorbs any loans (bank's assets) that must be written off. Capital requirements requires banks to maintain a certain amount of bank capital relative to size and risk of its asset portfolio. During the great recession many banks' capital requirements were insuffcient to absorb the large number of write-offs that occurred at once.

What advantages do banks realize when securitizing (convert an asset i.e. a loan) into marketable securities loans, such as mortgage contracts?

Banks benefit by removing the risky mortgages from their balance sheets, while receiving funds that can be used to make additional loans and investments while retaining the service rights of the mortgages.

What advantages do banks realize when securitizing (converting) loans, such as mortgage contracts?

Banks can get risky loans off their books and frees up financial capital for other investments. Banks also retain the servicing rights on the loans they originated, which is the source of income.

How does a Credit Default Swap (CDS) differ from a standard insurance contract? What is a Naked CDS?

CDS is not required by law to maintain adequate reserves to meet any claims that may arise in the event of a default. A naked CDS is a CDS in which the purchaser has no insurable interest in the financial asset being insured

A collateralized debt obligation (CDO)

Collateralized debt obligation (CDO) may have portfolio collateral that consists of pools of various tranches of collateralized mortgage obligation (CMOs), or even of other CDOs. can produce some highly rated (low-risk) tranches for investors even if the portfolio collateral is entirely "junk," that is, the collateral has the lowest credit rating (and carries the highest risk).

Financial weapons of mass destruction

Derivatives Financial weapons of mass destruction refers to the financial derivatives tied to the housing market that eventually imploded and financial crisis erupted.

Describe the importance of requiring mortgage originators to retain some "Skin in the Game" when they securitize mortgage pools, that is, how does it alter their incentives when originating mortgages?

Going back to moral hazard, if it is your money you tend to play it more safely than if you get money elsewhere to risk. The importance of requiring mortgage originators to retain some skin in the game is so that originators will have an incentive to reduce risk for mortgage default, play it safer because if they are too risky, they will lose their money, rather than someone else's.

Bear Stearns fate

In response, the Federal Reserve engineered a "shot-gun marriage" between Bear Stearns and its lead commercial bank JP Morgan Chase. Essentially the Federal Reserve made a large loan to JP Morgan Chase to purchase Bear Stearns.

How does investment banking differ from commercial banking?

Investment banks (riskier) Consultants to large corporations Advise how to raise funds in the capital markets Underwrite new securities offerings Assists firms in IPOs Advise firms on mergers and acquisitions Manage client's investments Manages investment of their own accounts. Leverage ratios 30:1 - 35:1 Less stringently regulation than commercial banks Commercial banks (less risky-backed by Fed): Derive most of their funds from federally insured deposit accounts, thus subject to strict regulations on excessive risk-taking Leverage ratio of 10:1

Merill Lynch fate

Merrill Lynch was sold to Bank of America in a re-sale to AIG. Merrill lynch was also facing a bank run. Merrill Lynch's portfolio was suffciently strong to sell AIG.

How does the problem of "Too Big To Fail" relate to "systemic risk"? In what ways has Dodd-Frank attempted to deal with this problem?

Systemic risk is the risk of the failure of an entire financial system, as opposed to the failure of any one entity. Too big to fail is essentially the failure of a large financial institution with so much relationships to other financial institution that the failure of that one firm will cause a domino effect resulting in a systemic failure. Thus the systemic risk is dependent on the risk of the too big to fail firm. Dodd-Frank created Financial Stability Oversight Council (FSOC)

What was the Troubled Asset Relief Fund (TARP) originally designed to do and how was it ultimately used?

TARP was designed to buy toxic assets from troubled financial firms. It was ultimately used to bail out, the auto industry, and to homeowners to avoid foreclosures. It also was used to fund the initial bailout of AIG by the Fed.

What role did the Nationally Recognized Statistical Rating Organizations (NRSROs) play in deepening the financial crisis, and what actions have taken in Dodd-Frank to deal with this problem?

The Nationally recognized statistical rating organizations failed to adequately assess the risk of many financial derivative products and debt of the rm that owned those assets. This poor reading of the risk of CMOs and CDOs fueled the demand of these instruments and increased the quantity supplied of these assets, spreading the risk to world wide financial institutions. Dodd-Frank would have had the NRSRO report the methodologies they used in obtaining ratings, use 3rd party information of ratings, and track the record for the ratings. If the NRSRO is constantly inaccurate with ratings, Dodd-Frank has the power to deregister the ratings agency. Individuals can take legal action against the ratings agency. Finally, the ratings analysts must pass a qualifying exam.

Lehman Brothers fate

The federal Reserve tried to engineer a takeover however no buyer could be found, so the Federal Reserve and Treasury Department determined the asset portfolio was too weak to save so they filed for bankruptcy. On "Lehman Day" September 15, 2008, Lehman led for bankruptcy.Similarly Lehman Brothers also had a bank run. The failure of Lehman's Brother signaled other firms and investors that the Federal reserve and the Treasury were not going to always bail out large, troubled financial institutions.

What steps were taken to strengthen the Federal Reserve? In what ways did Dodd-Frank increase oversight of the Federal Reserve's activities?

The federal reserve will be the principal regulator over large, complex financial firms whose operation could pose a systemic risk to financial stability. Dodd-frank increase the oversight of the federal reserve by establishing a vice chair for supervision. President of the Federal reserve bank of New York will be appointed by the president, and GAO can audit any emergency lending facility operated by the federal reserve.

What are the differences between a conventional (traditional) and a subprime mortgage?

The terms on a traditional mortgage is often 20% down, fixed interest rate for the life of the mortgage, which is usually 30 years, and foreclosure if the payment is not met. Sub-prime mortgage are targeted individuals who do not qualify for traditional mortgages (reduced requirements for income, asset holdings, credit history). The terms for these mortgages are usually low down payments, sometimes with numerous "interest only" contracts. They also come with low teaser rates for the first few years of the contract, after which there was a "balloon payment" requiring refinancing at the market rate.

Credit default swaps (CDSs)

To gain some protection against possible default on these very complex assets, many investors sought to purchase insurance whereby they could obtain the value of the assets in the event of default. These contracts are known as credit default swaps or CDSs. have a constructive role to play in the management of portfolio risk for financial firms, but they nonetheless contributed to deepening the financial crisis of 2007-2009.

Why is "transparency" such a critical issue in the trading of financial derivatives? How is Dodd-Frank attempting to enhance transparency in those markets?

Transparency is important in trading financial derivatives because of their inherent complexity, and without transparency it is impossible to determine the actual value of financial derivatives. Dodd-Frank made banks with these derivatives register with the SEC, Report trading activities, and gave states responsibility for smaller hedge funds.

Transparency

Transparency is the extent in which the investor has ready access to financial information about the investment. Less transparency means more risk about the investment, and no transparency leads to a toxic asset.

A mortgage-backed security (MBS)

is designed to increase funding of mortgages by producing securities that can be sold directly in the financial markets with the proceeds used to purchase mortgages from the institutions that originated them.

Describe the recent updates to Dodd-Frank as they relate to small-and medium-size banks? Why were these changes made?

medium banks are of the systematically important financial institution, which relives these institutions from significant amount of costly regulatory requirements, and exceptions for the Volcker rules for small banks.