Econ 2035 Chapter 1

What is a key financial service provided by the financial system?

Risk sharing, liquidity, and information

By the end of 2009, loan losses were ________ at the end of 2007.

four times greater than

The financial system is primarily a means by which

funds are transferred from savers to borrowers

Financial intermediaries

include banks and other depository institutions

Until very recently, investment banks rarely engaged in what?

lending to households

If you buy a bond issued by Intel, the bond is a(n)

liability to Intel and an asset to you.

Fannie Mae and Freddie Mac both

sell bonds to investors and use the funds to purchase mortgages

A decline in bank lending has the most significant effect on

smal businesses

Diversification refers to the

splitting of wealth into many assets

Financial securities that represent partial ownership of a corporation are known as

stocks

Economists define risk as

the chance that the value of financial assets will change from what you expect

The Federal Reserve System

is the central bank of the United States

All of the following are true regarding securitized loans

they cannot be resold

The main role of financial intermediaries is to

borrow funds from savers and lend them to borrowers

At the beginning of the financial crisis, banks were hurt by all of the following

declines in the value of mortgage-backed securities, defaults on mortgages by those with subprime mortgages, not being repaid on loans to real estate developers

Alt-A borrowers were those who

did not provide documentation of their income when applying for a mortgage

From 1978 to 2016, the percentage of wealth held by households decreased for all of the following categories of assets

bonds, deposits, equity in unincorporated businesses

Because securitized loans are loans that have been bundled with other loans and sold to investors, they are

both financial assets and financial securities

A bank lending depositors' money to a local business and a pension fund investing contributions in shares of a company are similar financial activities in that

both involve funds being channeled from savers to borrowers through financial intermediaries

Increased liquidity in recent decades has reduced interest rates on which of the following assets (holding constant all other things that affect interest rates)?

business loans

Financial markets

channel funds directly from lenders to borrowers

The role of the financial system is to

channel funds from households and other savers to businesses

Securitization is the process of

converting loan into securities

Funds flow from lenders to borrowers

indirectly through financial intermediaries

The financial system provides risk sharing by allowing

savers to hold many assets

In the United States, monetary policy is carried out by

the Federal Reserve System

The Troubled Asset Relief Program (TARP) allowed

the Treasury to inject funds into commercial banks in return for stock in the banks

All of the following took place during the economic crisis that began in 2007

the financial system was disrupted, large portions of the U.S. economy were cut off from the funds they needed to thrive, there was a devastating decline in the production of goods and services throughout the economy

The financial crisis of 2007-2009 worsened after the failure of which firm?

Lehman Brothers

Which firm did the Treasury allow to fail during the financial crisis?

Lehman Brothers

In the United States, the lender of last resort is

The Federal Reserve

All of the following were significant changes in the mortgage market in the 2000s

investment banks became significant participants in the secondary mortgage market, lenders loosened lending standards, mortgage-backed securities became more popular with investors.

By providing and communicating information, the financial system

relieves individual savers from the necessity of searching out individual borrowers

What are examples of financial assets?

A bond issued by Google, a home mortgage loan, a certificate of deposit

Briefly explain the difference in how banks and peer-to-peer lenders make profits on loans.

Banks have traditionally earned profits on loans by paying a lower interest rate to depositors than they charge to borrowers. Peer-to-peer lenders make profits by charging borrowers a one-time fee and charging the people providing funds a fee for collecting the payments from borrowers.

Describe the relationship between banks and small businesses during the 2000s

Banks typically applied fixed guidelines for granting loans, leaving little room for personal judgment, many small businesses were receiving loans from regional and national banks, more banks became convinced that it would be profitable to loosen their loan guidelines to make more borrowers eligible to receive credit

All of the following represent returns to savers

Dividends on stocks, interest on deposits, coupon payments on bonds

Which president said, "Prosperity is just around the corner"?

Herbert Hoover near the start of the Great Depression

What is a not liquid asset?

House

The funds for loans from peer-to-peer lenders come from three key sources.

Individuals, financial firms, other businesses

What made the recession of 2007-2009 different than any other recession since the Great Depression?

It was accompanied by a financial crisis

Briefly discuss three reasons why firms may borrow funds from a bank

Many firms rely on bank loans to meet their short-term needs for credit, such as funds to pay for inventories or to meet their payrolls. Many firms rely on bank loans to bridge the gap between the time they must pay for inventories or meet their payrolls and when they receive revenues from the sales of goods and services. Some firms also rely on bank loans to meet their long-term credit needs, such as funds they require to physically expand the firm.

How did securitization and the bursting of the housing bubble contribute to the Financial Crisis of 2007-2009?

Many investment banks and other investors purchased mortgage-backed securities because they paid higher interest rates than securities of comparable default risk. When the housing bubble burst, the value of the mortgage-backed securities declined significantly, resulting in massive losses for those who owned them, including many investment banks.

What is a liquid asset?

Money market mutual fund

What are some financial intermediaries?

Mutual fund, bank, insurance company

The leading federal regulatory body for financial markets in the United States is the

Securities and Exchange Commission

What was the intent behind the intervention of the Fed and Treasury in financial markets during the Financial Crisis of 2007-2009?

The actions by the Fed and Treasury were meant to restore the flow of funds between savers and borrowers. Without an increase in the flow of funds to a more normal level, households would have a difficult time making certain purchases and businesses would have difficulty financing investments and inventories.

How are interest payments on mortgages distributed to investors who own mortgage-backed securities?

The banks that grants, or originates, the original mortgages will still collect the interest paid by the borrowers and send those interest payments on to the government agency or financial firm to distribute to the investors who have bought the mortgage-backed security.

Why did some economists and policymakers criticize the Fed and Treasury for arranging the sale of Bear Stearns to JP Morgan Chase in 2008?

The main concern was with the moral hazard problem, which is the possibility that managers of financial firms such as Bear Stearns might make riskier investments if they believe that the federal government will save them from bankruptcy

Briefly explain the process of securitizing mortgages

The mortgage lender sells the loan to a government-sponsored enterprise or financial firm that bundles the mortgage with mortgages from other lenders, providing the basis for a mortgage-backed security.

If a bank grants you a mortgage, the mortgage is

a liability to you, but an asset to the bank.

Borrowers who stated but did not document their incomes are referred to as

alt-A

All of the following are examples of risky mortgages that became more common in the 2000s

alt-A mortgages, adjustable-rate mortgages with low rates for a few years and then higher rates in later years, subprime mortgages.

If you purchase a Treasury bond, the Treasury bond is

an asset to you, but a liability to the U.S. government

Which of the following best describes a "bubble"?

an unsustainable increase in the price of a class of assets

Economists define money as

anything that people are willing to accept in payment for goods and services or to pay off debts

The Fed and Treasury took action to restore the flow of funds from savers to borrowers in order to encourage all of the following

enable households to purchase durable goods, increase the likelihood of purchases of houses, allow firms to finance purchases of structures and equipment

Ordinary (non-securitized) loans cannot be resold after they have been granted by a bank or another lender. Therefore, these loans are

financial assets but not financial securities

The interest rate on loans made by peer-to-peer lenders tends to be

higher than the interest rate on bonds and lower than the interest rate on credit cards

A "primary market" is a market

in which newly issued claims are sold to buyers by borrowers

The financial system performs the role of communicating information by

incorporating all available information into the prices of financial assets

The distinguishing feature of a well-functioning financial market is the

incorporation of available information into asset prices

Liquidity

is the ease with which an asset can be exchanged for money

What forms the largest share of household holdings of financial assets?

pension fund reserves

The purpose of diversification is to

reduce risk

Which type of borrowers were least likely to default in their mortgage at the beginning of the financial crisis?

those with fixed-rate mortgages who made large down payments

The process by which investment banks guarantee a certain price to a firm issuing stocks or bonds is known as

underwriting