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Chapter 12 The Financial Collapse of 2007 - 2009

Chapter 12 The Financial Collapse of 2007 - 2009. These slides supplement the textbook, but should not replace reading the textbook. Why is Growth important?. If we do not grow there is less goods and services as things deteriorate over time. Where do we begin?.

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Chapter 12 The Financial Collapse of 2007 - 2009

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  1. Chapter 12The Financial Collapse of 2007 - 2009 These slides supplement the textbook, but should not replace reading the textbook

  2. Why is Growth important? If we do not grow there is less goods and services as things deteriorate over time

  3. Where do we begin? The role of government – free markets vs. a planned economy

  4. Does the Keynesian policy of increasing government spending lead to more growth or less growth? Keynesians believe that it increases growth by shifting the aggregate demand curve to a full employment equilibrium

  5. Does the Keynesian policy of increasing government spending lead to more growth or less growth? The Austrian viewpoint is that in the short run it could lead to more growth, but in the long run it will lead to less growth

  6. Why does an increase in government spending lead to less growth? • Higher taxes • More debt • More regulations • Diminishes private investments • Choices made because of politics rather than economics

  7. What is the upshot to the story of our financial collapse of 2007-2008? Policies of the government and the Federal Reserve distorted markets

  8. What was the policy of Alan Greenspan, chair of the Fed from 1987-2006? The easy-money policies of the Fed during Greenspan's tenure has been suggested to be a leading cause of the subprime mortgage crisis

  9. Why were the easy money policies of the Fed a factor in the mortgage crises? People borrowed money to buy homes, the price of homes increased, equity increased, and many people borrowed against the home’s equity

  10. Why is excessive debt a problem in an economic downturn? People cannot meet their debt obligations and a dominoes affect sets in

  11. When was Fannie Mae founded? It was founded in 1938 as a government sponsored enterprise (GSE), privately owned but publicly chartered, which went public in 1968

  12. What is the purpose of Fannie Mae? Its purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage backed securities (MBS)

  13. What is a Security? A financial instrument representing financial value such as mortgages, bonds, banknotes, stocks, future contracts, and derivatives

  14. What does Securitizing securities mean? The financial practice of pooling debts, like mortgages, and selling the consolidated debts as bonds (securities) which pay the investors principle and interest regularly

  15. What is the purpose of Securitizing securities? Its purpose is to allow lenders to reinvest their assets into more lending and in affect increase the number of lenders in the mortgage market

  16. What are some problems with securitizing debt? The complexity can limit investors ability to monitor risk, and make it more difficult to standardize the market

  17. What are some other problems with securitizing debt? Off-balance sheet arrangements and excessive leverage

  18. What is an off-balance sheet arrangement? Financial institutions can have responsibility for assets (often securities) for clients without actually owning the securities

  19. What is leverage? Leverage is the practice of investing with borrowed money. For example, in 2004 the SEC authorized investment banks to leverage with ratios as high as 40 to 1

  20. What is Freddie Mac? Authorized by Congress in 1972 to purchase private mortgages on the secondary market to compete with Fannie Mae

  21. Why did Fan and Fred defraud investors? To increase market share in the subprime loan market and to meet the demands of the Housing and Community Development Act of 1977

  22. What is the Housing and Community Development Act of 1977? Banks were required to make substantial loans to low income persons even with bad credit ratings

  23. What is the Housing and Community Development Act of 1992? Fannie Mae and Freddie Mac were required to meet a goal of 30% mortgages bought should be from low and moderate income families, raised to 55% in 2007

  24. What pressure was put on Fannie Mae in 1999? The Clinton Administration encouraged an increase in loan purchases stemming from inner city areas and pressed for an easing of standards in the primary mortgage market

  25. Who is Angelo Mozilo and what is Country Wide Mortgage? Angelo Mozilo founded Country Wide, a mortgage company that specialized in subprime mortgages

  26. What role did Country Wide Home Loans play? Country Wide, partnered with Fannie and formed a reduced documentation loan program, Country Wide found the customers and Fan provided the money

  27. What is an Alt-A Loan? Sometimes called “Liar Loans” they required less documentation than traditional subprime loans

  28. What is the Private Securities Litigation Act of 1995? This act protected Wall Street firms from legal suits and restricted investors from suing banks for fraud

  29. What was the result of the secondary mortgage market and the Private Securities Litigation Act of 1995? They gave banks and mortgage related companies a free hand to engage in high levels of speculation and fraud

  30. What is the Financial Crises Inquiry Commission? A Congressional commission that spent 18 months investigating the subprime mortgage problem and in 2011 found Fan and Fred innocent of any fault and blamed the crises on private bankers

  31. What is the lawsuit that the SEC brought against Fannie and Freddie in 2012? The SEC claims that six Fan and Fred executives defrauded investors because they knew and approved misleading statements about their subprime loan exposure

  32. What is an example of hedging? A farmer agrees to sell his corn to someone at a set price on a set date in the future

  33. What is an option? A derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike price)

  34. What are the two types of options? An option to buy something at a specific price in the future is named a “call”; an option to sell something at a specific price is named a “put”

  35. What does it mean to short the stock market? You borrow shares from a brokerage house in order to sell them in the hope that you can buy them later at a lower price, you gain when the price declines and lose when the price increases

  36. What is a hedge fund? A private investment fund which may invest in a diverse range of assets and may employ a variety of investment strategies to protect from downturns and maximize the market upswings

  37. What is aderivative instrument? A contract between two parties that specifies conditions under which payments are to be made between the two parties

  38. What is aderivatives market? A financial market for future contracts, these financial instruments in a futures market are called options

  39. What is afutures market? A specific type of derivative involving a bet between two parties on the future price, called the strike price, of some specified standardized product, like the price of corn six months from the agreement

  40. How is future value determined? Derivatives often rely on some complicated mathematical model to determine future value, like the Black - Scholes model

  41. What is an example of speculative trading in the derivatives market? In 1995 Nick Leeson, a trader for Barings Bank, the oldest investment bank in London, made poor and unauthorized investments in futures contracts bankrupting the bank

  42. What is anover-the-counter derivatives market? A market that is an agreement between two parties and no one else, the contract is personal between the two parties, there is no exchange where information is shared

  43. Is it possible that even the purchaser of the derivative is not privy to the facts? Yes, investment companies like Bear Stearns often sold contracts to others, like pension funds, without divulging all the facts

  44. How large is the derivatives market today? The notional value, the hypothetical value existing only in theory, is about $600 trillion!!!

  45. What is the Commodity Futures Trading Commission (CFTC)? Authorized to regulate agricultural futures and the derivatives market

  46. Who is Brooksley Born? She was the head of the Commodity Futures Trading Commission from August 1996 to June 1999

  47. What did Brooksley Born do as head of the CFTC? She lobbied Congress and the President to give the CFTC oversight of the over-the-counter derivatives market

  48. Why was Brooksley Born concerned ? Dangerous things were happening in the market like fraud and excessive speculation leading to major failures

  49. What was the event that brought these excesses to light? In 1996 Proctor and Gamble ended up owing $200 billion in the derivatives market and it sued their derivatives dealer, Bankers Trust, for fraud claiming it was not given proper explanation

  50. What was the outcome between Proctor and Gamble and Bankers Trust? In 1996 Bankers Trust settled with Proctor and Gamble forgiving most of the debt

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