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Chapter 12 The Financial Collapse of 2007 - 2008

Chapter 12 The Financial Collapse of 2007 - 2008. These slides supplement the textbook, but should not replace reading the textbook. What is the main point of Frederick Hayek’s 1944 book The Road to Serfdom ?.

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Chapter 12 The Financial Collapse of 2007 - 2008

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  1. Chapter 12The Financial Collapse of 2007 - 2008 These slides supplement the textbook, but should not replace reading the textbook

  2. What is the main point of Frederick Hayek’s 1944 book The Road to Serfdom? The loss of personal freedom comes when planners realize that the only way for the plan to work is to mandate that everyone adhere to the plan

  3. What is the main point of Philip Howard’s 2014 book The Rule of Nobody? Rules are replacing basic principles and with the proliferation of arcane rules and lengthy and complex regulations, individual freedom is destroyed

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

  5. Where do we begin? free markets / planned economy The role of government

  6. 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

  7. According to Keynesians why does an increase in borrowing and government spending lead to growth? The Keynesian multiplier supports the idea that when people have a dollar they will save some of it, but if the government has the dollar it will spend all of it

  8. What is the main objection that Austrian Economists have against Keynesians? The Keynesian emphasis on government borrowing and spending impede growth because it works at cross purposes to saving, investing and supply

  9. According to Austrians 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

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

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

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

  13. What does Securitizing Debts 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

  14. What is the Purpose of Securitizing Debts? 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

  15. What is a Collaterized Debt Obligation (CDO)? A type of structured asset whose value and payments are derived from a portfolio of fixed income assets, it is a collection of streams of income under one roof

  16. How are CDOs structured? Hundreds of loans are put into a pool and then divided into different tranches according to risk level

  17. What gives CDOs value? The money that flows into and out of the CDO as people pay their monthly installment loans or retire the loans

  18. Show me how collateralized debt obligations work http://www.khanacademy.org/finance-economics/core-finance/v/collateralized-debt-obligation-overview

  19. 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)

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

  21. 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

  22. What is leverage? The act of using borrowed money to make bets on some future event

  23. What is aSubprime Mortgage? A type of mortgage which involved a high level of risk to the lender and in some cases actual deceit and fraud

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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. What mandates were put on Fannie Mae and Freddie Mac in 2004? They were required to purchase subprime loans from banks to the tune of about $1 billion per week

  32. What is the Securities and Exchange Commission (SEC)? This commission is responsible for enforcing the federal securities law and regulating the securities industry

  33. What did the SEC do in 2004 that effected the securities market? It allowed banks to set their own “debt-to-net-capital rule” which changed the industry standard from a 12 to 1 debt capital ratio to 40 to 1 ratio

  34. Which firms benefited the most from this change in legal ratios? • Goldman Sachs • Bear Stearns • Morgan Stanley • Merrill Lynch • Lehman Brothers

  35. What happened in 2008 to these investment banks? They all collapsed and either disappeared or were converted to bank holding companies so they could be bailed out by the Fed

  36. 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

  37. 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

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

  39. 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

  40. 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

  41. 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

  42. 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

  43. 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)

  44. 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”

  45. 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

  46. 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

  47. What is aDerivative Instrument? A contract between two parties that specifies conditions under which payments are to be made between the two parties

  48. What is aDerivatives Market? A financial market for future contracts, these financial instruments in a futures market are called options

  49. 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

  50. How is Future Value Determined? Derivatives often rely on some complicated mathematical model to determine future value, like the Black - Scholes model

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