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VOCABULARY

VOCABULARY. FDIC DUAL BANKING SYSTEM SECURED LOANS UNSECURED LOANS PRIME RATE STANDARD LOAN DISCOUNTED LOAN. CD’s BANK LIQUIDITY BANK SOLVENCY INTEREST RATE RISK CREDIT (DEFAULT) RISK GLASS-STEGALL ACT GRAMM-LEACH-BLILEY ACT. CAUSE OF FINANCIAL CRISIS IN 2008

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VOCABULARY

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  1. VOCABULARY • FDIC • DUAL BANKING SYSTEM • SECURED LOANS • UNSECURED LOANS • PRIME RATE • STANDARD LOAN • DISCOUNTED LOAN • CD’s • BANK LIQUIDITY • BANK SOLVENCY • INTEREST RATE RISK • CREDIT (DEFAULT) RISK • GLASS-STEGALL ACT • GRAMM-LEACH-BLILEY ACT

  2. CAUSE OF FINANCIAL CRISIS IN 2008 -- Mortgage-backed securities -- Collateralized debt obligations -- Credit default swaps -- Proprietary trading -- Credit Freeze

  3. CREDIT DEFAULT SWAPS DEFAULT v. INTEREST RATE RISK Insurance against default on bonds, mortgages Traded in unregulated market Don’t have to own mortgage to purchase CDSs When purchase CDSs, betting that you will be able to resell at higher price when bond/mortgage issuer’s credit deteriorates Unlike traditional insurance, payments not government guaranteed (states tightly regulate insurance companies) CDSs were used to gamble for higher profits and ended up almost destroying our economy (spread default losses throughout the banking industry) AIG, which was biggest issuer of CDSs was bailed out to keep from destroying confidence in the financial sector It was estimated that $60 trillion of CDSs were outstanding

  4. INVESTORS ISSUE BONDS TO PURCHASE SECURITIZED MORTGAGE LOANS --Bank C issues bonds for interest rate lower than securitized mortgages ($90 million to buy $100 million of mortgages) --When mortgage defaults occur (say value drops to $80 million) bank is technically insolvent and would have to either sell other assets or additional shares of stock (which would cause significant drop in stock price)

  5. LOANS SOLD Bank A sells loan ($150,000) to Bank B Bank A receives about same as mortgage balance --Bank A “Profit” is closing fees plus maybe small margin (sells for $150,000) --Bank B (investment bank) has loan worth $150,000 (maybe more if interest rates have gone down) LOAN SECURITIZED Bank B combines hundreds or thousands of similar mortgages Bank B sells slices of loan pool to investors (banks c, d and e) for secure investments with cash flow stream netting interest income slightly less than the underlying mortgage interest rates

  6. RUNS ON BANKS Banks may loan long-term while borrowing short term Banks can become technically insolvent if savers with- draw balances, and if bonds they issue mature or are called Once credit problems develop, banks are hesitant to loan to other banks to keep solvent due to fear of default (banks have to be able to roll over short term debt to survive) Note: Run by savers (individuals) generally does not occur due to FDIC insurance (government guarantee of deposits up to $250,000)

  7. SAVINGS & LOAN CRISIS Last half of 1980’s and first half of 1990’s over 2000 savings & loan associations were closed or merged. Causes –   -- Borrowed short-term, loaned long-term -- Short-term interest rates rose -- Deregulation allowed investments in speculative ventures -- Invested in junk bonds -- Greed, high salaries -- FSLIC that guaranteed deposits went bankrupt in 1989 Regulations covering S&L’s were tightened in 1988 Resolution Trust Corporation (RTC) was created to take over bad assets

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