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Essay 1, Exam 1

    Essay 1, Exam 1

    Answer the questions below.
    o    In order to answer this essay you must
    ?    Read/listen to  the information suggested in this document
    ?    Watch a 50+ minute video -
    ?    Research your own secondary resources
    ?    Incorporate our PowerPoint lecture, “Financial Instruments.”
    o    I will grade this “essay” based upon whether you have included a detailed summary of all of the above sources.  Therefore, either footnote your information or

    clearly state, “According to X……….”  Make sure I understand that you have read and listened to all of the information.
    o    Remember, Blackboard will not allow you to submit your essay after Tuesday, September 23 – Your grade will be a zero if you attempt to answer the questions

    after that date.
    o    Complete your questions in a word document – Answer each question individually.  Do not combine your answers.  Then submit your answers by attaching your

    document.  Attachment of the essay can be done any time prior to  September 30, 8:00 AM

    The objective of this essay is

    We recently experienced the worst recession since the Great Depression.  Some say that the recovery changed our economy from a capitalistic society to one where we saw

    a reason for government intervention.  In 2008 banks and other financial institutions in the United States and other countries needed bailout money to survive. They

    were “too big to fail.”  Businesses saw no reason to grow because people were not spending.  People were not spending because unemployment was over 10%.  People,

    businesses, and banks were afraid to spend.  Credit was not available to banks, corporations, and people. The housing market collapsed.  The government had to step in.

    The United States was not the only country impacted.  Nearly every developed economy went into a recession.

    As economists we must understand how and why did this happen; and just how bad was it;

    As an economist we must understand these institutions were too big to fail; thusore needing a government bailout and what can we do to prevent this from happening


    As economists we must understand how the government had to become involved to insure the free fall of the economy would not result in another depression.

    As economists we must learn from this experience and better understand how to proceed in the future.

    According to economists the recession lasted eighteen months – from late 2007 to June of 2009. Yet, 54% percent of American adults polled by NBC News and the Wall

    Street Journal think America is still in a recession. This after the recession technically ended nearly five years ago.  Why do some people feel we still exist in a

    recessionary economy?

    Your sources –

    50+ minute Frontline video must be listened to in order to answer the following questions and to contribute to a discussion.

    Please read the timeline of events below.

    Current events regarding banks and regulations





    1. Why did the Federal Reserve decide to lower interest rates in the early 2000s; thus, making money easily and cheaply available?  Explain this in terms of economic

    concepts of supply and demand.

    2.  What is the definition of a housing bubble (research definition?)  Why did the value of houses increase prior to 2008?  Remember, the reason why house prices rose

    is multi-faceted.  Include all reasons.

    3.  What are sub-prime loans?  Why did banks sell their sub-prime mortgages?  What is happening now with subprime loans?

    4.  Why did the housing bubble burst?  Again, a multi-faceted answer.

    5.  Define collateralized debt obligations?  Who sold them and who bought them?  Why did people/banks/governments/investors want to buy these financial investments?

    6.  The problem came when credit dried up, banks failed, businesses stopped.  Watch the above video.  Describe the domino effect of bank failures.  Who failed.

    Explain the concept of “too big to fail.”

    7.  Why did the Federal Reserve decide to intercede?  What did they do?

    8.  At the time of the initial bank failures, who was the chairman of the Federal Reserve, who was the head of the Treasury, and who was our president?


    10.  Briefly discuss three ways the government intervened or at least wanted to intervene.   See PowerPoint, “Federal Regulations.”  Include the specifics of the

    Dodd-Frank Bill.

    11.  Based upon the current event links above, what is the current status of our banks?  Make sure you incorporate all links.




    A.     Years 1995 – 2001 – What lead to this prior recession?
    •    In the early 1990’s it became clear to investors and speculators that the internet had created a wholly new and untapped international market, IPOs of internet

    companies started to follow each other in rapid succession. Sometimes the valuations of these companies were based on nothing more than just an idea on a single sheet

    of paper. The excitement over the commercial possibilities of the internet was so big that every idea which sounded viable could fairly easily receive millions of

    dollars’ worth of funding. The basic principles of investment theory with regard to understanding when a business would turn a profit, if ever, were ignored in many

    cases, as investors were afraid to miss out on the next big hit. – Hundreds of companies were formed weekly.  People heavily invested in these companies even though

    most were not making money, investors thought they had potential.  This demand for companies drove up the price of stock way beyond the worth of these dotcoms.

    Many of these companies failed and investor lost money.  The stocks they bought in these companies at a higher price were now worth very little or the company failed.

    •    In addition to the burst of the bubble, American programming jobs were outsourced, which led to widespread unemployment.
    •    Combine this with the 9-11 attack, the economy came to a stand-still.

    B.     Years 2000 – 2003 – How did the government react to stimulate growth again?
    o    The Federal Reserve (our country’s central bank whose responsibility is to oversee banks and the economy) reduced the Fed Funds Rate (which we will discuss

    later but is the rate that banks charge each other for money and is tied to the lowest rate that a consumer and/or business can get a loan) was lowered from  6.5% to

    1%.  They did this to stimulate the economy.  If interest rates are low, people will buy and the economy will grow.  Lower interest rates made mortgage rates cheaper,

    and demand for homes began to rise, sending house prices up.


    •    People were greedy.  Credit was cheap because the Federal Reserve policy was to reduce the interest rate at which people could borrow – see “B”   Why bother

    saving????  Consider people and businesses want to make money.  They are looking for the best return on their investment.  Why should they save? Credit was easily


    o    Housing bubble – Between 1997 and 2006 the price of a typical house rose 126%.  Buying a house became the best investment – where else can your investment

    increase in value this much!!!  If you take out a mortgage and buy a house and the prices of houses are going up, the worth of your house is less than your mortgage –

    this is a good investment. More and more homes were bought on speculation – homes bought at a low price and sold shortly after at a higher price. More and more people

    bought a second vacation home.  But… the dotcoms, at some point the housing bubble will burst…..but when?

    o    Because most of the desirable, qualified customers dried up; they all had homes. Banks offered subprime mortgages (credit quality of borrower was lower than

    prime.)  Subprime mortgages were 10% of all mortgages until 2004 then went up to 20% in 2005 and 2006.  Prior to the 21st century banks were very cautious about to

    whom they would give a mortgage or credit to because they held onto the mortgage and/or credit instrument.  It was in their best interest to make sure the person was

    credit worthy banks required a credit score of 620 and a down payment of 20%; during the housing boom they would settle for 500 or less and no money down. Other than

    supply of qualified buyer shrinking, why did the banks lower their standard?

    o    The government passed some legislation to loosen standards so that the poorer sector could buy homes. In the mid-1990s, new governmental policies were enacted

    that contributed to a relaxing of standards for mortgage loans. In 1995 the Community Reinvestment Act was modified to compel banks to increase their mortgage lending

    to lower-income households.  To meet the new requirements of the Community Reinvestment Act, many banks relaxed their mortgage lending standards. Research has shown

    that home ownership helps pull people out of poverty.  However, the bottom line is that people should be able to have the capability to pay the mortgage.

    o    Along came a new financial vehicle – Mortgage-Backed Securities. Banks longer held the risk of a mortgage, they sold these mortgages, and other credit loans to

    investors (people, states, pension funds, etc.) and/or organizations like Fannie Mae in investment securities called mortgage- back securities
    ?    Banks no longer had to hold the mortgages; they could now transfer the risk of these mortgages to investors.  Mortgage-backed securities (MBSs) are simply

    shares of a home loan sold to investors. They work like this: A bank lends a borrower the money to buy a house and collects monthly payments on the loan. This loan and

    a number of others — perhaps hundreds — are sold to a larger bank that packages the loans together into a mortgage-backed security. The larger bank then issues

    shares of this security, called tranches (French for “slices”), to investors who buy them and ultimately collect the dividends in the form of the monthly mortgage

    payments. These tranches can be further repackaged and sold again as other securities, called collateralized debt obligations (CDOs). Home loans in 2008 were so

    divided and spread across the financial spectrum, it was entirely possible a given homeowner could unwittingly own shares in his or her own mortgage

    ?    With the introduction of MBSs, lenders no longer assumed the risk of a loan default. They simply issued the loan and promptly sold it to others who ultimately

    took the risk if payments stopped. And since MBSs created early on were based on mortgages granted to the more dependable prime borrowers, the securities performed

    well. They performed so well that investors clamored for more. In response, lenders loosened their restrictions for mortgage applicants and borrowed heavily to create

    cash flow for loans in order to create more mortgages. Without mortgages, after all, there are no mortgage-backed securities.

    o    Because they were offering mortgages to less desirable people, banks were offering non-traditional mortgages.  They offered low introductory rates and minimal

    initial cost or adjustable rate mortgages (interest rate on the note is periodically adjusted based on a variety of indices).  This made it more difficult to know what

    your mortgage payments might be in the future and……if you can afford these payments. A high percentage of these subprime mortgages, over 90% in 2006 for example, were

    adjustable-rate mortgages.

    Because interest was so cheap savings were zero.  Credit cards, mortgages, and other types of loans were marketed and used aggressively.  U.S. households had become

    increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in 1990 to 127% at the end of 2007, much of this increase mortgage-related.

    People, businesses and banks became highly leveraged. The definition of leveraging is to borrowed capital for (an investment), expecting the profits made to be

    greater than the interest payable
    o    With short-term interest rates extremely low, investors could increase their return by borrowing at a low short-term interest rate and investing in higher

    yielding long-term investments.  People borrowed more heavily to buy homes, investors borrowed money to buy mortgage-backed securities, etc.  Investments were more

    readily bought on borrowed money.

    Consumer debt relative to GDP increased from 46% to 73% in 2008

    Years 2004 and 2006
    •    The housing market started to slow.  People started to default on loans – why?
    o    As we noticed above prices for everything, particularly houses were going up (little supply and strong demand because interest rates were so low forced prices

    to rise.) To protect the economy from going into rapid inflation, the Federal Reserve raised interest rates 17 times – increasing the Fed Funds rate from 1% to 5.25%.

    This increased the interest rates for borrowing.
    o    This made mortgages more expensive; therefore demand for homes lessened
    o    People with adjustable rate mortgages mentioned above found that because the interest rate that they paid was tied to the Fed Fund rate their interest rate due

    on their mortgage went up.  People ` who over-extended their credit found the new mortgage rate too high.
    o    The supply of homes increased because contractors had over produced homes because of the boom in prices of homes. This resulted in an overabundance of homes

    available for sale; therefore, the price of the homes decreased
    o    Over supply of homes lessened prices of homes
    o    Foreclosures increased the supply of homes as well.  People found that their mortgages were higher than the worth of their home.  For example, a person who

    bought a house at the peak of the Boom for $650,000 found that they could not sell the house for $650,000 because of the above mentioned over-supply of homes and the

    demand for homes plummeted because of higher interest rates.  Many people over-extended themselves on their credit and/or lost their jobs resulting in homes being

    foreclosed (the bank took ownership of the home due to non-payment of mortgages).
    o    Between higher interest rates, over production of home, foreclosed homes, and less demand because of higher interest rates, the housing bubble burst.


    •    Banks are profit-making companies. They offer loans and charge interest.  All banks rely on home mortgages to make their profits to some degree (Some banks are

    lend more to businesses others to home buyers.)  However, because of the housing bubble more and more banks found that offering more mortgages were very profitable.

    The demand for mortgages was high and even if the payee could not pay the mortgage, the house at the time of nonpayment was worth more than the mortgage itself. These

    mortgages were considered a great investment because they had little risk. Therefore, banks like Countrywide, Bear Stearns Mortgage Lending, Washington Mutual who

    relied heavily on the mortgage markets to make a profit failed because the housing bubble had burst and they were now holding toxic mortgages – mortgages that could

    not be paid.  When they repossessed the home (foreclosure,) the worth of the home was not as great as the mortgage…  –

    o    The U.S. housing bubble would have been largely contained within the United States except for the creation of mortgage backed securities/collateralized debt

    obligation (CDO.)  Investment banks an such as Goldman Sachs, Lehman Brothers, Merrill Lynch, Bear Stearns and organizations such as Fannie Mae and Freddie Mac bought

    the mortgages (some good, some toxic, some not known how secure), and bundled them and sold them to investors – national, global, pension funds – anyone.  These bonds

    were considered safe because if the original mortgage carrier (person who owns the home) defaulted, you could get your money back by selling the home.  The assumption

    was that real estate prices would continue to rise.

    o    These collateralized debt obligations were giving high credit ratings.  Given optimistic assumptions about housing prices not going down, the U.S. ratings

    agencies Standard and Poors and Moody’s assigned the highest ratings (AAA, lowest risk) to these mortgage backed securities.  Investors thought they were safe

    investments.  A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime

    loans in their mortgage pools. Some argue that the rating agencies such as Moody’s and Standard and Poors should have foreseen the high default rates for subprime

    borrowers, and they should have given these CDOs much lower ratings than the ‘AAA’ rating given to the higher quality tranches. If the ratings had been more accurate,

    fewer investors would have bought into these securities, and the losses may not have been as bad.

    o    Therefore, people, countries, companies, etc. who bought these collateralized debt obligations felt that they were a safe investment.  To add to their feeling

    that these were safe.  Companies such as AIG and investment banks even offered insurance that people could buy to insure the security of these CDO’s.  Often Fannie and

    Freddie offered guarantees on the mortgage backed securities that they sold.

    o    Another player in spreading these toxic loans to all investors was people who dealt with derivatives.  We will discuss these later.  But consider this,

    investors didn’t have to hold these CDOs, they could bet on their increase or decrease in wealth
    Who owned the mortgages (good and toxic) – the banks retained some mortgages, investment banks still had some, Fannie and Freddie had some, they were sold to investors

    as very secure investments.  People looking for a secure investment, bought them.  Therefore, pension fund operators, countries, other banks, states, anyone bought

    these CDOs thinking that this was the stable factor in their investment portfolio. When home prices started to collapse in the latter half of 2007, a growing number of

    homeowners were forced into foreclosure, and the securities backed by these mortgages started to default. The bad loans quickly started to erode the balance sheets of

    financial institutions that had purchased MBS.

    CRASH – Between 2007 and 2008 American’s lost about l/4 of their income, S& P down 45%, Housing market dropped 20%.  Banks stopped lending to everyone – including

    businesses.  They had too many toxic assets that they could not back.

    Wasn’t anyone watching?  Why didn’t the banks, investment companies, Fannie and Freddie, or AIG have enough money to support their losses?   Also consider

    •    In 2004 Security and Exchange–relaxed its capital rules for investment banks (how much money a bank needs to have on hand before they can loan)

    •    Policy makers did not recognize the importance of investment banks and hedge fund operators in supplying money.  Investment banks were not regulated.

    •    From 2004 to 2007 the top five investment banks significantly increased its financial leverage (buying things on credit with funds to back their assets if they


    To add to the injury, the price of oil nearly tripled 2007 2008 – Inflation increased.  People had less money to spend on consumer goods thus adding to the economic

    Credit Crunch, Bank and Business Failures
    By the fall of 2008 it became clear there was a major problem as house prices continued to fall, more and more people owed more than their homes were worth and

    defaults and foreclosures were rising well beyond what the models had predicted would ever happen, it was beyond their worst case scenario.
    Banks started to have severe capital and liquidity problems as home prices fell and their mortgage backed CDOs dramatically sank in value. Banks were in danger of

    running out of money on any given day. People were pulling their money out of the banks and banks were desperately trying to find buyers and mergers before they went

    •    On March 16, 2008 Bear Stearns was sold to JP Morgan for $2 per share (later amended to $10). In January 2007 the price of Bear Stearns was $171 per share.
    •    In July 2008 IndyMac failed becoming the second largest bank failure in US history.
    •    On September 7, 2008, the government took over Freddie Mac and Fannie Mae.
    •    On September 15, 2008 Lehman Brothers failed and that shook Wall Street and the financial world.
    •    Washington Mutual failed on September 26, 2008 becoming the largest US bank failure.
    At this time, banks were afraid to lend to each other or anyone else, this is what really started the Great Recession on Main Street. Companies use this borrowing to

    finance their business. For example, Target will take a 30 day loan to pay for its inventories and payroll. Without any way to borrow as usual, the layoffs started.
    Once the layoffs started, more people couldn’t pay for their mortgage causing more defaults and foreclosures. And the consumer stopped buying. Construction halted on

    the building of new homes. The economy came to a halt causing the Great Recession to move from Wall Street to Main Street America
    Financial Crisis Causes Global Recession
    Credit is a crucial input for both households and firms; once it dried up, both business and consumer confidence plunged. Firms stopped investing and households

    slashed spending. The combination of tumbling confidence and a loss of credit created the conditions for recession in the United States that quickly spread around the

    globe. As the global financial crisis gained momentum, it became virtually impossible for the economy to avoid slipping into recession

    Now that we’ve lived through a stock market decline in 2008-2009 that not only wiped out a decade’s worth of growth but also changed the face of Wall Street forever,

    what have we learned
    We’ve also learned that diversification means more than just stocks and bonds. The simultaneous decline of stocks, bonds, housing and commodities is a stark reminder

    that there are no “sure bets,” and that a cash cushion could save the day when times get tough. The blind pursuit of profit with no thought to the downside is a

    strategy that failed spectacularly.
    We put a lot of trust in experts, including stock analysts, economists, fund managers, CEOs, accounting firms, industry regulators, government and a host of other

    smart people. They all let us down. A great many of them lied to us, intentionally misleading us in the name of greed and personal profit
    Derivatives, special investment vehicles, adjustable-rate mortgages and other new-fangled investments that may be too complex for the average investor racked up huge

    fees for financial services firms and huge losses for investors

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