chapter 8

Question 1

Direct Finance

Answer 1

A borrower deals directly with the lender

Question 2

Maturity

Answer 2

The date that the payment will be made

Question 3

face value

Answer 3

the amount paid at redemption

Question 4

coupon rate

Answer 4

interest rate

Question 5

Why would you buy a bond that does not make interest payments?

Answer 5

Since they buy the bond for less than the face value, they are paid back more than they paid, so the interest rate is implied.

Question 6

Indirect finance

Answer 6

when individuals and businesses use middlemen, such as banks for borrowing and lending

Question 7

How do banks add value to the economy?

Answer 7

Spread risk of nonpayment. Develop comparative advantages in credit evaluation and collection. Divide denomination of loans. Match time horizons.

Question 8

Usury law

Answer 8

price ceiling on interest rates. Causes a shortage on loanable funds.

Question 9

Why do supply/demand for loanable funds have their shapes?

Answer 9

People are willing to save more at higher interest rates but willing to borrow less and higher interest rates. (Supply is upward sloping. Demand is downward sloping.)

Question 10

If the public decides to save less, what happens to the supply and/or demand for funds? What happens to the interest rate?

Answer 10

Supply falls and interest rates rise

Question 11

If people decide to borrow more, what happens to the supply and/or demand for loanable funds? What happens to the interest rate?

Answer 11

demand increases and interest increases and supply is not affected

Question 12

Besides savers, which other group can affect the supply of loanable funds?

Answer 12

The Fed

Question 13

What is the difference between funds supplied by savers and funds supplies by the Fed?

Answer 13

When savers delay consumption, they can eventually spend those savings on the increased consumption created by the investments their savings fuel. But with Fed money creation, there is no reservoir of savings to later consume the increased production, so bubbles are formed.

Question 14

How does the federal government (not the Fed) affect the credit market?

Answer 14

The federal government is the largest borrower so it plays a big role in the demand for loanable funds

Question 15

What is the difference between stocks and bonds?

Answer 15

Someone who owns a company’s stock, owns part of the company. Someone who owns the company’s bond is the company’s creditor.

Question 16

How can a leveraged buyout create value?

Answer 16

A badly managed firm owns assets that are worth more than the stock value. Another firm borrows, buys the stock, then sells the assets to those who are willing to pay more for the assets because they can better manage them.

Question 17

leveraged buyout

Answer 17

where a firm borrows money in order to purchase another firm, then immediately sells the firm in whole or in parts

Question 18

illiquid

Answer 18

a company cannot pay its immediate obligation

Question 19

insolvent

Answer 19

the company owes more than it owns

Question 20

absolute priority rule

Answer 20

the rule says that the highest ranked bondholders are paid everything they are owed first, and then so on. Stockholders are paid last. The creditors are ranked with regard to how long ago the company became indebted to them then every penny is paid to the “senior” debt, before any less senior debt is paid.

Question 21

What is an example of a secondary market

Answer 21

a used car lot

Question 22

What is Fannie Mae and why was it created?

Answer 22

Federal National Mortgage Association. Created to restart lending on housing after the Great Depression crisis. Privatized in the late 1960’s as a secondary market for home lending.

Question 23

Fannie Mae was the major player in “the secondary market for home lending.” What does that mean?

Answer 23

Fannie Mae bought home loans from banks and sold bonds to the public which were backed by the loan payments.

Question 24

What is Freddie Mac and why was it created?

Answer 24

Federal Home Loan Mortgage Corporation. to compete with Freddie Mae.

Question 25

What is a nonconforming loan?

Answer 25

A loan in which the borrower is a high credit risk.

Question 26

What was the purpose of the Community Reinvestment Act of 1977?

Answer 26

To encourage banks to make loans to poor people. No penalties were levied on banks that did not follow these instructions, so they had no incentives to give out such loans.

Question 27

What is the relationship between the Department of Housing and Urban Development and Fannie Mae?

Answer 27

HUD instructed FM to purchase nonconforming loans

Question 28

What was the Fed’s role in the housing crisis of the 2000s?

Answer 28

In the early 2000s the Fed increased the money supply, keeping interest rates low, resulting in an expansion of lending.

Question 29

Why didn’t Fannie Mae care if homeowners defaulted when home prices were rising?

Answer 29

Foreclosed homes could sell for more than their purchase price

Question 30

How did private lenders attempt to compete with Fannie Mae’s implicit government guarantee that their debt would be honored?

Answer 30

By buying insurance on privately issued market mortgage backed bonds from AIG insurance.

Question 31

What is TARP? What was it intended to do?

Answer 31

The Troubled Asset Relief Program was $700 B, intended to buy bad mortgage backed bonds.

Question 32

What is the job of the Financial Stability Oversight Council? Who are its most important members?

Answer 32

To identify risks to the entire financial system and resolve them. The US Treasury Secretary & the Fed Chairman

Question 33

When the FSOC identifies a financial institution as a SIFI–too big to fail–what happens to that institution’s ability to acquire funds?

Answer 33

With a government bailout guarantee the “too big to fail” firm grows bigger.

Question 34

What is the effect of bailout insurance on banks and other financial institutions?

Answer 34

Due to insurance, they will take more risks.

Question 35

Unemployment rate in 2014

Answer 35

5.9%

Question 36

Average amount of time an unemployed person is out of work

Answer 36

31 weeks

Question 37

Why are excess reserves so high?

Answer 37

Because the Fed began paying interest on reserves

Question 38

what are systemic risks

Answer 38

risks to the entire financial system

Question 39

What are SIFI’s and how does the FSOC help them?

Answer 39

Systemically Important Financial Institutions. “Too big to fail companies” that have guaranteed bailout if needed, causing the market to pour more money into them.

Question 40

Consumer Financial Protection Bureau

Answer 40

CFPB regulates consumer credit for the poor.