chapter 8 Flashcards
Direct Finance
A borrower deals directly with the lender
Maturity
The date that the payment will be made
face value
the amount paid at redemption
coupon rate
interest rate
Why would you buy a bond that does not make interest payments?
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.
Indirect finance
when individuals and businesses use middlemen, such as banks for borrowing and lending
How do banks add value to the economy?
Spread risk of nonpayment. Develop comparative advantages in credit evaluation and collection. Divide denomination of loans. Match time horizons.
Usury law
price ceiling on interest rates. Causes a shortage on loanable funds.
Why do supply/demand for loanable funds have their shapes?
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.)
If the public decides to save less, what happens to the supply and/or demand for funds? What happens to the interest rate?
Supply falls and interest rates rise
If people decide to borrow more, what happens to the supply and/or demand for loanable funds? What happens to the interest rate?
demand increases and interest increases and supply is not affected
Besides savers, which other group can affect the supply of loanable funds?
The Fed
What is the difference between funds supplied by savers and funds supplies by the Fed?
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.
How does the federal government (not the Fed) affect the credit market?
The federal government is the largest borrower so it plays a big role in the demand for loanable funds
What is the difference between stocks and bonds?
Someone who owns a company’s stock, owns part of the company. Someone who owns the company’s bond is the company’s creditor.
How can a leveraged buyout create value?
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.
leveraged buyout
where a firm borrows money in order to purchase another firm, then immediately sells the firm in whole or in parts
illiquid
a company cannot pay its immediate obligation
insolvent
the company owes more than it owns
absolute priority rule
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.
What is an example of a secondary market
a used car lot
What is Fannie Mae and why was it created?
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.
Fannie Mae was the major player in “the secondary market for home lending.” What does that mean?
Fannie Mae bought home loans from banks and sold bonds to the public which were backed by the loan payments.
What is Freddie Mac and why was it created?
Federal Home Loan Mortgage Corporation. to compete with Freddie Mae.
What is a nonconforming loan?
A loan in which the borrower is a high credit risk.
What was the purpose of the Community Reinvestment Act of 1977?
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.
What is the relationship between the Department of Housing and Urban Development and Fannie Mae?
HUD instructed FM to purchase nonconforming loans
What was the Fed’s role in the housing crisis of the 2000s?
In the early 2000s the Fed increased the money supply, keeping interest rates low, resulting in an expansion of lending.
Why didn’t Fannie Mae care if homeowners defaulted when home prices were rising?
Foreclosed homes could sell for more than their purchase price
How did private lenders attempt to compete with Fannie Mae’s implicit government guarantee that their debt would be honored?
By buying insurance on privately issued market mortgage backed bonds from AIG insurance.
What is TARP? What was it intended to do?
The Troubled Asset Relief Program was $700 B, intended to buy bad mortgage backed bonds.
What is the job of the Financial Stability Oversight Council? Who are its most important members?
To identify risks to the entire financial system and resolve them. The US Treasury Secretary & the Fed Chairman
When the FSOC identifies a financial institution as a SIFI–too big to fail–what happens to that institution’s ability to acquire funds?
With a government bailout guarantee the “too big to fail” firm grows bigger.
What is the effect of bailout insurance on banks and other financial institutions?
Due to insurance, they will take more risks.
Unemployment rate in 2014
5.9%
Average amount of time an unemployed person is out of work
31 weeks
Why are excess reserves so high?
Because the Fed began paying interest on reserves
what are systemic risks
risks to the entire financial system
What are SIFI’s and how does the FSOC help them?
Systemically Important Financial Institutions. “Too big to fail companies” that have guaranteed bailout if needed, causing the market to pour more money into them.
Consumer Financial Protection Bureau
CFPB regulates consumer credit for the poor.
