Chapter 5 Financial Markets Financial Regulation and Economic

Financial Markets and the IS/LM Model • How can fundamental macroeconomic instability that originates

Figure 5 -1 The Log Percent Output Gap for the United States, the Euro

Figure 5 -2 The Log Percent Output Gap for the United States in Two

Figure 5 -3 The Log Percent Employment Gap for the United States, 1960 -2010

Figure 5 -4 Percent of the Labor Force Unemployed More Than 26 Weeks in

Financial Markets and Institutions • Financial markets are organized exchanges where securities and financial

Direct vs. Indirect Finance • What determines whether savers channel their funds through financial

Figure 5 -5 The Role of Financial Intermediaries and Financial Markets Copyright © 2012

Balance Sheets • A balance sheet sums up a unit’s assets and liabilities –

Table 5 -1 The Initial Balance Sheet of the First Reliable Bank Copyright ©

Bank Assets and Liabilities • Bank assets consists mainly of loans of all types

Leverage • Leverage is the ratio of the liabilities of a financial institution to

Table 5 -2 The New Balance Sheet of the First Reliable Bank After a

Bank Insolvency and Deposit Insurance • A bank is insolvent when its equity is

“Nonbank” Financial Institutions • “Nonbank” financial institutions make loans like banks, however, they do

Table 5 -3 The Balance Sheet of the Exotica & Toxic Fund Copyright ©

Bubbles and Crashes • An asset bubble is a sustained large rise in the

Figure 5 -6 Ratio of S&P 500 Stock Price Index to Earnings of S&P

Figure 5 -7 Ratio of Housing Price Index to an Index of Rents of

Financial Innovation and the Subprime Mortgage Market • Securitization is the process of combining

Why Buy Risky Subprime MBS’s? • Individual investors were misled – Security ratings agencies

The End of the Housing Bubble • Risk-taking was fueled by the premise that

Figure 5 -8 A Negative Demand Shock Followed by a Monetary Policy Stimulus Copyright

Figure 5 -9 An Unusually Large Negative Demand Shock Cannot BE Fully Offset by

The Term and Risk Premiums • The term premium is the average difference over

Figure 5 -10 The Federal Funds Rate, the Ten-Year Treasury Bond Rate, and the

Figure 5 -11 The Risk Premium and the Term Premium Make a Bad Situation

The IS/LM Summary of the Causes of the Global Economic Crisis • Causes that

New Fed Instrument: Quantitative Easing • Before: Fed’s policy instrument was to target the

Table 5 -4 The Balance Sheet of the Federal Reserve, January 9, 2008 Copyright

Table 5 -5 The Balance Sheet of the Federal Reserve, August 11, 2010 Copyright

Figure 5 -12 Major Components of Federal Reserve Assets and Liabilities, January 2008 to

How The Financial Crisis Became Worldwide • U. S. subprime housing market estimated at

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Financial Markets and the IS/LM Model • How can fundamental macroeconomic instability that originates in financial models be modeled using the IS/LM model? • Wealth effect: W↓ Cα↓ IS shifts ← – Stock market crash – Housing bubble bursts – Households borrow too much so that interest payments become burdensome, especially if variable r’s rise • Ease of lending: More loans Cα↓ IS shifts → • New assumption for the LM curve: More than one interest rate – As risk in financial markets↑ difference between the federal funds rate and r charged to households and corporations↑ Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -2

Financial Markets and Institutions • Financial markets are organized exchanges where securities and financial instruments are bought and sold. – Direct Finance: When borrowers issue securities directly to lenders – Indirect Finance: When borrowers are matched to lenders indirectly via financial intermediaries, who make loans to borrowers and obtain funds from savers, often by accepting deposits. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -7

Direct vs. Indirect Finance • What determines whether savers channel their funds through financial markets or through intermediaries? • Direct finance depends on reputation, which limits transactions to large, well-established corporations. • Role of financial intermediaries – Spreading of risk – Efficient collection of information Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -8

Balance Sheets • A balance sheet sums up a unit’s assets and liabilities – If assets are greater (less) than liabilities, then the unit has a positive (negative) net worth – Represented by a “T” account (see next slide) • The difference between a bank’s assets and liabilities is referred to as the bank’s equity. – Note: The bank’s equity is often called “bank capital” and is also the same as the bank’s net worth – The ratio of a bank’s equity to the value of its assets is used as a measure of the bank’s financial health Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -10

Bank Assets and Liabilities • Bank assets consists mainly of loans of all types – Examples: Treasury bills, Mortgage-backed securities – Loans are generally risky • Risk is the probability that a given investment or loan will fail to bring the expected return and may result in a loss of the partial or full value of the investment. – Vault cash is also a bank asset • The main liability of banks is the deposits it owes the depositors Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -12

Leverage • Leverage is the ratio of the liabilities of a financial institution to its equity capital – Leverage increases when banks develop methods to grant more loans with their existing equity capital – Leverage magnifies (reduces) profits when the value of an investment is increasing (decreasing) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -13

Bank Insolvency and Deposit Insurance • A bank is insolvent when its equity is zero or negative – If this happens, a bank is said to “fail” • Should depositors monitor their bank to make sure it has adequate equity? – 1929 -1932: Thousands of banks failed as depositor feared for the solvency of banks and rushed to withdraw their deposits • This is known as a bank run – 1933: FDR established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits against loss • FDIC insures deposits up to $250, 000 • FDIC also responsible for shutting down insolvent banks – 2009: 140 bank failures Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -15

“Nonbank” Financial Institutions • “Nonbank” financial institutions make loans like banks, however, they do not accept deposits – Source of funds = borrowing from other financial institution – Not regulated by the Fed, so no need to hold reserves – Often hold little equity to boost leverage and thus, profits – Examples: Bear Stearns and Lehman Brothers • Both failed in 2008! Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -16

Bubbles and Crashes • An asset bubble is a sustained large rise in the price of an asset relative to its fundamental value, followed by a collapse in prices that eliminates most or all of the initial price gain. – Bubbles originate from an outside shock that changes perceptions about profit opportunities • Main ingredients for bubbles: – High degrees of leverage that boost profit potential – Easy source of credit – In some bubbles, financial innovation makes borrowing easier with complex new financial instruments that are hard to understand • Some important bubbles: – Stock price bubble of 1927 -29 lead to the Great Depression • Cause: Speculation fueled by high allowed levels of leverage – Stock price bubble 1996 -2000 lead to 50% ↓ in stock prices • Cause: Unbounded optimism in “Dot. com” company profit potential – Housing bubble of 2000 -06 lead to the Global Economic Crises • Causes: (1) Very low interest rates from the Fed and (2) financial innovations Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -18

Financial Innovation and the Subprime Mortgage Market • Securitization is the process of combining many different debt instruments like home mortgages into a pool of hundreds and even thousands of individual contracts, and then selling new financial instruments backed by the pool – Example: Mortgage-backed securities (MBS) • Banks that originated loans no longer needed to worry about borrower creditworthiness • The subprime mortgage market consists of borrowers who have some combination of low incomes, unstable employment histories, and poor credit records – Risky loan nickname: “NINJA Loans” = “No Income No Job No Assets” – Thrived as long as the Fed kept interest rates low and granting home loans to risky borrowers was in harmony with overall government policy • In mid-2004, Fed raised short term rates, and many subprime loans began to “reset” • Borrowers fell behind mortgage payments foreclosures followed Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -21

Why Buy Risky Subprime MBS’s? • Individual investors were misled – Security ratings agencies (like Moody’s and Standard and Poors) gave unrealistic “AAA” ratings to subprime debt • Why did financial institutions buy MBS’s? – Ignorance: No previous housing bubble in history – Greed: Fees and bonuses fueled additional risk-taking Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -22

The End of the Housing Bubble • Risk-taking was fueled by the premise that housing prices would increase indefinitely • But Fed raised the federal funds rate from 1. 0% to 5. 25% between mid-2004 to mid-2006 – Adjustable rate mortgages interest rates rose – Families had to choose between defaulting on mortgages vs. cutting other household expenses – New loans became more difficult to receive Housing demand↓ – “Flippers” became fearful and started to sell – Result: Housing prices plummeted! • Housing price collapse Onset of financial crisis – Value of MBS collateral↓ MBS value↓ Financial institutions failed Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -23

The Term and Risk Premiums • The term premium is the average difference over a long period of the interest rate on long-term bonds and the interest rate on the short-term federal funds rate – The Fed can push the federal funds rate to zero, but not the long term bond interest rate – Long term interest rates are generally higher than short term interest rate • Compensates for the risks of investing money for many years (e. g. inflation) • Consumer and firms borrowing at the long term interest rate are riskier borrowers than the government • The risk premium is the difference between the corporate bond rate and the risk-free rate of Treasury bonds having the same maturity – Gives the additional interest bond purchasers require on home mortgages and corporate debt – Provides a measure of financial panic Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -26

The IS/LM Summary of the Causes of the Global Economic Crisis • Causes that pushed the IS curve to the left – Negative wealth effect from the collapse of the housing bubble C↓ – Negative wealth effect from the 50% decline in the stock market C↓ – End of cash-out mortgage refinancing C↓ – Growing unwillingness of financial intermediaries to grant loans I↓ • Causes that prevented a monetary stimulus from eliminating the output gap – Negative interest rate required, but Fed limited to lowering i to zero – Businesses cannot obtain financing at the federal funds rate, they must borrow at the higher long term i – Higher risk premium lead to higher long term i Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -29

New Fed Instrument: Quantitative Easing • Before: Fed’s policy instrument was to target the federal funds rate – Two problems • “Zero Lower Bound: ” The federal funds rate cannot be pushed below zero • Firms do not borrow at the federal funds rate, so even a low rate may not boost investment • New method to ease the crisis: Quantitative Easing occurs when a central bank purchases assets for the purpose of increasing bank reserves (not lowering short-term interest rates) – Provided liquidity to markets for distressed financial assets like MBS’s, which improved balance sheets of suffering financial institutions – Radically changed the balance sheet of the Fed (see next two slides) • IS/LM model interpretation – Quantitative easing increases demand for long term and risky financial assets, thereby reducing the term and risk premiums Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -30

How The Financial Crisis Became Worldwide • U. S. subprime housing market estimated at $250 B – World decline in GDP from 2007 -09 = 20 times $250 B – World decline in stocks equaled 100 times initial shock • Why such an amplification of the subprime shock? – Dramatic jump in interest rate risk premium lead to higher costs of doing business worldwide • Global slowdown in investment and employment • Slowdown in lending by financial intermediaries worldwide – Many foreign financial institutions invested heavily in U. S. subprime debt • These investments were financed by borrowing short-term low-interest USD loans • When short-term loans evaporated, these financial institutions could not renew loans • But value of their MBS investments collapsed crisis exacerbated Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5 -35