ECON 105 1nd Edition Lecture 24 Outline of Last Lecture I. Primary and Secondary MarketsII. Stock and Bond Markets Provide Capital III. Why Do Stock Prices Fluctuate So Much?IV. Disclosure Outline of Current Lecture I. The Financial Crisis of 2007-2009II. Did Principal-Agent Problems Help Bring on the Financial Crisis?a. Investment banksb. Glass-Steagall Act Current LectureI. The Financial Crisis of 2007-2009 a. Financial innovation led to securitization i. They expected the housing market to continue to rise, so the banks originated mortgage loans but instead of keeping them they resold them to investors. Because the banks no longer owned those mortgage loans, they had little incentives to check the creditworthiness of borrowers. 1. Banks made lots of subprime loans b. Property Market Crash (2006)i. Caused a series of defaults on mortgage loans, which affected everyone who held those loans as assets. 1. Assets nicknamed toxic assetsii. What happened?1. Credit rating agencies: initially all those loans or securities were rated AAA. In 2007, some of those loans were quickly downgradedto junk statusiii. Why did they give AAA ratings?1. Many of these securities were issued by investment banks. The credit rating agencies were being paid by the same companies who they are supposed to rate causing a conflict of interest. So because of this conflict of interest, credit rating agencies were reluctant to give unfavorable ratings to these securities. These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.a. Starting in 2007, all the investors tried to sell this “toxic assets” because they feared they would lose value, and most did. b. Many firms ended up filing for bankruptcy because they had no valuable assetsiv. Height of the Crisis1. Sept. 15 when Lehman Brothers filed for bankruptcy and AIG had to be bailed out by the FED and Treasury II. Did Principal-Agent Problems Help Bring on the Financial Crisis?a. Investment Banksi. Traditionally concentrated on providing advice to corporations on selling new stocks and bonds and on underwriting their issuance by guaranteeing a price to the firm selling them ii. Investment banking is considered more risky than commercial banking because investment banks can suffer heavy losses on underwritingiii. Traditionally organized as partnerships1. By 2000 they had all converted to being publicly traded corporations 2. In a partnership, the funds are put directly at risk and the principal-agent problem is reduced because there is little separation of ownership from control3. With a public traded corporation principal-agent problem can be severe b. Glass-Steagall Act (1993)i. Prevents financial firms from being both commercial and investment banksii. Repealed the act in 1999 and some commercial banks began engaging in investment
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