Ch 1 Why Study Money Banking and Financial Markets August 30 2012 Financial Markets Financial markets markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds Stocks and bonds Direct finance borrower and lender interact directly Financial Intermediation Not a financial market Banks move around money and collect fees for doing so Indirect finance o Depositors are the source of bank s funds Uses of funds Loans Bonds Sources of funds Deposits Create income try to sell as highly as possible Create expense want to buy as cheaply as possible Money a universally accepted object that can be used to buy goods and services and can repay o Labor Theory of Money Marx think of money in terms of the labor required to earn it loans not just what it can buy 2004 2006 Housing Bubble Asset bubbles when the price of an asset rises above its fundamental value o There is always a rational price that makes sense when the price increases above that there is a bubble irrational pricing Causes of the Housing Bubble o 1 Low interest rates builders increase production of homes increased home supply people buy homes increased home demand Alan Greenspan Chairman of the Fed Sustained economic growth between 1900 2000 bc of low interest rates and technology boom o 2 Financial innovation Mortgage lenders paid on commission lenders relaxed the rules and created mortgage products to make it easier to make the loan get more commission Adjustable Rate Mortgage ARM lender can increase or decrease mortgage rate based on changes on the interest rate Lenders expected interest rates to continue to decrease but in 2008 interest rates rose and the lender was forced to increase mortgage payment hurt borrowers Also made it easier to access mortgage lender i e internet o 3 High inflow of foreign capital in US economy financial capital Look for low risk and high return US attractive to foreigners Further lowered interest rates in the US o 4 Mortgage backed securities most deadly feature of housing bubble and making the crisis go global Banks have a limit to the number of loans they can make but these mortgage backed securities allowed banks to over extend their ability to make loans People who bought mortgage backed securities also lost money made things go global If banks are in trouble the entire economy is in trouble i e Bailouts via the Fed and Treasury Dept When large banks go under smaller banks go under everyone invested in large bank goes bankrupt ripple effect The Fed lowered interest rates and provided liquidity to financial market successful 2 The federal government provided a stimulus package fiscal bailout failed Foreclosure cannot make mortgage payment so bank evicts residents and owns property banks do not want to do this because it creates costs for them but are forced to do so In the global economy everyone is suffering i e Euro is extremely fragile In 2007 the bubble burst Real Potential GDP 14 5 trillion Real adjusted for inflation Potential GDP how much we can produce o i e Production Possibilities Curve Actual GDP 13 5 trillion due to recession Debt deflation Assets Cash Stocks Bonds Car Household Liabilities Credit cards Consumer loans Mortgage loans Real estate Other debts Total 500 000 Total 400 000 Net worth liquidity 100 000 New Total 200 000 New net worth liquidity 200 000 3 During recessions the market value of assets decrease bc directly linked to market value liabilities remain the same net worth decreases Output gap 1 trillion about 3 200 per person a year Unemployment 8 3 ideal 5 6 Federal debt in reality the money taxpayers owe 15 9 trillion o Citizens fault ask the government to spend money via programs If government does not raise taxes it borrows via treasury bonds increases debt o Interest on federal debt 500 billion get the money to pay interest rates by borrowing more increases debt Congress gives Treasury the authority to raise money in bond market and anyone can buy a treasury bond The Chinese have loaned a lot of money to US and expect to be repaid The average Chinese family has savings rate of 50 The Bond Market and Interest Rates Security financial instrument a claim on the issuer s future income or assets i e bonds and Bond a debt security that promises to make payments periodically for a specified period of stocks time like renting money o Seller borrower o Buyer lender Interest rate the cost of borrowing or the price paid for the rental of funds AAA the highest credit rating a borrower can achieve if lower then have to pay a higher interest rate Figure 1 Interest Rates on Selected Bonds 1950 2011 4 Trends move together but with a spread no such thing as one interest rate Largest peak at around 1980 85 2 severe oil crises and chairman of Fed tried to decrease inflation interest rates peaked From 1990 95 all dipped but Three Month Treasury Bills short term paid lower interest rates than others risk and term structure of interest rates September 4 2012 The Stock Market Equity Market Share of stock a claim on the residual earnings and assets of the corporation Common stock represents a share of ownership in a corporation Equity ownership See return on investment through o 1 Dividends money given to shareholders from company for buying their stock o 2 Capital gain make profit or capital loss Stock Prices as Measured by the Dow Jones Industrial Average 1950 2011 5 Not adjusted for inflation 1985 1995 technology boom o Technology helps the stock market because makes businesses more efficient decrease costs increase profits increase stock prices Before technology boom we did not have the info to detect economic changes so the market did not react as quickly Decrease in early 2000s 9 11 Decrease in 2006 07 housing crisis Why Study Financial Institutions and Banking Financial intermediaries institutions that borrow fund from people who have saved and make loans to other people o Banks accept deposits and make loans Bank is not the lender the lender is the depositor the bank is the intermediary Commercial banks are most important in our economy 1 Make consumer loans i e car student loans 2 Make mortgage loans 3 Make business loans makes commercial banks unique Conduit for monetary policy 6 o Other financial institutions insurance companies finance companies pension funds mutual funds and investment companies Insurance companies Collect premiums Invest lend investing loaning Buy bonds stocks purchase