Chapter 1 Financial crisis Resulted in a devastating decline in production of goods and services throughout the economy Workers entering the labor force during a recession receive 10 less pay and they remain lower for a decade Loan losses during 2007 2009 were by far the largest since the great depression Bubble unsustainable increase in the price of a class of assets such as stocks Could be caused by overoptimistic expectations i e housing bubble many thought that the prices of homes would continue to increase so they purchased homes they could not afford Fannie Mae and Freddie Mac were created to make it easier for families to borrow money to buy houses mortgages being issued to subprime borrowers and alt a borrowers also adjustable rate mortgages were created low rates high rates over a long period of time Troubled asset relief program tarp was created to provide funds to commercial banks in exchange for stock in those banks meant to restore the flow of funds from savers borrowers Many feared this would reduce banking independence 3 components of a financial system 1 Financial assets anything of value owned by a person or firm Financial claim on someone else to pay you money 5 Key assets Money stocks bonds foreign exchange securitized loans Security tradeable to be bought and sold in a financial market Financial markets places channels for buying selling stocks bonds and other securities Non Security not tradeable 2 Financial institutions 3 The FED and other financial regulators Money Coins paper currency funds in checking accounts Anything people are willing to accept in payment for goods and services or to pay off debts Money supply total quantity of money in the economy Stocks equities financial securities that represent partial ownership of a corporation When you buy a stock shareholder you have a legal claim to a share of the corporation s assets and to a share of its profits Dividends payments corporations typically make each quarter to shareholders Financial capital funds available to the firm Bonds financial security issued by a corporation that represents a promise to repay a fixed amount of money Interest rate cost of borrowing funds Bonds typically pay interest amounts called COUPONS When a bond matures the seller of the bond repays the principal Bonds can be bought and sold therefore they are securities Short term bond less than a year Long term bond more than a year Foreign Exchange units of foreign exchange Most important buyers and sellers are large banks who engage in these transactions on behalf of investors who want to buy foreign assets i e factories import export goods Securitized Loans loans that banks could sell on financial markets securities Mortgage backed security security that functions like a bond Bank receives fees for originating the loan and for collecting the loan payments from borrowers and distributing them to lenders Financial Liability Financial claim owed by a person or firm Financial system matches savers and borrowers through 2 channels 1 Banks flows indirectly because the funds the bank lends come from people who have put money in checking saving deposits in the bank bank you 2 Financial markets flows directly ex Stock Savers receive returns through dividend payments on stock coupon payments on bonds and interest payments on loans Commercial banks take deposits from households firms and invest these deposits by making other loans of buying securities Many households rely on banks for big ticket item loans i e house Many firms rely on banks for big ticket item loans i e expansion to multiple factories or short term loans for payroll purposes Non bank financial intermediaries i e savings and loans savings banks credit unions insurance companies pension funds mutual funds hedge funds and investment bank Share a similar function in that they channel funds from savers borrowers Insurance Companies specialize in writing contracts to protect policyholders from the risk of financial losses associated with particular events Collect premiums and invest these to obtain the funds necessary to pay policyholders and to cover their costs Pension funds invest contributions from workers and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments during workers retirements Mutual Funds Obtain money by selling shares to investors reinvests the money in a portfolio of many different financial assets Typically charge a small management fee Not very risky because a mutual fund has a large portfolio with MANY investors which provides a good buffer for major crises i e a firm declares bankruptcy stock bond to lose all value the effect of this would not be felt Provides savers with easy access to their money Hedge Funds Similar to mutual funds Accept money reinvest in their portfolio of assets however hedge funds are MUCH smaller typically only have 100 investors and they are all WEALTHY RISKY investments Charge MUCH higher fees Investment banks Do not take deposits and rarely lend directly to households they concentrate on providing advice to firms and engage in underwriting in which they guarantee a price to a firm issuing stock and make a profit by selling them at a higher price Heavily involved in mortgage loans as well as buying selling securities Financial Markets places or channels for buying selling stocks bonds and other securities Traded by dealers who would meet face to face but now it is also done electronically Primary market financial market in which stocks bonds and other securities are sold for the first time Initial Public Offering First time a stock is sold to the public Secondary market Financial market in which investors BUY AND SELL existing securities When there is a stock boom there is an increase in the purchasing of other securities when there is a stock crash there is a decrease in the purchasing of other securities and an increase in the amount of savings deposits When left along the financial system has experienced period of instability which has lead to the creation of Securities and exchange commission SEC regulates financial markets Federal deposit insurance corporation FDIC insurances deposits in banks Office of the comptroller of the currency regulates federally chartered banks The FED the central bank of the US The Federal Reserve 1913 Established to handle whenever a large number of depositors withdraw money at the same time Known as the lender of last resort Makes short term loans that
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