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Exam 1 Study Guide by Darcy Hock Chapter 1 Borrowers Impacted by Financial Crisis During the financial crisis of 2007 2009 there was the largest amount of loan losses since the Great Depression Banks tightened their loan guidelines which made it hard for households and businesses to qualify for loans Cut off from a source of funds small businesses had to resort to borrowing from pawn shops running up credit cards and borrowing from friends family Bank Lending Impact on Community Most households rely on borrowing money from banks for big ticket items such as cars or homes Firms rely on banks to meet short term and long term needs for credit Key Components of the Financial System Financial assets Financial institutions The Federal Reserve and other financial regulators Financial Assets an asset is anything of value owned by a person or firm A financial asset is a FINANCIAL CLAIM which means you have a claim on someone else to pay you the money Financial assets can be divided into those that are securities and those that aren t o Security tradable can be bought and sold in a financial market o Financial market places or channels for buying and selling stocks bonds and other securities Ex New York Stock Exchange 5 Key Categories of Assets Money Stocks Bonds Foreign exchange Securitized loans Money anything that is generally accepted in payment for goods and services or to pay off debts o Money supply the total quantity of money in the economy Stocks equities financial securities that represent partial ownership of a firm When you buy a share of stock you become a shareholder This is done to increase the funds available to the firm its financial capital in exchange for increasing the number of owners As a shareholder you have legal claim to a share of a firm s assets and profits if there are any o Dividends firms keep some of their profits in retained earnings and pay the remainder to shareholders typically paid every quarter Bonds a financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money When you buy a bond you are lending the corporation or the government a fixed amount of money Bonds pay interest in fixed dollar amounts called coupons and when the bond matures the seller of the bond repays the principal A bond that matures in a year or less is a short term bond and a long term bond matures anything longer than a year Bonds can be bought and sold in financial markets so they are securities o Interest rate the cost of borrowing the funds or the payment for lending the funds usually expressed as a percentage of the amount borrowed Foreign exchange units of foreign currency to buy foreign goods and services a domestic business or investor must first exchange domestic currency for foreign currency Large banks are the most important buyers and sellers of foreign exchange because they engage in foreign currency transactions on behalf of investors who want to buy foreign financial assets or firms who want to import export goods services or invest in physical assets in foreign countries Securitized loans loans that banks can sell in financial markets Securitization is the process of converting loans and other financial assets that are not tradable into securities Ex A bank could take a mortgage sell it to a government sponsored enterprise or financial firm that will bundle it with other mortgages which forms a new security called a mortgage backed security that will function like a bond The bank sends the interest paid by the borrowers and send those interest payments to the firm to distribute to the investors who have bought the mortgage backed security o Financial liability a financial claim owned by a person or firm Financial Institutions financial intermediaries financial markets Funds flow from lender to borrowers indirectly through financial intermediaries banks or directly through financial markets NYSE If you get a loan from a bank this is called indirect finance because the bank is not lending its own funds directly to you If you buy a stock the flow of funds is direct finance because the funds are flowing directly from you to the firm Financial intermediaries a financial firm such as a bank that borrows funds from savers and lends them to borrowers o Most important financial intermediary A financial firm that serves as a financial intermediary by taking deposits and using them to make loans They also buy securities like government bonds or securitized loans Firms rely on bank loans to meet their short or long term credit needs Short term would be to pay for inventories or payroll Long term would be funds to physically expand the firm Nonbank financial intermediaries savings and loans savings banks and credit unions are legally distinct from banks but operate in a similar way by taking in deposits and making loans o Insurance companies specialize in writing contracts to protect their policyholders from the risk of financial losses associated with particular events They collect premiums from policyholders which the companies then invest to obtain the funds necessary to pay claims to policyholders o Pension funds invest contributions from workers and firms in stocks bonds and mortgages to earn the money to pay pension benefit payments during workers retirements o Mutual funds obtains money by selling shares to investors then invests the money in a portfolio of financial assets typically charging a small management fee Savers reduce the costs and risks they would incur if they were many individual stocks and bonds If a firm issuing a stock goes bankrupt the effect on the mutual fund s portfolio is small This also allows easy access the saver s money because mutual funds are willing to buy back shares at any time A Portfolio is a collection of assets such as stocks and bonds o Hedge funds similar to mutual funds in that they accept money from investors and use the funds to buy a portfolio of assets except they typically have no more than 99 investors all of whom are wealthy individuals or institutions such as pension funds They charge investors high fees o Investment banks differ from commercial banks in that they don t take in deposits and rarely lend directly to households Instead they concentrate on giving advice to firms issuing stocks and bonds or considering mergers with other firms They engage in underwriting where they guarantee a price to a firm issuing stocks and bonds and sell them a higher price They became


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FSU FIN 3244 - Borrowers Impacted by Financial Crisis

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