FIN 3244 EXAM 1 NOTES CHAPTER 1 The financial system is like an irrigation system The three major components of the Financial System are 1 Assets anything of value owned by a person or firm A Financial asset is a financial claim meaning that if you own one you have a claim on someone else to pay you money i A checking account is a financial asset ii Financial Assets are broken down into those that are Securities and those that aren t 1 Securities Securities are tradable meaning that they can be bought or sold in the 2 Financial Institutions Intermediaries Financial Market A financial firm such as a bank that borrows funds from savers and lends them to borrowers i Commercial Bank A financial firm that serves as a financial intermediary by taking in ii deposits and using them to make loans Insurance Companies Specialize in writing contracts to protect their policy holders from the risk of financial losses associated with particular events iii Pension Funds Invest contributions from workers and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments iv Mutual Funds Invest money collected by selling shares to investors in a portfolio of financial v assets such as stocks and bonds Investment Banks Concentrate on providing advice to firms that are issuing stocks and bonds or considering mergers with other firms 3 The Federal Reserve The central bank of the United States i Establishes Monetary Policy Actions taken to manage the money supply and interest rates to pursue macroeconomic policy objectives ii The Fed is run by a 7 member group appointed by the President known as the Board of Governors iii The Federal Reserve System is divided into 12 districts iv The FOMC is the policy making body of the Fed 1 They meet 8x a year to discuss monetary policy and decide on a target for the Federal Funds Rate a The Federal Funds Rate The interest rate that banks charge each other on short term loans FDIC Insures deposits in Commercial Banks The SEC Regulates the financial markets The 5 Key Categories of Assets 1 Money anything that people are willing to accept in payment for goods and services to pay off debts a Money Supply The total quantity of money in the economy 2 Stocks Financial securities that represent partial ownership of a firm also called equities a Dividends The remainder of a company s profit that it pays to its shareholders 1 of 8 3 Bonds A financial security issued by a corporation or a government that represents a promise to repay a fixed a Interest Rate The cost of borrowing money as a percentage of the amount borrowed 4 Foreign Exchange Units of foreign Currency 5 Securitized Loans Loans that have been converted into securities through securitization a Securitization The process of converting loans and other financial assets that are not tradable into amount of money securities Financial Liability A financial claim owed by a person or a firm Financial Market Places or channels for buying and selling stocks bonds and other securities such as the NYSE o Primary Markets Where stocks bonds and securities are sold for the first time o Secondary Markets Where investors buy and sell already existing securities 3 Key Services the Financial System Provides to Savers and Borrowers 1 Risk Sharing A service the financial system provides that allows savers to spread and transfer risk through diversification a Diversification Splitting wealth among many different assets to reduce risk 2 Liquidity The ease with which an asset can be exchanged for money a More Liquid Quicker and Easier b Illiquid Exchanged after a delay or by incurring costs 3 Information Facts about borrowers and about expectations of returns on financial assets If you buy debt you are investing The Financial Crisis of 2007 2009 Origins lie in the housing bubble of 2000 2005 o A bubble is an unsustainable increase in the price of a class of assets Mortgages were the first loans to be widely scrutinized To promote home ownership Congress created Fannie Mae and Freddie Mac o These two enterprises sold bonds to investors and used the funds to purchase mortgages from banks In the 2000 s Investment Banks became significant participants in the mortgage market o They bundled large numbers of mortgages into securities and resold them to investors o Mortgage backed securities became popular with investors because of their higher interest rates In 2005 2006 lenders loosened the standards for obtaining a mortgage loan o Before only borrowers with good credit and a 20 down payment were eligible o Now almost anyone was eligible Alt A Borrowers who stated income but did not prove it Sub Prime Borrowers with flawed Credit Histories Prime Borrowers with good credit histories Lenders also created Adjustable Rate Mortgages which had a higher likelihood of default Buyers and lenders agreed on the mortgages because they anticipated that housing prices would continue to rise which would reduce the chance f buyers defaulting on their mortgages In 2006 the decline of housing prices led to rising defaults of buyers with Adjustable Rate Mortgages 2 of 8 Due to the amount of defaults the value of mortgage backed securities declined sharply because investors feared that they would lose money purchasing them By 2007 the decline in Mortgage backed securities and large losses suffered by commercial and investment banks began to cause turmoil in the financial system o Many investors refused to buy mortgage backed securities o Some investors would only buy bonds issued by the U S Treasury Banks began to restrict credit In March 2008 the Fed began making loans to Investment Banks to all but the safest borrowers o Also the Fed and the Treasury helped JP Morgan acquire Investment Bank Bear Stearns by guaranteeing any losses suffered on Bear Stearns holdings of Mortgage backed securities up to 29 Billion In September 2008 Lehman Brothers went Bankrupt o This resulted in a sharp decline in most types of lending In October 2008 Congress passed the Troubled Asset Relief Program o The treasury provided funds to commercial banks in exchange for stock The Government now had Liquidation When a company goes bankrupt and sells everything concrete to earn cash to pay debts partial ownership of these commercial banks Collateral Something concrete tangible that backs a loan Restructuring A change in the way a company owes its loans Financial Innovation Unintended Consequences CHAPTER 2 If the value of a banks investments drop below
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