FIN3244 Chapters 5 and 8 Exam 2 Chapter 5 Investment banks mutual and hedge funds and the shadow banking system The Great Depression Banks failed and people crowded around trying to get their money out Banks typically get their money from deposits and invest in mortgage loans There was a mismatch in the maturity of moneys because the deposits were short term as the customers could get it back whenever they wanted whereas the mortgages were typically over 30 years Essentially short term deposits were funding long term loans The bank is required to give the customer their money when they want it but runs into a problem if too many people want this at the same time because the money is wrapped up in mortgages The economy runs in cycles Things go up and everything increases until the bubble bursts Then similarly there is a decline for a while and then things start to improve This was exacerbated by the dust bowl which continued it for as long as it did It started with the roaring 20s where the Dow Jones was at 381 and it dropped to 41 points Great Depression Statistics Stock market crashed in 1929 Economy soon followed o GDP growth went negative The worst period was between 1931 1933 and that s when the production of goods and services drop by 42 which is huge Then we start to come out of it then it dips again by 9 o Unemployment skyrocketed Got up to 25 We got out of it slowly o Bank failures were astronomical The U S has a huge amount of banks In 1929 there were over 24 thousand banks and in 1933 there were just over 15 thousands banks o By 1933 almost half of all U S banks had failed Worsened by drought The Dust Bowl o Started around 1930 lasted almost 10 years o Land was farmed without rotating crops and nothing was done to protect the soil The Midwest drought and lack of trees and grass to create farmland made it so there was nothing to hold the soil down It just blew away Farms were abandoned and towns were covered Recovery took 25 years Although the recession was not nearly as bad as the great depression the great depression was the reason that the government took such strong and unprecedented precautions to help the economy from getting any worse Ben Bernanke said the great depression was caused by a tightening of money policy which is what the Fed does When they remove money from the money supply interest rates increase The roaring 20s caused high inflation and this had to be combated with higher interest rates This would reduce the amount of people borrowing money and allow prices to go down In the spring of 1928 interest rates were increased to try to combat inflation The Fed didn t balance it well and continued to increase the interest rates even through a recession leading to the market crash of October 1929 If interest rates are too high for too long no one can borrow money and the economy is slowed At this time the U S was on the gold standard and speculators began selling their dollars for gold The Fed had to increase interest rates to preserve the value of the dollar Raising interest would restrict dollar availability so people were afraid they weren t going to have enough money and started to hoard their dollars Investors who had money in banks started demanding to get their money back which wasn t all available The Fed kept reducing the money supply up to 30 even though it was screwing up banks left and right This created a liquidity crisis and the start of the depression began within commercial banks as they were the most important financial institutions at the time Commercial banks The majority of the funds they use are put into real estate loans including mortgages The next highest is for purchasing securities these are government securities like treasury bonds Most of the funds come from deposits 73 of funds deposits are FDIC insured checking savings CDs and they borrow from other banks and entities Basic operations take in deposits from individuals and small firms and male loans to small firms or as mortgages The problem is mismatched funds they use short term money to make long term loans demand deposits make mortgages o This creates a liquidity problem which can lead to bank runs if everyone tried to get their money out at the same time the bank would be screwed They keep some money on hand to satisfy withdraws that people make but they wouldn t be able to keep up if everyone came at the same time o This creates an adverse selection problem because the customer doesn t know how to trust if the bank is secure enough to pay you back This used to be a bigger problem If the bank ran out of money it was first come first serve Also if this happened to a bank people started to lose faith in all banks So people stopped trusting good banks and this created a contagion This is what happened in the great depression o The solution to the great depression problem was FDIC insurance This guaranteed that if the bank didn t have enough funds the federal government would step in and supply the funds or liquidity to get the customer their money back This stopped the problem and was a key difference between the great depression and the past few years But if the federal government stands behind all banks will it ever allow a bad bank to fail If banks can t cover their liabilities they should fail but FDIC may prevent this failure When the banks know there is no way they can go under they are more likely to make riskier choices o Moral hazard problems are mitigated by monitoring Government regulates banks extensively Does this make them overly restricted especially in the global economy Need a balance There are always unintended consequences all of the restrictions towards banks benefited the other intermediaries Investment banks They give advice on new security issues like how to raise new funds o Borrow issue new stock or bonds timing what price to charge etc A primary thing they do is underwriting new issues o Primary market IPO initial public offering the first time a company goes public 6 8 or seasonal issues 2 4 Mergers companies combine and acquisitions a company buys another company they don t have to invest their own funds they identify clients corporations Create new products and strategies called financial engineering or innovation o Fannie Mae was created in 1938 in response to the problem the banks were having as they were afraid people couldn t afford their mortgages Through an act of congress Fannie Mae was created to help local banks have federal money to
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