Ch 18

Question 1

derivatives

Answer 1

contract/security derived from underlying assets - stocks, MBSs, bonds

Question 2

speculation

Answer 2

buyers assume prices will stay increasing and buy houses to eventually sell

Question 3

reflexivity

Answer 3

• investors base decisions on perception of reality - like believing house prices will keep increasing

Question 4

moral hazard

Answer 4

• firms take greater risk when insured
• believe will be bailed out by government - often are
• “too big to fail”

Question 5

financial fragility

Answer 5

• firms linked with network payment obligations - if one fails -> domino effect
• take big risks relative to their networks
• stretched to the limit of debt they can handle

Question 6

characteristic of recession

Answer 6

2 quarters of declining GDP

Question 7

asset market vs. goods market

Answer 7

• asset value depends heavily on state of economy which can change very quickly
• value of good can be determined by inspection, reviews, etc.

Question 8

non-financial causes of crisis

Answer 8

• high employment & higher wages = lower profits - firms indulge in risky behavior to compensate
• overinvestment to match competition
• under consumption from rising income inequality & stagnating wage incomes

Question 9

collateral damage

Answer 9

damage to those who aren’t responsible for the crisis

Question 10

what are often the soil in which seeds of crisis grow

Answer 10

financial assets

Question 11

federal funds rate

Answer 11

rate at which banks lend money to each other

Question 12

feedback loop

Answer 12

when X causes Y which causes X

Question 13

prime vs. subprime mortgage

Answer 13

• prime - low-risk borrower, good income
• subprime: higher interest rate->higher monthly payments
• can be interest-only for first while -> gives borrower hope that they can sell when house price goes up
• can also refinance to lower payments

Question 14

recommendations/solutions

Answer 14

• breaking up big banks & financial institutions to end the “too big to fail phenomenon” (putting size limit on assets of one bank)
• investments should be actively regulated instead of being asked to follow standards
• establishing public banks or nationalizing

Question 15

recommendations –> changing incentives of actors taking up risky behaviors

Answer 15

• risky behavior made very costly
• limit creation of risky securities & discourage sales with little information
• prohibit newly created securities from sales unless examined very well
• prohibition of over-the-counter sales of derivatives
• banks to hold capital reserves equal to substantial share of the value of their assets
• executives required to repay large share of bonus/income when firms receive government bailouts