Questions About the Bank Industry an Economic

2. Explain 4 of the basic facts and what it means for our financial markets.

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3. A credit default swap is an insurance policy between a protection seller and a protection buyer covering an organizations specific loan or bond. Credit default swaps are unique in that third parties can take out the insurance policies on an organization or entity they have no association with. However, in the case of the financial crisis, there was no way to know how much the bankruptcy of one company would cause the insurers. Often a company had CDS worth much more than the actual book value of the company.

4. a. Securitization of loans. Traditionally, banks retained most of the loans that they gave out. The practice gave the lenders incentive to underwrite loans that had little chance of defaulting. As loans underwent securitization, the practices faded since there was less incentive to investigate the quality of the underlying assets.

b. the dominant economic ideology of the time was the benefits of unrestrained free markets that led to the deregulatory fever thus preventing the formation of a regulatory body overseeing CDS.

c. The banks and speculators that were the source of the crisis were focused only on short-term profits as compared to longer-term sustainable profits. While the financial transactions increased GDP, the fed had no motivation to investigate their sustainability.

d. The habit of the Federal Reserve under the leadership of the then chairman Alan Greenspan to lower interest rates after every financial crisis led to the massive uptake of loans by people even though most of them were subprime

5. Starting December 2008, the fed began the purchase of long-term Treasury securities as well as the Mortgage backed securities of Freddie Mac and Fannie Mae.

The fed has also increased their securities based on GSE debts to prevent the collapse of major financial institutions in the country

The mortgage backed securities, which were one of the main causes of the financial crisis have also increased as the fed seeks to prevent another financial meltdown.

6. There are three theories that try to describe the future yield curve

i. the pure expectation theory explains the yield curve in relation to the expected short-term rates. The theory is based on the argument that a two-year yield is similar to a one-year bond purchased today plus the expected returns on a one-year bond purchased an year later. The major fallacy of this theory is its assumption that all investors have no preferences on the different maturities and the various risks

ii. The liquidity preference theory argues that investors like compensation for the risk incurred when purchasing long-term securities. Because of the long maturity date, there is a greater chance for price volatility.

iii. The market segmentation theory focuses on the demand and supply for specific maturities thus determining the interest rates. An additional argument of this theory is that if an investor wants to move to another sector, then they have to be compensated for the additional risk.

8. The rational expectations theory is an idea in economics that economic agents make choices based on their rational outlook, past experiences and the available information. Therefore, the theory argues that the current expectations reflect the actual future state of the economy. This theory is a direct contradiction of the government policy theory that argues peoples decision are shaped by government policies.