Essay 1

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Essay 1, Exam 1

1. Why did the Federal Reserve decide to lower interest rates in the early 2000s; thus, making money easily and cheaply available? Explain this in terms of economic concepts of supply and demand.

The Federal Reserve was responding to the internet bubble burst. Many people had invested in numerous start-up internet companies. They did not bother to check the viability of their investment. Therefore, most of them ended up losing their money. The high demand in the investments led to a subsequent increase of stock prices. The failure of the companies meant that the investors lost money since they had spent a lot to buy the stocks and the companies were now worth very little. Lowering the interest rates would make people buy more and this would lead to a growth in the economy. People could afford to take mortgages because of the low interest rates and this increased the demand for houses.

2. What is the definition of a housing bubble (research definition?) Why did the value of houses increase prior to 2008? Remember the reason why house prices rose is multi-faceted, include all reasons

A housing bubble is a situation that leads to quick increases in house prices. It is caused by speculation in the market, which leads investors to believe that there will be high returns. This causes a high demand for homes. The value of the houses increased because of the high returns associated with the investments. People wanted to make quick returns and there was high demand because of the increased value of the houses. Moreover, the low interest rates made it possible for people to afford the houses, which lead to increased demands and subsequent price increases.

3. What are sub-prime loans? Why did banks sell their sub-prime mortgages? What is happening now with sub-prime loans?

Sub-prime loans are loans offered at high interests to any borrower regardless of whether he qualifies for it. They are often offered to people with a substandard credit history and with poor financial knowledge. Banks sold sub-prime mortgages so that they could attract more customers. Doing so enabled them to attract a larger market as the poorer segment of the population could now afford to take the loans. Lenders are taking advantage of desperate people and they are offering them sub-prime loans. Banks are selling them as forms of securities to different investors and this has led to an increase demand in the loans. The loans are offered for longer periods but the high interest rates and the fact that they are offered to customers who cannot afford them have caused many people to be in debt (Greenberg and Corkery).

4. Why did housing bubble burst?

There was increased demand for the houses yet there was little supply and this led to an increase in the prices. The Federal Reserve decided to increase the interest rates to prevent inflation. Many people with adjustable mortgages could no longer afford to pay the rates required because of the high interest. This decreased the number of people who were purchasing homes thus increasing the number of homes available in the market. Moreover, the number of homes being foreclosed increased thereby increasing the houses in the market. In addition, there was increased supply of new homes because of the previous demand. This led to an increase supply in the market and to a subsequent reduction in home prices.

5. Define collateralized debt obligations. Who sold them and who bought them? Why did people/banks/governments/investors want to buy these financial investments?

Collateralized obligations are financial products that are repackaged by banks into loans that can then be purchased by other investors such as security firms and other banks. Banks sold the obligations to investors who bought them in form of trenches. The investors benefited from the dividends collected from the mortgage payments received monthly. The collateralized debt obligations appealed to people because they could own shares of their own homes. They investors could get high return for their investments and the banks could reduce their risks.

6. The problem came when credit dried up, banks failed, businesses stopped. Describe the domino effect of bank failures. Who failed? Explain the concept of “too big to fail.”

The failure of banks led to a situation where people and businesses could not get the credit they needed. Businesses could not get the funds they needed to continue with their business operations. This had negative consequences because they were forced to lay off some employees. People could no longer afford to pay for their mortgages since they did not have any source of income. This led to more houses being foreclosed. Since there was less demand for homes, new construction stopped and those who worked in the industry no longer had jobs. The increased unemployment also reduced the rates of consumption. Banks and financial regulators had failed. There was no control over the mortgages issued. The situation could have been different because it could not have led to a housing bubble and an eventual burst. Speculation from Wall Street worsened the situation. The fear that one of Bear Stearns, an investment bank that dealt mostly with mortgages, would fail created some panic within the financial industry.

Some banks believe that they are too big to fail since doing so would affect the economy by creating financial chaos if they were to fail. Such banks believe that they would have to be bailed by policymakers if they were in a dire situation that signaled their collapse (Nasiripour).

7. Why did the Federal Reserve decide to intercede? What did they do?

The Federal Reserve had to intervene as failing to do so would destroy the economy. The banks were already in a bad position financially and the market was in a panic. The head Federal Reserve had announced that the government would cover the toxic mortgages by Bears Stearns following its purchase by JPMorgan. The federal government also took over control of Fannie Mae and Freddie Mac following their collapse. The government announced a bail out plan that amounted to $700 billion.

8. At the time of the initial bank failures, who was the chairman of the federal reserve, who was the head of treasury, and who was our president?

The Federal Reserve Chair at the time was Ben Bernanke. The head of treasury was Henry Paulson. The president during the 2008 crisis was George W. Bush.

9. Greed, poor oversight and lack of responsibility caused the recession of 2008-who was greedy, who didn’t regulate. List all the parties that were greedy

The consumers were greedy because they wanted quick and easy mortgages. The banks were greedy because they wanted to offer high-risk investment opportunities so that they could benefit from the quick returns. The investors wanted to make quick money and they did not take enough care when considering their investments. There was failure by the financial authorities responsible to regulate the banks. The government could have been at the forefront to ensure that the banks maintained some level of responsibility, and that they were accountable for the actions they took.

10. Briefly discuss three ways the government intervened or at least wanted to intervene. Include the specifics of Dodd-Frank Bill

The government intervened by bailing out one bank and nationalizing three of the country’s largest companies. The government volunteered to buy toxic mortgages and it set some money aside that would be used for bailing out other institutions. The government aimed at regulating financial institutions through the Dodd-Frank Bill. It proposed several amendments aimed at ensuring that the country would not experience the sort of crisis it had. It granted the Federal Reserve more responsibility and authority over the institutions that are responsible for maintaining the financial stability of the nation. It ensured that the big banks were more accountable for their actions. They were to deal with the repercussions of their failure and the government would not take any measures to bail them out (Acharya et al., 5)

11. What is the status of our banks?

Despite the challenges experienced in the previous recession, banks have failed to take enough precaution. They continue to engage in high risk ventures and they still hold the belief that they are too important for the government and the policymakers to allow to fail. For instance, the banks have little capital and their funding is not stable. The banks engage in risky market activities (Thoma). Despite these shortcomings, the big banks continue to benefit over other financial institutions. They receive subsidies at the expense of the taxpayers. Because of the previous bailouts and the understanding that some banks are more important than others, many people would withdraw money from the small to the big banks incase there was a looming crisis (Morgenson).

Works Cited

Acharya, Viral V. et al. Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance. Hoboken, NJ: John Wiley & Sons, 2010. Print

Greenberg, Silver and Michael, Corkery. “In A Subprime Bubble for Used Cars, Borrowers Pay Sky-High Rates.” The New York Times. 19 July 2014. Web. 29 September 2014

Frontline. Inside the Meltdown. 17 February 2009. Web. 29 September 2014

Morgenson, Gretchen. “Big Banks Still A Risk.” The New York Times. 2 August 2014. Web. 29 September 2014

Nasiripour, Shahien. “’Too Big to Fail’ Lives As Regulators Slam Banks’ Living Wills.” The Huffington Post. 5 August 2014. Web. 29 September 2014

Thoma, Mark. “Are Banks too Large?” Economist’s View. 15 May 2014. Web. 29 September 2014