1. Dolan, Economics Combined Version 4e, Ch. 21 Survey of Economics Edwin G. Dolan and Kevin Klein Best Value Textbooks 4 th edition Chapter 9 Money and Central Banking

2. Dolan and Klein, Survey of Economics 4e, Ch. 9 What is Money? Money is any asset that serves as  a store of value  a unit of account  a medium of exchange

3. Dolan and Klein, Survey of Economics 4e, Ch. 9 Components of the Money Stock  paste in Table 8.1 when available

4. Dolan and Klein, Survey of Economics 4e, Ch. 9 The Equation of Exchange  M = money stock (M1 or M2)  V = velocity of circulation of money (how many times per year each unit of the money stock is used to purchase final goods)  P = price level (e.g., consumer price index)  Q = real GDP MV = PQ

5. Dolan and Klein, Survey of Economics 4e, Ch. 9 The U.S. Banking System  Banks are financial institutions that accept deposits and make loans.  Types of banks:  Commercial banks  Thrift institutions (savings and loans; mutual savings banks; credit unions)  The Federal Reserve System (Fed) is the central bank of the United States.

6. Dolan and Klein, Survey of Economics 4e, Ch. 9 The Balance Sheet  A balance sheet is a financial statement showing what a firm owns and what it owes.  Assets are all the things that the firm or household owns or to which it holds a legal claim.  Liabilities are all the legal claims against a firm by non-owners or against a household by nonmembers.  Net worth, also listed on the right- hand side of the balance sheet, is equal to the firm’s or household’s assets minus its liabilities. In banking, net worth is called capital. Assets Liabilities Net worth The accounting equation: Assets = Liabilities + Net Worth

7. Dolan and Klein, Survey of Economics 4e, Ch. 9 Balance Sheet of U.S. Banks The principal assets of U.S. commercial banks are loans. The principal liabilities are deposits.

8. Dolan, Economics Combined Version 4e, Ch. 21 Money: A Balance Sheet View

9. Dolan, Economics Combined Version 4e, Ch. 21 Effects of a Loan

10. Dolan and Klein, Survey of Economics 4e, Ch. 9 Effects of a Cash Withdrawal

11. Dolan and Klein, Survey of Economics 4e, Ch. 9 The Money Multiplier  In equation form, we can state the relationship between the money stock (currency in circulation plus bank deposits) and the monetary base (total currency plus bank reserve deposits at the central bank) as follows: Money stock = Monetary base X [(1+CUR)/(RES+CUR)]  RES = the target reserve ratio (amount of reserves banks want to hold for each dollar of deposits)  CUR = desired currency ratio (the amount of currency that the public chooses to hold per dollar of bank deposits)  The expression (1+CUR)/(RES+CUR) on the right-hand side of the equation is known as the money multiplier. The money multiplier gives the total quantity of money that can be created for each dollar of the monetary base.

12. Dolan and Klein, Survey of Economics 4e, Ch. 9 Effects of an Open Market Purchase

13. Dolan and Klein, Survey of Economics 4e, Ch. 9 Instruments of Monetary Policy  Open market operations are purchases and sales of government securities by the Fed. They are the most frequently used instrument of monetary policy.  Changes in interest rates  Discount rate charged by the Fed on reserves it loans to commercial banks  Deposit rate paid by the Fed on reserve deposits of commercial banks  Changes in required reserve ratios can also be used to affect the money supply. The Fed does not use this instrument of monetary policy, but it is used by some other central banks around the world.  Purchases and sales of foreign assets are used by many central banks as an instrument of monetary policy, but not by the Fed in recent years.

14. Appendix to Chapter 9 Dolan and Klein, Survey of Economics 4e, Ch. 9

15. Traditional Banking: Originate-to-Hold Traditionally, banks rarely sold loans to other investors.  No two loans were exactly alike.  Bankers needed personal knowledge of their customers.  Buyers feared that any loan a bank wanted to sell must be a “lemon”. ? www.pdclipart.org. ?

16. Dolan and Klein, Survey of Economics 4e, Ch. 9 The Beginnings of Securitization  Starting in the 1930s, Government Sponsored Entities (GSEs) were created to buy loans from banks.  Banks used the funds to make new loans.  The GSEs bundled the loans into securities and sold them to investors—a process called securitization.

17. Dolan and Klein, Survey of Economics 4e, Ch. 9 Simple Pass-Through Bonds  Earliest mortgage-backed securities were simple pass- through bonds.  Each bond received an equal share of all principal and interest payments on a pool of loans.  Each bond shared an equal part of the loss from any default.

18. Dolan and Klein, Survey of Economics 4e, Ch. 9 Senior-subordinate structure  In important innovation was introduction of tiers of bonds with different risk.  Senior bonds have first priority to receive interest and principal payments, last to bear losses.  Subordinate bonds bear the first risk of losses from defaults and stand last in line for income.  Mezzanine bonds stand in between.  Investors select safe, low-yield senior bonds or riskier, high-yield subordinate bonds according to their appetite for risk.

19. Dolan, Economics Combined Version 4e, Ch. 20 Growing Complexity Over time securitization became more complex. First, households and firms borrow from originating banks. The banks then sell the loans to GSEs and other specialized intermediaries, who issue securities divided in "tranches" according to risk. Each type of security is rated and then sold to investors, often hedge funds or other institutions, who buy the type of security that best fits their appetite for risk. Investors can further protect themselves against risk by means of credit default swaps.

20. Dolan and Klein, Survey of Economics 4e, Ch. 9 Perceived Benefits For originating banks  New sources of fee income  No additional capital needed  Reduced credit risk For the economy  Banks can make many more loans because they do not have to hold the loans to maturity on their own books.  Credit risk is borne by hedge funds, insurance companies, and other investors thought best positioned to bear it.  Wide distribution of credit risk makes financial system more stable.  Cost of credit is reduced for everyone.

21. Dolan and Klein, Survey of Economics 4e, Ch. 9 Housing and Social Policy  In the 1990s, affordable housing received increased attention as a social issue.  Why should only the middle class be able buy a home? Why were low-income families excluded?  Banks’ answer: Because loans to low-income households are too risky!  Subprime loans were invented to resolve the conflict between the conservatism of traditional banking and the demands of social policy. www.pdclipart.org.

22. Dolan and Klein, Survey of Economics 4e, Ch. 9 Standard vs. Subprime Mortgages Standard (prime) mortgages:  Borrowers are expected to repay loan from current income  Lenders profit primarily from interest payments  Borrowers get full benefit of increase in home value or bear full loss from decrease Subprime mortgages  Banks rely on appreciation of home value, not borrowers’ income, for repayment  Lenders profit primarily from fees for origination, servicing, and refinancing  Lenders share benefit from appreciation of home value and risk of loss if value decreases

23. Dolan and Klein, Survey of Economics 4e, Ch. 9 Standard vs. Subprime Mortgage terms Standard (prime) mortgage terms:  Loan to value ratio usually 80%-90%  Constant fixed rate for full 30- year life of mortgage  No prepayment penalty  Require careful documentation of income and assets of borrower Subprime mortgage terms:  Loan to value ratio up to 100% or even more  Low teaser rate for 2 or 3 years followed by high step- up rate  Large prepayment penalty  May not require documentation of income or assets

24. Dolan and Klein, Survey of Economics 4e, Ch. 9 Profitable in a Rising Market  Subprime mortgages are profitable to both lender and borrower in a rising market.  Borrowers accumulate equity in homes they could not otherwise afford to buy.  Lenders extract profit at end of initial 2 or 3 year period in one of three ways:  Through prepayment penalties if property is sold or refinanced  Through high step-up interest rates if not refinanced  Through foreclosure in case of default www.pdclipart.org.

25. Dolan and Klein, Survey of Economics 4e, Ch. 9... but Risky in a Falling Market In a falling market, subprime mortgages are more likely than prime mortgages to produce losses.  Negative equity is more likely because of high initial loan-to- value ratio.  Low income borrowers are more likely to default when equity becomes negative.  Recovery rates on forced sales of low-quality housing may be low. www.pdclipart.org.

26. Dolan, Economics Combined Version 4e, Ch. 20 But house prices never fall, do they?  From 1975 to 2006, house prices never had a nationwide down year.  From 2000 on, prices rose far above the historical trend based on gradually rising household incomes.

27. Dolan and Klein, Survey of Economics 4e, Ch. 9 Do Banks Take Excessive Risks? Spillover effects  Failure of one bank may trigger runs on other banks.  Failure of one bank may causes losses for counterparties (other financial firms who do business with the bank).  Failure of the banking system damages the nonfinancial economy by interfering with normal flows of credit. Gambling with other people’s money  Conflicts of interest when one party gets the gains and the other party is stuck with the losses:  Managers vs. shareholders  Managers vs. traders  Shareholders vs. bondholders  In economic terminology, these are called principal- agent problems.

28. Dolan and Klein, Survey of Economics 4e, Ch. 9 Gambling with your own or others’ money When gambling with their own money, many people choose games like the lottery that  lose most of the time, but not more than they can afford.  don’t win often, but have a huge payoff when they do win.  These are called positively skewed risks. When gambling with other people’s money, the best games are ones that...  win a moderate amount most of the time.  rarely lose, but may have really huge losses when they do.  Once a big loss comes, the game is over; however, the gambler keeps past winnings and someone else bears the cost.

29. Dolan and Klein, Survey of Economics 4e, Ch. 9 Fiduciary Duties of Managers  Financial managers are paid to gamble with other people’s money.  In doing so, they have a fiduciary duty to act in their shareholders’ best interests.  They should take prudent risks when there is a good chance of a high return for shareholders … ... but they should not put their personal gain ahead of shareholder interests.  Executive compensation plans are often misaligned with fiduciary duties.  Bonuses for short-term performance  Lack of “clawback”  Golden parachutes  Such bonus-based compensation plans cause managers to seek excessively risky strategies.

30. Dolan, Economics Combined Version 4e, Ch. 20 Example of misaligned incentives Strategy A  5 quarters of $100 million profit  5 quarters of $10 million loss  10-quarter net for shareholders: profit of $449.5 million  10-quarter result for executive: total bonuses of $500,000 Strategy B  9 quarters of $200 million profit  1 quarter of $2,000 million loss  10-quarter net for shareholders: loss of $201.8 million  10-quarter result for executive: total bonuses of $1.8 million Strategy B has higher payoff for the executive but lower payoff for shareholders Assume an executive bonus plan that pays 0.1% of net profit each quarter

31. Dolan and Klein, Survey of Economics 4e, Ch. 9 Safety and Soundness: Bank Examinations  Bank examinations are the oldest tool for ensuring the safety and soundness of the banking system.  These examinations, conducted by state or federal officials, are intended to ensure that banks do not make unduly risky loans, that they value their assets honestly, that they maintain adequate levels of net worth and liquid reserves, and that they have competent management. The “CAMELS” Checklist for bank examiners  Is there adequate Capital?  Are Assets of high quality?  Is Management competent?  Are Earnings reliable?  Is there adequate Liquidity?  Is there too much Sensitivity to market risk? www.pdclipart.org.

32. Dolan and Klein, Survey of Economics 4e, Ch. 9 Tools to Ensure Safety and Soundness Lender of last resort  During a bank panic, banks may be unwilling to lend to one another.  Lack of interbank credit causes failure to spread.  Central bank makes emergency loans to protect banks from failure. Deposit insurance  During a bank panic, a run may occur because depositors fear only the first in line will get their money back.  Government deposit insurance means there is no need for a run.

33. Dolan and Klein, Survey of Economics 4e, Ch. 9 Sources of the Crisis  The housing bubble, financed by subprime lending  Ratings failures and disappearance of liquidity  Regulatory failures

34. Dolan and Klein, Survey of Economics 4e, Ch. 9 Rehabilitating Failed Banks Three questions for helping failed banks:  Who should be helped?  All banks or only failing banks?  Are some too big to fail?  Who should bear the losses?  Shareholders?  Taxpayers?  How should aid be provided?  Carve-out?  Capital injection? www.pdclipart.org.

35. Dolan and Klein, Survey of Economics 4e, Ch. 9 How a Carve-out Works  The government first creates a bank assistance agency (example: TARP).  The bank assistance agency exchanges good government bonds for low-quality financial instruments (“toxic waste”).  If the value of the low-quality instruments turns out to be less than that of the good bonds, the bank assistance agency loses net worth and the financial institutions gain.

36. Dolan and Klein, Survey of Economics 4e, Ch. 9 How a Capital Injection Works  The bank assistance agency exchanges good government bonds for equity (common or preferred stock) in financial institutions.  Low quality assets stay with the financial institutions.  The value of the government’s stock rises or falls depending on what happens to the value of the low-quality assets.