Economics of Money: Chapter 12
A major disruption in financial markets characterized by sharp declines in asset prices and firm failures is called a
- A) financial crisis.
- B) fiscal imbalance.
- C) free-rider problem.
- D) "lemons" problem.
A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system
- A) causes severe adverse selection and moral hazard problems that make financial markets incapable of channeling funds efficiently.
- B) allows for a more efficient use of funds.
- C) increases economic activity.
- D) reduces uncertainty in the economy and increases market efficiency.
A serious consequence of a financial crisis is
- A) a contraction in economic activity.
- B) an increase in asset prices.
- C) financial engineering.
- D) financial globalization.
________ are asymmetric information problems that act as a barrier to efficient allocation of capital.
- A) Asset prices
- B) Credit imbalances
- C) Financial frictions
- D) Financial derivatives
Financial crises in advanced economies might start from a
- A) debt deflation.
- B) currency crisis.
- C) mismanagement of financial innovations.
- D) currency mismatch.
When financial institutions go on a lending spree and expand their lending at a rapid pace they are participating in a
- A) credit boom.
- B) credit bust.
- C) deleveraging.
- D) market race.
When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process called
- A) deleveraging.
- B) releveraging.
- C) capitulation.
- D) deflation.
When financial intermediaries deleverage, firms cannot fund investment opportunities resulting in
- A) a contraction of economic activity.
- B) an economic boom.
- C) an increased opportunity for growth.
- D) a call for government regulation.
When asset prices rise above their fundamental economic values, a(n) ________ occurs.
- A) asset-price bubble
- B) liability war
- C) decline in lending
- D) decrease in moral hazard
Most U.S. financial crises have started during periods of ________ either after the start of a recession, a stock market crash, or the failure of a major financial institution.
- A) high uncertainty
- B) low interest rates
- C) low asset prices
- D) high financial regulation
If uncertainty about banks' health causes depositors to begin to withdraw their funds from banks, the country experiences a(n)
- A) banking crisis.
- B) financial recovery.
- C) reduction of the adverse selection and moral hazard problems.
- D) increase in information available to investors.
In a bank panic, the source of contagion is the
- A) free-rider problem.
- B) too-big-to-fail problem.
- C) transactions cost problem.
- D) asymmetric information problem.
Debt deflation occurs when
- A) an economic downturn causes the price level to fall and a deterioration in firms' net worth because of the increased burden of indebtedness.
- B) rising interest rates worsen adverse selection and moral hazard problems.
- C) lenders reduce their lending due to declining stock prices (equity deflation) that lowers the value of collateral.
- D) corporations pay back their loans before the scheduled maturity date.
A substantial decrease in the aggregate price level that reduces firms' net worth may stall a recovery from a recession. This process is called
- A) debt deflation.
- B) moral hazard.
- C) insolvency.
- D) illiquidity.
A possible sequence for the three stages of a financial crisis might be ________ leads to ________ leads to ________.
- A) asset price declines; banking crises; unanticipated decline in price level
- B) unanticipated decline in price level; banking crises; increase in interest rates
- C) banking crises; increase in interest rates; unanticipated decline in price level
- D) banking crises; increase in uncertainty; increase in interest rates
The economy recovers quickly from most recessions, but the increase in adverse selection and moral hazard problems in the credit markets caused by ________ led to the severe economic contraction known as The Great Depression.
- A) debt deflation
- B) illiquidity
- C) an improvement in banks' balance sheets
- D) increases in bond prices
The ________, the difference between the interest rate on Baa corporate bonds and U.S. Treasury bonds. rose sharply during the Great Depression.
- A) credit boom
- B) credit spread
- C) adjustable-rate
- D) default swap
Typically, the economy recovers fairly quickly from a recession. Why did this NOT happen in the United States during the Great Depression?
Answer: The 25% decline in the price level from 1930-1933 triggered a debt deflation. The loss of net worth increased adverse selection and moral hazard problems in the credit markets and increased and prolonged the economic contraction.
________ is a process of bundling together smaller loans (like mortgages) into standard debt securities.
- A) Securitization
- B) Origination
- C) Debt deflation
- D) Distribution
A ________ pays out cash flows from a collection of assets in different tranches, with the highest-rated tranch paying out first, while lower ones paid out less if there are losses on the underlying assets.
- A) collateralized debt obligation (CDO)
- B) adjustable-rate mortgage
- C) negotiable CD
- D) discount bond
The originate-to-distribute business model has a serious ________ problem since the mortgage broker has little incentive to make sure that the mortgagee is a good credit risk.
- A) principal-agent
- B) debt deflation
- C) democratization of credit
- D) collateralized debt
If mortgage brokers do not make a strong effort to evaluate whether the borrower can pay off a loan, this creates a
- A) severe adverse selection problem.
- B) decline in mortgage applications.
- C) call to deregulate the industry.
- D) decrease in the demand for houses.
Agency problems in the subprime mortgage market included all of the following EXCEPT
- A) homeowners could refinance their houses with larger loans when their homes appreciated in value.
- B) mortgage originators had little incentives to make sure that the mortgagee is a good credit risk.
- C) underwriters of mortgage-backed securities had weak incentives to make sure that the holders of the securities would be paid back.
- D) the evaluators of securities, the credit rating agencies, were subject to conflicts of interest.
The growth of the subprime mortgage market led to
- A) increased demand for houses and helped fuel the boom in housing prices.
- B) a decline in the housing industry because of higher default risk.
- C) a decrease in home ownership as investors chose other assets over housing.
- D) decreased demand for houses as the less credit-worthy borrowers could not obtain residential mortgages.
When housing prices began to decline after their peak in 2006, many subprime borrowers found that their mortgages were "underwater." This meant that
- A) the value of the house fell below the amount of the mortgage.
- B) the basement flooded since they could not afford to fix the leaky plumbing.
- C) the roof leaked during a rainstorm.
- D) the amount that they owed on their mortgage was less than the value of their house.
If a borrower takes out a $200 million loan in a repo agreement and is asked to post $220 million of mortgage-backed securities as collateral, the "haircut" is
- A) 5%.
- B) 10%.
- C) 20%.
- D) 50%.
As "haircuts" increased during 2007-2009, financial institutions found that to borrow the same loan amount now required ________ collateral.
- A) less
- B) no
- C) more
- D) default-free
Although the subprime mortgage market problem began in the United States, the first indication of the seriousness of the crisis began in
- A) Europe.
- B) Australia.
- C) China.
- D) South America.
Which investment bank filed for bankruptcy on September 15, 2008 making it the largest bankruptcy filing in U.S. history?
- A) Lehman Brothers
- B) Merrill Lynch
- C) Bear Stearns
- D) Goldman Sachs
The global financial crisis of 2007-2009 not only led to a worldwide recession, but also a ________ in the European nations that use the euro currency.
- A) currency devaluation
- B) budget surplus
- C) sovereign debt crisis
- D) tax cut
The government passed the Economic Recovery Act in October 2008 to prevent the financial crisis from continuing to worsen. A controversial component of this act was the
- A) temporary decrease in the federal deposit insurance limit.
- B) sale of new subprime mortgage assets.
- C) borrowing of $150 million from AIG.
- D) Troubled Asset Relief Program (TARP).
Microprudential supervision focuses on the safety and soundness of
- A) individual financial institutions.
- B) the financial system as a whole.
- C) the shadow banking system.
- D) government credit agencies.
Microprudential supervision does all of the following EXCEPT
- A) checking capital ratios of a bank.
- B) checking a bank's compliance with disclosure requirements.
- C) assessing the riskiness of an individual bank's activities.
- D) focusing on financial system liquidity.
Macroprudential supervision policies try to prevent a leverage cycle by changing capital requirements so that they ________ during an expansion and ________ during a downturn.
- A) increase; decrease
- B) increase; increase
- C) decrease; increase
- D) decrease; decrease
In order to ensure that borrowers have an ability to repay residential mortgages, the new consumer protection legislation requires lenders to do all of the following EXCEPT
- A) verify the income of the borrower.
- B) verify the borrower's job status.
- C) check the credit history of the borrower.
- D) verify that the borrower can read and understand a loan contract.
The new Consumer Financial Protection Bureau is an independent agency but is funded and housed within
- A) the Treasury Department.
- B) the Federal Reserve.
- C) the SEC.
- D) the IRS.
The Dodd-Frank legislation of 2010 permanently increased the federal deposit insurance to
- A) $40,000.
- B) $100,000.
- C) $200,000.
- D) $250,000.
Firms that are designated as systemically important financial institutions (SIFIs) are subject to all of the following additional Federal Reserve regulations EXCEPT
- A) higher capital standards.
- B) stricter liquidity requirements.
- C) providing a plan for orderly liquidation if necessary.
- D) interest rate ceilings on time deposits.
The Volcker Rule addresses the off-balance-sheet problem involving
- A) trading risks.
- B) selling loans.
- C) loan guarantees.
- D) interest rate risks.
The Dodd-Frank bill created an agency to monitor markets for asset price bubbles and the buildup of systemic risk. This agency is called the
- A) Resolution Trust Authority.
- B) Board of Governors.
- C) Financial Stability Oversight Council.
- D) Macroprudential Supervisory Agency.
One suggested method of dealing with the too-big-to-fail problem is to reimpose the restrictions that were in place under
- A) Glass-Steagall.
- B) McFadden.
- C) the Edge Act.
- D) the Federal Reserve Act.
One suggested method of reducing excessive risk-taking by SIFIs is to require them to hold ________ capital when credit is expanding rapidly and ________ capital when credit is contracting.
- A) less; more
- B) more; no
- C) more; less
- D) less; no
Dodd-Frank addressed many of the issues that led to the financial crisis. Which of the following was NOT addressed by Dodd-Frank regulations?
- A) stricter consumer protection laws
- B) privately owned, government-sponsored enterprises (GSEs) such as Fannie mae and Freddie Mac
- C) resolution authority over the large financial institutions
- D) higher requirements on firms dealing in derivatives
The global financial crisis showed the need for increased financial regulation, however, too much or poorly designed regulation could
- A) choke off financial innovation.
- B) increase the efficiency of the financial system.
- C) increase economic growth.
- D) increase international financial integration.