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Economic History I: Introduction

Why the Past and the Present Are Inextricably Linked

“Those who cannot learn from history are doomed to repeat it.” – George Santayana

Click here to be taken to Part II if you’ve already read the intro.

Over the last few years, the most pressing issue on the minds of Americans, and many without the country’s borders, is the uncertainty revolving around the state of the economy.



Source: Bureau of Labor Statistics, U.S. Department of Labor

With January’s unemployment rate at 9%, both graduate and undergraduate students are being pressured, both internally and externally, to look to more practical and secure academic pursuits. As a second-year at the University of California at Davis, a mere 15 miles from Sacramento, the state’s capital, I have witnessed this phenomenon firsthand many times over. As an Economics major, I must confess that I too have—and continue to—experience this pressure. With each lecture, I find myself questioning whether the subject matter of the day, week, month, or quarter will provide me with the tools to become a success in my field.

To fulfill the requirement of achieving an A.B. in Economics at UC Davis, all undergraduates must take at least one Economic History course, though additional courses may count towards other major requirements. As can be expected, especially in times of recession, the first question most of my peers ask is: “How is this class relevant? What am I going to learn in here that’s going to help me succeed?”

I would never myself, for example, challenge the practicality of Econometrics which factors in mathematical formulae, statistics, and economic concepts to create mathematical models in an attempt to determine the statistical significance of findings to describe economic systems. Thus it seems only natural for majors within the Economics department to lean towards these branches of study as opposed to Economic History.

Economic History encourages its disciples to find patterns in the sequence of past events which will prove useful in making day-to-day decisions, determining policy, and anticipating the future. Individuals should leverage all of the resources they have at hand in order to make informed decisions. Why would you overlook the events of the past in making such determinations?

What can we learn from the collapse of the Soviet Union? Were there events that foreshadowed its failure? Can we use our findings to help us determine the success or failure of other countries?

How did the Federal Reserve first come to be? How has it adapted to different crises and is it effective enough at its regulation and oversight duties to justify its existence?

Mission Statement: The goal of this series is to explore and link events of the past with modern day issues in order to gain insight into the topics/phenomena at hand as well as those we might expect in the future.

This series has benefited from the supervision of Dr. Janine Wilson at UC Davis.

Additional sources:

  1. http://freepages.history.rootsweb.ancestry.com/~cescott/economics.html
  2. http://www.federalreserve.gov/pubs/frseries/frseri.htm

 

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Posted by on April 2, 2011 in Economic History

 

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Mutual Funds 101: Demystifying Investment

Definition: Mutual funds are an investment strategy which pools money from many, many different investors to construct a portfolio of stocks, bonds, real estate, and/or other securities, depending on its charter. Each investor in the fund gets a slice of the total pie.

What are the perks to investing in mutual funds? Diversification, one of the basic rules of investing in general is varying your portfolio. Diversification is a technique that mixes a wide variety of investments within a portfolio. This is meant to yield higher returns for lower risks because while you might take hits in some parts of your portfolio, the positives—if chosen correctly—will offset those.

“Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.” – Investopedia

Another pro to the mutual funds game are the relatively low minimum investment amounts. Some you can join with just a few hundred dollars, spreading the risk across to more people, allowing investors to make some riskier decisions with higher potential returns.

So, there’s active management and passive management.

Active Management:

Is the actual practice of picking your stocks and market timing to pick securities which will beat out the market. This is the most common type of management. The high volume of trading results in higher expenses.

Passive Management:

These funds do not attempt to meet the market, but to match the risk with the return of the stock market. These usually track a market index such as the S&P 500. Those that follow this index, for example, tend to hold the stocks within the S&P 500.

Advantages:

1. The percentage of fees paid to the company to manage and operate the fund is less in passive funds than in active funds.
2. Lower mutual fund capital gains distributions.

A good analogy I found regarding the difference between active and passive investment management is the distinction between the actions of one individual vs. the actions of the group as a whole. “Active investment is like trying to bet on who will win the Super Bowl, while passive investing would be the ability to profit as all the NFL teams collectively made money on ticket and merchandise sales.”

Now, let’s move on. There are two different types of funds I’d like to talk about today: stock (equity) funds and bond funds.

Equity Funds:

Mutual fund that invests primarily in stocks; equity funds typically have their own distinct styles. Some focus on the different sizes of companies such as the size of businesses (small-cap versus large-cap) and their geography while others might buy shares within particular sectors such as health care or entertainment. These are sometimes referred to as “specialty stocks.”

Bond Funds:

Bond funds come in many different colors as well. There are safe investments with lower yields such as government bond funds, high-risk (and hopefully high-yield) bond funds. These can get extremely complicated, but if this is something you’re interested in, click here to be taken to a page which does an adequate job of explaining what type of things to look for to determine whether or not these bonds will be safe investments.

But don’t forget to pay your taxes. Regardless of whether or not you sell your fund shares, if you’re raking in money, you could be hit by a pretty hefty tax for both your dividends and capital gains. That sounds pretty painful doesn’t it? What if I told you that you’re stuck paying taxes even when your funds have declined in value? Well, the truth of it is that you’re going to end up paying taxes regardless of how your fund performs, but since there’s not much to be done about that, my only advice here is to be aware of this undeniable truth. According to CNN Money, the most tax-efficient funds avoid rapid trading.

CNN Money also advises investors to not chase winners and to look for consistency in the long-term rather than those particular funds which might be ranked highly at this one point in time. Investors are also told to not be too quick to dump underperforming funds as any fund can have an off year. Just make calculated decisions, watch for a pattern, and come up with a few forecasts.

A VERY SUCCINT DISCUSSION OF A FEW DIFFERENT TYPES OF STOCK FUNDS:

1. Value funds: look for cheap stocks. Either big companies/corporations which have been suffering in recent days and are selling shares at lower, discounted prices, or smaller companies which have been beaten out by competition or other investors but could have brighter days ahead.
2. Growth funds: varies depending on how aggressive the investor might be. Tend to favor established names, but look for rapidly growing companies as well. Good for long-term investors who should build around such funds in their portfolios.
3. Sector funds: as I mentioned before, these investors focus on particular sectors such as health care, entertainment, technology, etc. Just be aware that entire sectors are also liable to head south.

A VERY SUCCINT DISCUSSION OF A FEW DIFFERENT TYPES OF BOND FUNDS:

1. U.S. government bond funds: bonds issued by the U.S. Treasury or federal government agencies. Seen as extremely safe, so you shouldn’t expect extremely high returns with these. The longer you hold on to the bonds, the higher your yield. So if you’re comfortable with sitting on them—they fluctuate with the interest rate—then you probably might as well be in it for the long run.
2. Corporate bond funds: bonds issued by corporations. Each corporation has a credit quality issued to them, the highest being AAA. The longer the average maturity, the greater the volatility.
3. High-yield bond funds: focus on smaller and/or riskier companies. Expect a few defaults here and there. Shouldn’t be a huge proportion of your portfolio unless you’re comfortable taking risks for the chance of seeing higher returns.
4. Municipal bond funds: issued by cities, states, and other government localities. Are tax-exempt. Don’t have much more to say about these myself, so just click through the link if you’re interested in safe, low-yield prospects.

Now that we’ve hopefully demystified mutual funds (or at least opened a few doors for you) you might be wondering why exactly some active funds underperform. The costs of research, administration, management salaries, and other expenses are borne by the shareholders.

If you’re new to the game and want to try to get your own slice of the market, explore U.S. Securities and Exchange Commissions’ page to get started. Look for more posts on the subject of investing in the days and weeks to come!

Sources:CNN Money, Investopedia & About.com

 
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Posted by on March 23, 2011 in Business/Technology

 

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Small Business 101: Part II, Writing an Effective Business Plan

In Part I of the series, we reviewed some of the most common business structures to get our brains geared in the right direction. Now, if you’ll remember, I will be approaching this as if I were planning to start a business as consultants in the entertainment and technology industry. Chances are that unless you have a specific and well-developed idea, product, or service in mind, that you’re basically taking a shot in the dark.

What is a business plan?

Every business should have a business plan, even if it has operated thus far without one. It’s not so much about the document as it is about the thought process and critical thinking that goes on during the writing phase. A business plan is meant to help you focus your ideas, goals, think more effectively about your capital, and prepare for future obstacles as well as anticipate opportunities. You need to determine your priorities, distinguish your constraints, and optimize the tools at hand.

But I still haven’t provided a definition.

See your business plan as a dynamic framework for the business. Your business plan will include a company description, background on key members of your management and execution teams, cover your business strategy and implementation, market analysis, a financial plan, and an executive summary.

Here’s how I the plan for my company would look (the following has benefited from Entrepreneur’s wisdom):

EXECUTIVE SUMMARY

Introduction

Entertainment Solutions Consulting (ESC) is a young consulting firm dedicated to serving the needs of a rapidly growing industry in the full range of the business cycle. With a knowledgeable staff of a wide variety of strengths collectively working together to assist clients, ESC will be able to offer a more balanced quality service than many of its competitors.

The Company

Entertainment Solutions Consulting consists of eight business consultants, with each specializing in a particular discipline, including business development, sales, marketing, management, technology, human resources, metrics, etc.

ESC will target the mid-sized to large businesses which dominate the biggest portions of the market though the firm will offer services for start-up companies as well with the intentions of maintaining these relationships over the long term.

ESC will be established as a California based LLC with five principal partners, each of whom owns a 20% share in the company. Mr. Ash Ketchum brings in experience in the arenas of gaming, hunting, and tracking and has held various titles including Pokemon Master and honorary Elite Four member. Mr. Steve Jobs is relatively new to the scene, but has made a modest name for himself through his work at a humble company called Apple Computer, Inc. Mr. John Smith brings with him a lifetime of gaming and video game development, etc.

The Market

The entertainment industry is one of the biggest industries in existence and the term requires some elaboration. Entertainment Solutions Consulting will focus primarily on video games, films, board games and other interactive games, eBooks, and several other consumer-side technologically-relevant products.

Talk about the competition and what differentiates your business from them, and even mention your competitors specifically.

Financial

Each of the five partners will provide $20,000 which will cover the bulk of the start-up expenses. The rest of the financing will come from the Bank of America 10-year loan in the amount of $100,000. Combined, these funds will be sufficient to cover the company’s expenses throughout the first year of operations, which is the most critical from the cash flow standpoint.

MISSION STATEMENT

Entertainment Solutions Consulting aims to offer comprehensive consulting services. ESC will focus on providing personal and specialized services to meet each client’s specific entertainment needs.

KEYS TO SUCCESS

ESC’s keys to success include:

  1. A group of professionals with a broad range of specialty areas that complement each other.
  2. A high level of experience in these specialty areas.
  3. A team approach on most consulting projects.
  4. Many business contacts among the consultant group.

COMPANY SUMMARY

Entertainment Solutions Consulting is startup firm which will focus on providing a wide range of business consulting services to large and established companies as well as those in the earlier stages of operations. ESC is a team of eight business consultants. Each consultant specializes in a particular discipline including business development, sales, marketing, management, technology, human resources, metrics, etc.

COMPANY OWNERSHIP

Entertainment Solutions Consulting was registered as a California LLC, equally owned by…

START-UP SUMMARY

Co-owners Edris, Ash Ketchum, Steve Jobs, … and … will each provide $20,000 investments which will cover the bulk of start-up expenses. The rest of the financing will come from the Bank of America 10-year loan in the amount of $100,000. Combined, these funds will be sufficient to cover the company’s expenses throughout the first year of operations, which is the most critical from the cash flow standpoint.

This is where you insert a bar or some other type of graph broken up by expenses, assets, investments, and loans. Then include an excel balance sheet for your business.

SERVICE DESCRIPTION

Entertainment Solutions Consulting offers a list of services or business owners to choose from, depending on their business needs. Services include business plan preparation, marketing campaigns, product development, design services, IT consulting, e-commerce consulting services, operation advising, etc.

ESC is flexible, working with its clients in the fashion preferred by the client, be it on-site, remotely or a combination of both. ESC typically works on a project in a team fashion to assist the client in all areas of the business simultaneously. This allows for all involved parties to be in sync in terms of understanding the interconnections of all functional areas of the business.

SALES FORECAST – include graphs of your forecasting.

MANAGEMENT TEAM – Go over team’s bios and their individual past accomplishments.

BREAK-EVEN ANALYSIS

ESC’s Break-even Analysis is based on the average of the first-year figures for total sales by salaries, bonuses costs, and all other operating expenses. These are presented as per-unit revenue, per-unit cost, and fixed costs. These conservative assumptions make for a more accurate estimate of real risk. Such analysis shows that ESC will break-even by the x month of operations.

Now, if after reading this, you’re determined to write up your own expanded business plan, click through this link here and follow the directions. You’re at a crossroads now, and I promise you that this initial preparation stage of your efforts could make or break the success of your businesses’ future.

I combined or completely omitted several very important steps all into one in this post. Steps such as finding start up money, naming your business, determining your business structure (though the last post cover this), obtaining your license/permits, determining your business location, obtaining insurance, creating an accounting system, etc.

But like I’ve said before, there’s a method to my madness. Now that you’ve got in your possession either a complete business proposal, a rough outline, or even just an idea of what you’re up against, we can backtrack and go over some of the specific behind these steps.

Some more business plan templates:

Catering and ballroom rental business.

Real estate brokerage

Athletic Shoe Store Franchise

Hair and Beauty Salon

Internet Cafe

Web Design Business

 
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Posted by on February 14, 2011 in Small Business 101

 

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Tunisia: Trouble in Paradise?

“Flash back a little more than one month ago to December 17th of 2010—Mohamed Bouazizi, a 26-year-old Tunisian citizen and recent college graduate with a computer science degree, had started a fruit and vegetable stand to make ends meet. There was already a sense of unrest n the air as Tunisia was supposedly undergoing some of the worst unemployment rates in recent history as well as a spike in food prices across the country…”

Click here to continue reading the rest of this post. I posted it to a blog called Constantly Connected which is maintained by my technology research group through my university’s honors program.

Thanks!

 
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Posted by on January 28, 2011 in Recreational

 

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7 Ways to Overcome Writer’s Block

I know there are thousands of similar postings across the web, but I can personally attest that the following 7 methods have actually (and continue to) work for me. It doesn’t matter whether I’m working on fiction, press releases, school work, research, or even blogging, these suggestions are flexible and will deliver results:

*Will fix formatting errors ASAP.



Thanks for making it this far. Like I mentioned before, these are methods which worked for me, so while I can’t guarantee that they’ll have the same effect for you, I do guarantee that at least one of these will make you more effective in your work. I was inspired to write a post in this format largely due to a similar post I read from another blog I’m subscribed to. If you liked my list, definitely check this out too because it’s great.

Feel free to post any suggestions you might have for the rest of us! Good luck with your writing!

 
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Posted by on January 16, 2011 in Business/Technology

 

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Small Business 101: Introduction

Today begins part 1 of a series of posts dedicated towards helping you start your own business: Small Business 101. Just the thought of starting your own business can be overwhelming. Well I’m glad you’re reading this because I can tell you right now that it doesn’t have to be like that. I will break up the steps for your reading convenience; go at your own pace.

I predict that this will span beyond 8 posts, with each entry covering a new step or topic. While I recommend you go through them in the sequence I have myself ordered, feel free to browse through the titles and content and decide where you might need some help and throw out whatever doesn’t apply to you.

As an example, I will approach the series as though I am considering starting a consulting firm in entertainment and technology.

And I almost forgot to mention: even if you have no intention of starting your own business any time soon, I highly recommend you keep up with the series. Who knows, you might change your mind—and a little bit of learning never hurt anyone (disclaimer!).

I’ll be updating the below list with every new post, just click on the link to be taken to that page:

Table of Contents

  1. Part I, Business Structures
  2. Part II, Writing an Effective Business Plan
 
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Posted by on January 12, 2011 in Small Business 101

 

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The Financial Crisis of 2007-8

The following is a very crude and general overview of the Financial Crisis of 2007-8, which spurred on the recession the United States, and the rest of the world, is grappling with today. The idea behind this “report” is to break it down into terms such that anyone could understand it. Perhaps later I’ll go into the actual economics of it.

In order to grasp a firm understanding of the phenomenon that has been termed as the “Financial Crisis of 2007-08,” by some, one must look into the events precluding the recession which had begun in January of 2008 (Modjtahedi, p.3). Many of our current problems can be tied back to the splicing and dicing of risk which then extended to consumer lending in the form of asset-backed securities (Cecchetti, p.2). It is generally agreed upon that this trend began in 2000 with the rapid rise in home prices. In fact, these increases were higher than justified by fundamental values or replacement costs (Cecchetti, p.2). This post will discuss the economics of mortgage loans, the different banking models in the time of the crisis, the slicing and dicing of credit and asset securitization, the effects of the crisis itself, and finally, the macroeconomics of the crisis along with the policy options of the United States—and other international—governments.

To begin, mortgage loans are loans that people take out from financial institutions—lenders, such as banks—towards the purchase of a house. If the borrower defaults on the loan, any of the following may occur:

  1. The loan may become immediately due and payable.
  2. The loan may be turned over to a collection agency
  3. The borrower’s credit rating can be negatively affected.

It is important to note that if the borrower does not respond appropriately, the house may become forfeit and the property of the lender to do with as they please, the term for this being “foreclosure.”

As a result of the aforementioned housing boom, real estate rose and mortgage borrowing increased exponentially. At this time, the government had low restrictions on banks with regards to lending. It is important to note that mortgage brokers earn commission, so they have greater incentive to close a larger volume of deals. Lack of sufficient oversight and the financial prosperity of the time resulted in irresponsible loans. The banks would receive bonds from these loans after determining a term, generally 30 or 40 years, over which time the loan would be amortized (Modjtahedi, p.7).

In the wake of the Dotcom bust and the terrorist acts of September 11th, the Federal Reserve lowered interest rates down to a mere 1% to encourage investment spending and account for potential increases in aggregate demand. This encouraged borrowing money, as there arose an abundance in credit (Jarvis). Banks then used this credit to borrow money and amplify the outcomes of their deals, or “leverage” (Jarvis). With leverage, higher volumes of transactions were made possible. The process by which this occurred and the role these transactions had on the crisis is outlined in the following steps (Jarvis):

  1. A family saves money for a down payment.
  2. Mortgage broker connects family to a lender who gives them a mortgage, broker makes a commission.
  3. Family becomes homeowners. Have positive prospects because house values have been on the rise.
  4. Investment bankers buy these mortgages from the mortgage lenders, doing this in vast quantities.
  5. Homeowners’ payments then go to these investment bankers.
  6. Investment bankers then create collateralized debt obligations (CDO).
    1. CDO’s are divided up into three troughs based on level of risk.
  7. These slices were then sold and the investment bankers repaid their loans.
  8. With time, most of the potential homeowners who actually qualified for loans already had one, and so spawned some of the unsafe lending practices mentioned before; irresponsible people—or those unable to pay off their loans—were lent money.
  9. Foreclosures occurred, loans were not repaid, debts were not cleared, and the financial system collapsed.

Initially, before people caught on to the realities of the situation, it seemed that no one had actually carefully considered the following flaw in this system: where would the money come from? No one was worried because as soon as one party sold off the mortgage to another, it was no longer their concern. The monthly payments which were meant to go to the investment bankers disappeared, with houses serving as the collateral. These houses were then put on the market to be sold. As this process continued, the housing supply substantially increased and demand shrunk. All of this resulted in the plummeting of housing prices. Once housing prices dropped, people stopped paying because their mortgages cost more than their homes were worth, more people walked away from their houses, prices continued to plummet, and the trend continued.

Keeping this process in mind, let us return to the different kinds of mortgages. There are fixed rate mortgages where the rate taken out stays constant despite market fluctuation. The borrower will repay the debt in equal monthly payments over a period of time, and during the first years of the loan, the money paid goes toward paying off the interest on the loan. The advantages to such a mortgage are the security and consistent payments that accompany it. If overall rates decrease, however, you will still be paying the same amount. Adjustable rate mortgages are such that the interest rate can change based on the market. The rate can increase or decrease depending on the rate agrees d upon. With adjustable rates, some of the risk is transferred to the borrower because the rate could suddenly go up. It is essential that borrowers think critically about the pros and cons to each mortgage type before they take out loans.

Another important concept to consider is the loan-to-value, or LTV, ratio. This is the ratio of the total outstanding loan to the value of the house. There is actually a percentage calculated by dividing the amount borrowed by the price or appraised value of the home to be purchased; the higher the LTV, the less cash a borrower is required to pay as a down payment. Lenders obviously prefer lower LTV ratios and higher equity ratios due to the consideration of moral-hazard (Modjtahedi).

Equity is equal to the market value of house minus the outstanding loan.  It is essentially the amount the home owner actually owns of the house.  For example if your house is worth $100,000, and you owe $70,000, then you have $30,000 in equity.  A borrower can have positive, zero, or negative equity.  Negative equity is when the price of the house falls below the outstanding loan.  Now the borrower would have to pay more on the loan then what the house is worth.

For a person with positive equity, it is not favorable for them to default on their house.  It is in fact advantageous for the borrower to make a profit by keeping the house, paying off the mortgage, and selling it for a higher price then they originally bought it for.

Negative equity, however, is a “necessary but not sufficient” reason to default on loan.  If the borrower decides to default on the mortgage and walk out on the house, the borrower could save money because they owe more than the house is worth in mortgage payments.  The borrower at this time would not want to sell house at negative equity because no profit would be made and they still owe the bank money for the remaining mortgage payments.  Therefore, foreclosures increase when house prices fall because negative equity increases.

There are many reasons not to default and continue paying mortgage as well.  First of all, and perhaps most importantly in the long run, defaulting on a house would result in the borrower gaining bad credit.  Having bad credit would make it harder to borrow money in the future because banks see you as a higher risk.  Secondly, there is no penalty in waiting to see if the market will improve, and if it doesn’t, the owner can always default later.  Thirdly, the homeowner would still require a place to live.  If they default on their house they are going to have to pay additional money to rent an apartment or even try and find cheaper house.  Moving is an expense that should be avoided when possible.  Finally, for many people there houses have a lot of sentimental value you to them.  It might be worth it to some home owner to continue to paying the mortgage in order to keep the house they consider to be their “home.”

Negative equity is not just bad for the homeowner, but for the lender and community as well.  When a person defaults on their house the bank—the lender—will collect the house as collateral.  When they end up with too many foreclosed houses and have to sell the house at reduced price.  This in turn lowers housing prices in the neighborhoods, forcing more home owners in to negative equity and causing even more foreclosures.  When this happens it is referred to as a deflation spiral.

The originate-and-hold banking system is the original banking system.  This system was very simple and straightforward and also included less people.  In this banking system there are the depositors, the bank, and mortgage borrowers.  Depositors are people who put money into banks.  These deposits are usually relatively small, short term deposits.  People put their money into banks in order to save and receive interest on their deposits.  The banks, in return, take the depositor’s money and lend it out to the mortgage borrowers as loans.  The mortgage borrows in return give the bank a bond.  A bond is basically an “I owe you.” It is a contract by which the borrower agrees to pay back the loan, and with it a set interest.  The contract usually also states that if the mortgage is not fully amortized, or paid off, by the given period, the bank will take over their property. The borrower pays back the principal, the amount borrowed, and interest on the principal payment.

Adverse Selection is a problem with this banking system that occurs before transactions.  The banks are at a disadvantage because borrowers could have poor credit and be a high risk but they won’t tell the banks that, therefore the banks are at risk of the borrower defaulting.  In order to help prevent this, banks will to do background checks on the home owners to see if they have poor credit. Another way to help prevent the home owner from defaulting if to have the owner put down a down payment on the house.  This prevents the home owner from being a “moral hazard.”  The home owner has money invested in the house and is less likely to walk out on the house and is more likely to keep it up.

Maturity mismatch is another problem with the originate and hold banking system Because depositors are usually short term deposits while loans, especially mortgage loans can last up to 40 years.  If a lot of depositors decided that they wanted to take money out of the bank, then the bank would not have their money because it is tied up in long term loans that have not yet been paid back.  And reversely, if many people want to get a loan, the bank may not have enough money from deposits to fund the loans.  They are also unable to raise interest on loans because of regulation from the government. This is referred to as an “inelastic source of funds.”

Originate and distribute, the current banking system used today, is much more complex than the originate and hold system.  This second banking system still involves depositors, a bank, and mortgage borrowers the way that the originate and hold model does. However, the system also involves, as the name suggests, originators.  These institutes give home owners a loan and in return receive a mortgage bond from the borrower.  The originator then sells that same bond to a bank and receives a profit on the sale in addition to the origination fees they earn from the borrower. The reason the bank will pay more for the bond is that the bond is likely to increase in value over the years and also the bank will receive interest on the loan.  Now that the bank is in control of the bond, the mortgage borrower will pay back the principal and interest to the bank, not the originator.  In this way the originator has effectively taken themselves out of the loop. Because of this, the originators do not have as much incentive to do background checks and check the borrower’s credit.  This causes a major problem because the banks could be purchasing bonds from originators in which the borrower of that bond is a moral hazard.

One of the big problems that occurred with this type of banking system was that originators encouraged low income, high risk homebuyers to take out mortgages.  Then when these borrowers defaulted it was not a problem to the originator because they did not hold the bond. Instead, the banks lost money because they were the holders of the borrowers bonds.

Recall the decline in the value of homes as the supply of houses increased and demand subsequently fell. One amplification mechanism that operated during this liquidity crises works through asset prices and balance sheets (Krishnamurthy, p.2). Balance sheets are deteriorated when prices are lowered which comes about as a result of negative shocks of asset-holders (Krishnamurthy, p.2). To counter this, the Federal Reserve actively purchased mortgage-backed securities, essentially taking the “bad” loans and mortgages out of others’ hands to help alleviate the strains on the market (Krishnamurthy, p.13). Another strategy they have utilized is their offerings to finance the asset holdings of commercial and investment banks at margin requirements far lower than is offered in private-sector transactions (Krishnamurthy, p.13).

The lack of knowledge and uncertainty during the recent crisis served as a significant amplification mechanism (Krishnamurthy, p.17). As was mentioned before, mortgage brokers, financial intermediaries, and essentially everyone involved in the system practiced unsafe lending practices, classifying certain, and relatively risky credit structures as AAA (Krishnamurthy, p.17). When these tranches suffered losses and people defaulted on their loans, people did not know how to react, for these were supposed to be the safest of investments. All of this created an atmosphere of uncertainty, paralyzing many into inaction, devastating the private sector.

While the roots of the crisis may be firmly planted in United States soil, the repercussions already have impacted the economy on a global scale because of all of the foreign investment. It is important to remember that people and institutions from around the world purchased these mortgages and CMO’s. Paul Volcker, former Chairman of the Federal Reserve and the current chairman of the Economic Recovery Advisory Board said that the crisis that began in the U.S. housing market has become a global problem that requires a global solution (Policy Options, p.5). In response, many countries have provided public capital to financial institutions with guarantees on their liabilities (Shirakawa, p.5). The United States, along with Germany and several other countries, have instigated economic stimulus packages designed to stave off some of the destruction, though these actions are not always enough to counteract the downturns as Germany’s output is still projected to fall by 2.5% in 2009 (Andersen).

The Federal Reserve itself “has responded aggressively to the financial crisis since its emergence in the summer of 2007” (Federal Reserve).  The Reserve has instigated a cut in the discount rate as early as September of 2007, prodding an increase in investment rather than savings, increasing aggregate demand and GDP (Federal Reserve). As the crisis continued and matters intensified, the Committee “responded by cutting the target for the federal funds rate” (Federal Reserve). It has also provided liquidity to the private sector in order to support the functioning of credit markets and reduce financial strains (Federal Reserve). It has become the responsibility of all nations to combat the repercussions of the crisis and promote global economic recovery. International cooperation is essential to achieving sustained recovery.

This video is an absolute must if this topic is of any interest to you:

By Edris and Louise Marquino

Works Cited

Modjtahedi, Bagher. Sept. 2009. “Financial Crisis of 2007-09: Causes, Consequences, and Policy Options.” Dec. 2009.

Cecchetti, Stephen G. April 2008. “Monetary Policy and the Financial Crisis of 2007-2008.” Centre for Economic Policy Research.    Dec. 2009.

<http://www.cepr.org/pubs/policyinsights/PolicyInsight21.pdf&gt;.

Jarvis, Jonathan. The Crisis of Credit Visualized: The Short and Simple Story of the Credit Crisis. Video. March 2009.  <http://vimeo.com/3261363&gt;.

Krishnamurthy, Arvind. “Amplification Mechanisms in Liquidity Crises.” June 2009. National Bureau of Economic Research. Dec. 2009. <http://papers.nber.org/papers/w15040.pdf&gt;.

“Policy Options for Global Financial Crisis.” Jan. 2009. Lee Kuan Yew School of Public Policy. Dec.          2009. <http://www.spp.nus.edu.sg/docs/global_is_asian/LKYNewsletter_Issue1.pdf&gt;.

Shirakawa, Masaaki. “International Policy Response to Financial Crises.” Aug. 2009. Bank of Japan. Dec. 2009.             <http://www.kc.frb.org/publicat/sympos/2009/papers/Shirakawa.08.24.09.pdf&gt;.

Andersen, Camilla. “Germany Faces Extended Downturn Despite Stimulus.” Jan. 2009. International Monetary Fund. Dec. 2009.  <http://www.imf.org/external/pubs/ft/survey/so/2009/car012209a.htm&gt;.

“The Federal Reserve’s response to the crisis.” Nov. 2009. Board of Governors of the Federal Reserve System. Dec. 2009. <http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm

 
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Posted by on January 7, 2011 in Business/Technology

 

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