1. 1 Tutorial Chapter 12 The Financial Crises 2007-2008

2. 2 1. A derivative is a. the type of stock that pays dividends. b. a bond that has value derived from the profits of a government or a corporation. c. a financial instrument whose value is derived from tax revenues. d. a financial product whose value is derived from the price of something else. D. The word derivative comes from the word derived, the value is derived from some other event. For example, you and I make a bet on the weather next Monday, if I am correct you owe me $100, if you are correct I owe you $100. So this contract has value because of an event that will take place next Monday.

3. 3 2. A derivative is simply an agreement between two parties betting on some outcome that will occur in the future, the agreement is binding and cannot be transferred to a third party. False Derivative contracts can be bought and sold multiple times before the strike date, the date the agreement becomes binding.

4. 4 3. Because no one can accurately predict the future and with so many uncertainties, the buyers and sellers of derivatives would often rely on some complicated mathematical model to determine future value. True Because the value of derivative contracts depend on some future event, and because no one can for certain predict the future, participants in this market often relied on some formula derived by mathematical wizards called Quants, like the Black Scholes Formula, to base their predictions on.

5. 5 4. In 1996, Bankers Trust settled with Proctor and Gamble, forgiving most of the $200 billion lost in the derivatives market. True In 1994 the Federal Reserve raised interest rates, an invent that caused Proctor and Gamble to lose on a derivative bet. Proctor and Gambles losses mounted as the Fed raised interest rates several more times. To avoid a legal lawsuit and bad publicity, Bankers Trust decided to take the loss instead of Proctor and Gamble.

6. 6 5. An over-the-counter derivatives market is a market where a. only the two parties are privy to the facts of the contract. b. the participants have to divulge extensive financial data to that the investors know what they are investing their money. c. both stocks and bonds are bought and sold. d. only the very wealthy can participate. A. An over the counter market is a market void of an exchange whereby participants divulge financial information so that investors can make informed decisions. With an over-the- counter market there is no way of knowing the facts except what the seller wishes to divulge.

7. 7 6. Congress passed the Commodity Futures Modernization Act of 2000, which stripped the Commodity Futures Trading Commission of all responsibility over the derivatives market and forbade the SEC from interfering with over-the- counter derivatives. True The Commodity Futures Modernization Act of 2000 closed the door to any government oversight of the derivatives market.

8. 8 7. A subprime mortgage is a mortgage made to persons with poor credit histories. True A prime loan is a loan made to credit worthy individuals. Subprime loans are more risky due to the poor credit histories of the people the loans are given to.

9. 9 8. Fannie Mae and Freddie Mac are two government agencies who make mortgage loans. False Fan and Fred do not make loans, they purchase mortgage loans from banks. The purpose is to increase the flow of funds in the mortgage market. Instead of a bank receiving monthly payments over a long time period, they could get their money right away and thus have more cash to relend.

10. 10 9. Prior to 1992, the government required Fannie Mae and Freddie Mac to buy only prime mortgages. After 1992, Congress required Fan and Fred to purchase subprime loans as well. True Congress was eager to make almost everyone in American a home owner. Thus they pressured Fan and Fred to make more subprime loans to qualify more people for mortgage loans. In turn, banks came up with ingenious, and sometimes fraudulent, ways to convince people to borrow money.

11. 11 10. The practice of hedging one’s exposure to risk goes back hundreds, if not thousands of years, whereby farmers would hedge against possible future losses. True The practice of hedging is a sound business practice and has a lot more to do with stability than it does with gambling. Farmers will enter into a futures contract with someone by agreeing to sell their produce at a certain price (called the strike price) in the future regardless of what happens in the market. In this fashion the farmer is protected from the vagaries of the market. At times the strike price is lower than the market price and at other times it can be higher than the market price.

12. 12 11. A hedge is a position established in one market in an attempt to offset exposure in price fluctuations in another market. True Just as farmers use hedging to stabilize events, hedge funds (investment companies) will play off one possible scenario against another to protect themselves from any sudden market changes. Just like with the farmer, the main objective is stability. A key element in successful investing to avoid losses. Goldman Sachs Group, Inc. makes investments in things where profit is a certainty.

13. 13 12. When Brooksley Born was investigating the derivatives market as head of the Commodities Futures Trading Commission a. there were some spectacular failures by entities that were speculating with little restraint. b. almost no one in government were familiar with derivatives. c. all the biggest banks were dealers in the derivatives market. d. all of the above. D. Despite the enormity of the derivatives problem all the big players in government and banks vilified her for her attempt to rein in the excess of this market.

14. 14 13. Basically Allen Greenspan, the Chairman of the Federal Reserve before the financial crises of 2007 – 2008, believed that a. greed is so strong in human nature that it is necessary to regulate markets. b. the market can solve all problems. c. a centrally controlled economy would be the most efficient economic system. d. big business is at the root of most of our economic problems. B. He believed in totally free markets void of any government restrictions or regulation.

15. 15 14. Let’s suppose you are a farmer and you want to protect yourself from the uncertainties of the market. To add an element of certainty to your business you enter into a ______ _______ with a bank. a. futures contract b. balloon payment c. vertical contract A. A futures contract is a way to hedge your bets on some future event. In this case the farmer would agree to sell his crop for a set price on some date in the future. If the market price is greater than the agreed upon price the farmer makes less money than without the contract, and vice versa.

16. 16 15. By 2007 Long Term Capital, a hedge fund, had highly leveraged its bets. This means that Long Term Capital a. never took risks. b. had deep pockets. c. made risky bets with borrowed money. d. was very careful with its money. C. To be highly leveraged means that you put at risk a huge amount of money but only have a small amount of money on hand to back up any bad bets.

17. 17 16. What is a hedge fund? a. An investment fund opened to a limited range of investors, professionals and wealthy people. b. A retirement fund like a teachers union. c. A federal bond that protects people from inflation. d. A financial instrument that offers high returns in the bond market. A. A hedge fund attempts to establish a position on one market to offset price fluctuations in another market.

18. 18 17. What was the purpose of the Commodity Futures Trading Act of 2000? a. To give the Commodity Futures Trading Commission a free hand to regulate the derivatives market. b. Stripped the CFTC of all responsibility over the derivatives market. c. Banned states from interfering with the derivatives market. d. Both b and c are answers. D. The CFTA gave banks total freedom in the derivatives market, which is today a $600 trillion market.

19. 19 18. Many events transpired between 2000 and 2010 which greatly aggravated the financial melt down. Which of the following events transpired? a. The government took no action to regulate the market. b. Wall Street firms were showering Washington with $1.7 billion in campaign contributions and $3.4 billion on lobbyists. c. The practice of rent seeking was excessive. d. all of the above. D. Self explanatory

20. 20 19. What was the purpose of the Glass- Steagall Act of 1932? a. This act gave banks more opportunities to invest in the derivatives market. b. This act merged investment banks with commercial banks. c. This act separated commercial banks from investment banks. C. One of the causes of the Great Depression of the 1930s was that banks were taking depositors money and putting the money in highly leveraged and risky investments. This act prevented this practice by commercial banks but allowed investment banks a free hand.

21. 21 20. What was the Financial Services Modernization Act of 1999? This act a. gave more teeth to the Glass-Steagall Act of 1932. b. made it so that banks could participate in the derivatives market the same as investment banks. c. Allowed commercial banks to take depositors money and put it at great risk, similar to the way they did leading up to the Great Depression of the 1930s. C. Both b and c are answers. The FSMA obliterated the safety measures of the Glass-Steagall Act of 1932.

22. 22 21. In its simplest form the credit default swap (CDS) is a bet on a future outcome. The party that bets correctly makes a profit and the party the bets incorrectly suffers a loss. True A credit default swap is what is says, it swaps the risk of default from one party to another. It is like insurance. The purchaser of the CDS pays the seller money in the event of a default on stipulated investments. If no default occurs, the seller keeps the money. If a default does occur, the seller makes good on the money that was owed to the purchaser of the CDS.

23. 23 22. With a debt to capital ratio of 40 to 1 in 2007, when the economy went south, this excessive leverage led to the collapse of all five investment banks. True A debt to capital ratio of 40 to 1 means that an investment bank could lend out $40 with only $1 in reserve against the $40. This excessive leverage enabled these firms to make excessive profits when times were good, but when the economy slumped, losses were magnified.

24. 24 23. We experienced a big mortgage problem starting in 2007 partly because of the abundance of adjustable rate mortgages and the proliferation of Alt-A, sometimes called Liar Loans. True When mortgage lending companies made it easy to obtain a mortgage with very generous terms in the early years of the loan, many people flocked to take out mortgages. But the terms worked against them soon after as the interest rate increased. When banks added the feature of letting people borrow money with no due diligence by the banks, millions of people were trapped in loans they could not afford.

25. 25 24. A collateralized debt obligation (CDO) is a type of structured asset backed by security whose value and payments are derived from a portfolio of fixed income assets. True A CDO is a collection of debts, like mortgages, whereby payments are made from this income stream to purchasers of the CDO. It is like the CDO is a pizza and the pizza is divided into pieces. Instead of purchasing the whole pizza, people can purchase just a slice of the pizza.

26. 26 25. A collateralized debt obligation (CDO) is a financial instrument that pools loans together and divides them into different risk classes, called tranches, whereby the senior tranches were considered the safest and the junior tranches were considered the most risky. True The senior tranches paid out less than the junior tranches because there was less risk to the buyer. The junior tranches paid out a higher return to compensate the purchaser for the higher risk of loss. However, when the CDO experienced losses due to people not making their payments, like on a mortgage, the investors who bought from the junior tranches were the first who experienced losses.

27. 27 26. It was Executive Order 11,110 of President Kennedy in the 1969’s that repealed the Glass- Steagall Act. False The Gramm-Leach Bliley Act of 1999 repealed the Glass- Steagall Act, thus eliminating the divide between commercial banks and investment banks. Executive Order 11,110 of 1963 gave the U.S. Treasury the explicit order to “issue silver certificates against any silver bullion in the Treasury,” thus replacing real money with the fiat currency of a federal reserve note.

28. 28 27. It was Executive Order 11,110 of President Kennedy in the 1969’s that repealed the Glass- Steagall Act. False The Gramm-Leach Bliley Act of 1999 repealed the Glass- Steagall Act, thus eliminating the divide between commercial banks and investment banks. Executive Order 11,110 of 1963 gave the U.S. Treasury the explicit order to “issue silver certificates against any silver bullion in the Treasury,” thus replacing real money with the fiat currency of a federal reserve note.

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