1. Financial assets Asset is anything of value owned by a person or a firm. Fin asset is claim on someone. Include securities trade in a fin market (places or channels for trading). 2. Financial institutions Banks & other financial intermediaries (borrow from savers & lend to borrowers) Fin markets facilitate Indirect Finance ($ flows from lenders to borrowers via fin intermediaries) & Direct Finance ($ flow directly from savers to borrowers). Physical places (NYSE on Wall Street in New York) or OTC through electronic networks (today, most trading takes place on NASDAQ). Primary markets where securities are sold for the first time and secondary markets where investors trade among themselves. 3. The Federal Reserve and other financial regulators Key Components of the Financial System (transfer of funds)

Five Key Categories of Financial Assets 1.Money: anything that is generally accepted in payment for goods, services & debts. 2.Stocks (equity): represent partial ownership of a firm, pay dividends. 3.Bonds: promises to repay a fixed amount of money, pay interest or coupon as COC. 4.Foreign exchange: units of foreign currency needed to by foreign goods & services, 5.Securitized loans: conversion of non tradable financial assets into tradable securities.

Fin Intermediaries The most important are commercial banks (take in deposits to make loans). Firms use them for short- & long-term credits. Households borrow for “big ticket items”. Nonbank Fin Intermediaries Savings and loans, savings banks & credit unions also take deposits and make loans, but they are legally distinct from banks. Investment banks underwrite stocks & bonds for firms. Insurance companies collect & invest premiums to pay claims and other costs. Pension funds collect contributions from workers & firms to pay benefits in retirement. Mutual funds sell shares to investors & invests in a fin portfolio. Hedge funds are like mutual funds with very few wealthy risk seeking investors. Financial Institutions

Figure 1.1 Moving Funds Through the Financial System The financial system transfers funds from savers to borrowers. Borrowers transfer returns back to savers through the financial system. Savers and borrowers include domestic and foreign households, businesses, and governments.

Making the Connection What Do People Do With Their Savings?

The Federal Reserve and Other Financial Regulators Securities and Exchange Commission (SEC) – regulates financial markets The Federal Deposit Insurance Corporation (FDIC) – insures deposits in banks Office of the Comptroller of the Currency – regulates federally chartered banks The Federal Reserve System (FED) – US’ central bank (Established by Congress in 1913 to deal with banking and originally be lender of last resort.) Responsible for monetary policy, actions to manage the money supply & interest rates to pursue macroeconomic policy objectives. The Fed is divided into 12 districts. The main policymaking body is Federal Open Market Committee (FOMC). Meets 8 times per year to make decisions on the federal funds rate (banks charge each other on short-term loans).

Figure 1.2 The Federal Reserve System The Federal Reserve System is divided into 12 districts, each of which has a District Bank located in the city shown on the map.

What Does the Financial System Do? Risk Sharing Risk is the chance that the value of assets will fall below what you expect. Two ways to reduce a saver’s risk are diversification (splitting wealth among many different assets) & risk sharing (spread and transfer risk by holding different assets along with other savers) Liquidity The ease with which asset can be exchanged for money without lost in value. Financial markets and intermediaries help make financial assets more liquid. Information About borrowers and expectations of returns on financial assets. Financial markets convey information to both savers and borrowers by determining the prices of stocks, bonds, and other securities.

Solved Problem 1.1 The Services Securitized Loans Provide Securitized loans have been bundled with other loans and resold to investors; they are both financial assets and financial securities. Securitized loans provide: Risk Sharing buyers jointly share the default risk for securitized mortgage Liquidity since securitized loan can be resold in a secondary market Information investors rely on banks to gathered necessary info when loans are securitized

Financial Crises (significant disruption of $ flow from lenders to borrowers) of caused in part by the housing bubble (unsustainable price increase an asset class) of Overly optimistic expectations made it easier for families to borrow $ to buy houses. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) also helped homeowners borrow by selling bonds to investors and used the funds to purchase mortgages from banks. Investment banks also participated by bundling & selling mortgage-backed securities. Standards for obtaining loans were greatly loosened, so that many mortgages were being issued to subprime borrowers with flawed credit histories. Adjustable-rate mortgages allowed borrowers to pay a very low interest rate. In 2006, housing prices began to decline, leading to rising defaults and a sharp decline in the value of many mortgage-backed securities. The Origins of the Financial Crisis of

Figure 1.3 The Housing Bubble Panel (a) shows that the housing bubble resulted in rapid increases in sales of new houses between 2000 and 2005, followed by sharp decreases from early 2006 through early Panel (b) shows that home prices followed a similar pattern to home sales. Origins of the Financial Crisis

The Deepening Crisis and the Response of the Fed and Treasury In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury provided funds to commercial banks in exchange for stock in those banks. Many policies of the Fed and Treasury during the recession of 2007–2009 were controversial because they involved: Partial government ownership of financial firms Implicit guarantees to large financial firms that they would not be allowed to go bankrupt Unprecedented intervention in financial markets Many feared that the Fed’s actions might reduce its independence. Very weak recovery (the unemployment rate remained at 8% in late 2012).