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ECO 4223 Exam 2 Questions with 100% correct answers | verified | latest update 2024
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ECO 4223 Exam 2Interest spread - ANS-the difference between the interest paid and interest earned.
Interest spread example - ANS-a bank pays a 1.5% savings rate to lenders but charges a 4.5%
rate for a 30 year mortgage to borrowers. What is the interest spread? 3%
How is interest spread determined? - ANS-Market forces, when prices are above or below
equilibrium. (Shortage of funds or surplus of funds). Downward pressure on prices (surplus) and
upward pressure on interest rates. (Shortage)
What happens if there is a surplus in interest spread? - ANS-Downward pressure on prices
What happens if there is a shortage in interest spread? - ANS-Upward pressure on interest
rates
Different types of loans a bank offers - ANS-Commercial and residential mortgages, car loans,
student loans, interbank lending, personal loans
Asymmetric information - ANS-When one agent has more information than the other agent
Two types of asymmetric information? - ANS-Adverse selection and moral hazard
Adverse selection - ANS-Adverse selection occurs when individuals select into a program and
the program mistakenly only attracts the riskiest of agents.
For insurance to work properly... - ANS-underwriters must price in the value of the contract the
probabilities of insureds filing claims. This could lead to an underestimation of claims
frequencies, resulting in large losses to the insurer.
How to counter adverse selection - ANS-Create a plan where the risky individuals are just as
likely to sign up for insurance or lending as the less risky individuals.
How did state farm and other try to counter adverse selection. What is the problem with this? -
ANS-Progressive, State Farm, and Others have tried to solve this adverse selection problem by
distinguishing between types of individuals using their safe driving program discount. The idea
is that the device will record their driving behaviors and the data will tell whether they are safe or
not. The insurance company can then offer a discount if safer or the higher amount if riskier.
Moral Hazard
, Moral Hazard - ANS-Moral hazard occurs when individuals change their behavior based on the
incentives in the contract or relationship. It is an ex-post feature.
Causes of Housing market crisis - ANS-1.Federal Reserve interest rate policy (Lower rates,
higher housing prices)
2.Adjustable Rate Mortgages (ARM) offered "teaser" rates
3.Government policies to promote home ownership (Community reinvestment act (CRA))
4.Secondary Mortgage Market
5.Repeal of Glass Steagall Act of 1933
6.Little to no Collateral
7.Overconfidence that housing prices would continually rise
ARMs contribution to housing crisis - ANS-ARMs offered teaser rates and sometimes "interest
only" loans. These loans were cheaper for subprime borrowers, but they reset after a few years.
This was okay as long as housing prices continued to increase. Then, they could resell the
house and profit. When prices declined....
Gov't policies that contributed to housing crisis - ANS-Community Reinvestment Act (CRA)
helped propel the housing market crisis. This is debated. Arguments on the pro side say that the
CRA forced banks to make additional loans to poorer applicants because of government
regulation (redlining). Arguments on the con side say that the law didn't force banks to make
subprime loans nor did it ask them to lower their lending standards. They instead did that to
create profitable derivatives.
Secondary mortgage market contribution to housing crisis - ANS-The secondary mortgage
market is the primary culprit. It created moral hazard in banking because lenders now were less
concerned with the ability to pay back loans. If interest rates increased, the belief was that the
borrower could sell the house to pay back the loan. The term, Collateralized Debt Obligations
(CDOs) says just that.
Likely Main Culprit
how did the repeal of Glass Steagall Act contribute to the housing crisis? - ANS-Repeal of Glass
Steagall Act (separated commercial and investment banking). The act, in 1999, was
Gramm-Leach-Bliley Act.
What was the consequences of the housing crisis? - ANS-Largest recession since the Great
Depression. This is why it is sometimes referred to as "the Great Recession."
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