Question 1

A possible sequence for the three stages of a financial crisis in the U.S.might be ________ leads to ________ leads to ________.

Accepted Answer

Asset price declines often lead to banking crises as banks may not be able to cover their losses from the declining assets. Banking crises can then lead to an unanticipated decline in the price level as the credit supply is restricted and the economy experiences a period of contraction.

Question 2

The government bailout of troubled financial institutions occurred in the U.S.and many other countries.Which country saw their banking system collapse requiring the government to take over its three largest banks?

Accepted Answer

Iceland saw its banking system collapse in 2008, which led the government to take over its three largest banks.

Question 3

The Economic Recovery Act of 2008 had several provisions to promote recovery from the subprime financial crisis.These provisions included all of the following except

Accepted Answer

The Economic Recovery Act of 2008 did not guarantee all the deposits of commercial banks. However, it did temporarily raise the limit of federal deposit insurance from $100,000 to $250,000, guarantee the par value for money market mutual fund shares for one year, and purchase subprime mortgage assets from troubled financial institutions by the Treasury.

Question 4

Debt deflation occurs when

Accepted Answer

Debt deflation occurs when an economic downturn causes the price level to fall and a deterioration in firms' net worth because of the increased burden of indebtedness. As the economy slows down, borrowers become less able to repay their loans, leading to a rise in defaults and bankruptcies, which in turn lead to a decline in asset prices, and a vicious cycle sets in. Falling prices reduce the value of collateral, which makes it harder to obtain credit, which further exacerbates the downturn. This was evident during the Great Depression of the 1930s, where deflationary conditions contributed to debt deflation.

Question 5

________ is a process of bundling together smaller loans (like mortgages)into standard debt securities.

Accepted Answer

Securitization is the process of bundling together smaller loans, such as mortgages or car loans, into standard debt securities, which can be sold off to investors. This allows the original lender to free up capital and reduce risk, while investors have the opportunity to invest in a variety of loans at different risk levels.

Question 6

Mortgage brokers often did not make a strong effort to evaluate whether the borrower could pay off the loan.This created a

Accepted Answer

When mortgage brokers did not properly evaluate a borrower's ability to repay the loan, this created a severe adverse selection problem. Adverse selection is when one party in a transaction has more information than the other and uses that information to their advantage. In this scenario, the borrower may have been aware that they could not afford the loan, but the mortgage broker may not have known this and approved the loan anyway. This can lead to high rates of default and financial losses for lenders.

Question 7

Which investment bank filed for bankruptcy on September 15,2008 making it the largest bankruptcy filing in U.S.history?

Accepted Answer

Lehman Brothers filed for bankruptcy on September 15, 2008, sending shockwaves through the financial industry and becoming the largest bankruptcy filing in U.S. history.

Question 8

Financial innovations that emerged after 2000 in the mortgage markets included all of the following except

Accepted Answer

Adjustable-rate mortgages existed before 2000, while the other options became more prominent after 2000.

Question 9

A ________ pays out cash flows from subprime mortgage-backed securities in different tranches,with the highest-rated tranch paying out first,while lower ones paid out less if there were losses on the mortgage-backed securities.

Accepted Answer

This describes a collateralized debt obligation (CDO), which is a type of structured finance product that pools together assets such as subprime mortgages and pays out cash flows to investors in different tranches based on the risk profile of the underlying assets. The highest-rated tranches are paid out first, while lower ones are paid out less if there are losses on the mortgage-backed securities.

Question 10

Like a CDO,a structured investment vehicle pays off cash flows from pools of assets,however,rather than long-term debt the structured investment vehicle backs

Accepted Answer

Structured investment vehicles back commercial paper, which is short-term debt issued by corporations.

Question 11

A substantial decrease in the aggregate price level that reduces firms' net worth may stall a recovery from a recession.This process is called

Accepted Answer

Debt deflation occurs when falling prices reduce the value of assets and collateral, which can lead to insolvency and illiquidity for firms. This can further result in reduced economic activity and a stalled recovery from a recession. Moral hazard refers to the incentive for individuals to take higher risks when they are insured or protected from losses. Insolvency occurs when a firm's liabilities exceed its assets, and it is unable to meet its financial obligations. Illiquidity refers to a situation where a firm does not have the cash or assets that can be quickly converted into cash to meet its financial obligations. While insolvency and illiquidity can be the result of debt deflation, they do not necessarily contribute to stalling the recovery from a recession.

Question 12

When housing prices began to decline after their peak in 2006,many subprime borrowers found that their mortgages were "underwater." This meant that

Accepted Answer

"Underwater" refers to a situation where the value of the house falls below the amount of the mortgage owed on it. This means that the borrower owes more on their mortgage than the house is currently worth.

Question 13

The growth of the subprime mortgage market led to

Accepted Answer

The subprime mortgage market allowed individuals with lower credit scores to obtain mortgages, increasing demand for houses and contributing to the housing price boom.

Question 14

Agency problems in the subprime mortgage market included all of the following except

Accepted Answer

Homeowners refinancing their houses with larger loans when their homes appreciated in value is not considered an agency problem, as it is a normal and legal practice in the mortgage market. The other options listed all represent agency problems, where individuals or organizations involved in the mortgage market had weak incentives to ensure that risks were properly assessed and managed.

Question 15

Typically,the economy recovers fairly quickly from a recession.Why did this not happen in the United States during the Great Depression?

Accepted Answer

The answer of Typically,the economy recovers fairly quickly from a...

Question 16

Credit market problems of adverse selection and moral hazard increased as a result of all of the following except

Accepted Answer

An increase in housing market prices would not necessarily lead to credit market problems of adverse selection and moral hazard. In fact, it could have the opposite effect by increasing the value of collateral and reducing default risk. The other options - increased uncertainty from the failures of financial institutions, deterioration in financial institutions' balance sheets, and decline in the stock market of over 40% from its peak - can all contribute to credit market problems by creating conditions that make it harder for lenders to distinguish between good and bad borrowers and by reducing the incentives of borrowers to repay their debts.

Question 17

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.

Accepted Answer

The originate-to-distribute business model creates a principal-agent problem because the mortgage broker, who is the principal, has little incentive to ensure that the mortgagee is a good credit risk since the mortgage is being sold to third-party investors. This leads to a conflict of interest, where the mortgage broker may prioritize making a sale over ensuring that the mortgagee will be able to repay the loan. As a result, the mortgagee may default on the loan, which can lead to significant losses for the third-party investors who purchased the mortgage.

Question 18

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.

Accepted Answer

Debt deflation, which occurs when a decrease in the price level leads to an increase in the real value of debt, can create adverse selection and moral hazard problems in credit markets. This can make it difficult for lenders to identify good borrowers and for borrowers to use borrowed funds for productive investments. As a result, the economy can experience a contraction in output and employment that is difficult to reverse, as was the case during the Great Depression. Illiquidity (B) can also contribute to economic downturns, but it is not the primary cause of the Great Depression. Increases in bond prices (D) could actually be a sign of a recovery rather than a cause of a recession, and improving banks' balance sheets (C) can help to stabilize the economy but cannot on their own cause a severe contraction.

Question 19

Although the subprime mortgage market problem began in the United States,the first indication of the seriousness of the crisis began in

Accepted Answer

The first indication of the seriousness of the subprime mortgage crisis began in Europe, specifically in the UK when Northern Rock, a British bank heavily invested in mortgage-backed securities, experienced a run on deposits in September 2007. This event signaled the beginning of the global financial crisis.

Question 20

The largest bank failure in U.S.history was ________ which went into receivership by the FDIC on September 25,2008.

Accepted Answer

The largest bank failure in U.S. history was Washington Mutual, also known as WaMu, which went into receivership by the FDIC on September 25, 2008. Its failure was due to high-risk mortgage lending and a decline in the housing market. Bank of America, J.P. Morgan, and Wells Fargo are all still operating and did not experience the same level of failure as Washington Mutual.

Quiz 9: Financial Crises and the Subprime Meltdown

A possible sequence for the three stages of a financial crisis in the U.S.might be leads to leads to .