Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu

 
32.    How did the boom in the housing market in the early and mid-2000s exacerbate FI’s transition away from their role as specialists in risk measurement and management?
 
The boom (“bubble”) in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term money market rate that banks and other financial institutions pay in the Federal funds market and even made lender of last resort funds available to non-bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now popularly known as the “subprime market,” banks and other mortgage-supplying institutions often offered relatively low “teaser” rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step-up in rates after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that the loans would default. However, under the originate-to-distribute model of banking, asset securitization and loan syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan’s issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage. 
 
The following questions and problems are based on material in Appendix 1B to the Chapter.
 
33.   What are the tools used by the Federal Reserve to implement monetary policy?
 
The tools used by the Federal Reserve to implement its monetary policy include open market operations, the discount rate, and reserve requirements. Open market operations are the Federal Reserves’ purchases or sales of securities in the U.S. Treasury securities market. The discount rate is the rate of interest Federal Reserve Banks charge on “emergency” or “lender of last resort” loans to depository institutions in their district. Reserve requirements determine the minimum amount of reserve assets (vault cash plus bank deposits at Federal Reserve Banks) that depository institutions must maintain by law to back transaction deposits held as liabilities on their balance sheets. This requirement is usually set as a ratio of transaction accounts, e.g., 10 percent.
 
34.    Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion of securities.       Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks.
 
For the purchase of $1 billion in securities, the balance sheet of the Federal Reserve System and commercial banks is shown below.
 
                               Change in Federal Reserve’s Balance Sheet                                                  
 
                           Assets                                                     Liabilities