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412_midterm_fall_2010_with_answers - Fall 2010 Professor...

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Fall 2010 Professor Barsky Economics 412 Midterm Exam I. (35 points) Consider a large financial entity (perhaps an SIV) that buys mortgage-backed securities (exclusively) and borrows overnight from money market funds via the repo market. The institution borrows as heavily as it is able to. The mortgage-backed securities are insured by credit default swaps (written by an insurance company that is heavily, but not exclusively involved in mortgage-backed securities? ). They have a AAA rating, but there is some question about the veracity of the ratings process. a. Initially (as of 2004) the entity has $1 billion in mortgage-backed securities and $900 million in borrowing. How much risk capital does the firm have? What is the haircut on the mortgage-backed securities? What is the leverage ratio? Show your calculations. The firm has 1 billion 900 million = 100 million in risk capital. The haircut is 100 million/1 billion = 10%. The leverage ratio is 1 billion/100 million = 10. b. Should we regard this entity as excessively levered, given the circumstances? Why or why not? Is it very risky for the money market funds to lend overnight to this entity? Is a financial world of which this entity and its activities are representative highly prone to a financial crisis? Please make the case both for and against, while explaining why you favor one viewpoint over the other. The case that the firm is excessively levered is that risk capital is only 10% of the value of the firm s gross asset holdings. If they have to unwind their positions because of a loss of risk capital, the reduction in gross holdings of the risky asset would have to be ten times the initial losses. If the mortgage-backed securities lost only 10% of their value the firm would have no equity left, and may have to cease operating. A financial world with lots of the these firms would be subject to a loss spiral and a haircut spiral, and this could certainly constitute a financial crisis in which assets sell below their fundamental values and institutions avoid purchasing risky assets as well as accepting them as collateral. The argument that the leverage is not excessive rests on the notion that the assets are AAA and that ex ante, at least, 10% would be an improbably high level of losses though in retrospect this worst case scenario did occur. The argument that it is not too risky for money market funds to lend to this entity is that they choose a haircut sufficient to protect them against losses. c. Now it is 2007, and things are beginning to unravel. There have been waves of mortgage defaults, and losses on mortgage-backed securities. Imagine these losses are sudden, and close to though somewhat less than - %10 of the initial value of the securities. Among other things, the securities lose their AAA ratings. What initially happens to the balance sheets of this entity? How about those of the insurance company?
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Say the losses are 8% of the value of the securities.
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