5. (2.5 points total) Listen to “Another Frightening Show About the Economy”, episode #365 of This American Life (from 3 October 2008): [link also on Canvas] a. What is the commercial paper market? The commercial paper market is where companies take out (or make) very brief loans to finance their day-to-day operations. Banks on Wall Street act as intermediaries for these transactions. b. While there were $5 trillion in issued corporate bonds, how much were all of the outstanding credit default swaps on those bonds worth? value of outstanding credit default swaps on corporate bonds in 2008 $60 trillion c. Why was a stock-injection plan possibly preferable to the original Paulson plan of purchasing a bank’s toxic assets? Buying toxic assets is tricky because they have no clear market price. If the government pays too little, the banks still fail; if the government pays too much, the purchases are wasteful giveaways to careless banks that were partly responsible for the mess. A stock injection plan has the advantage that the banks get as much money as they need to survive (and not too much more), while the government establishes claims that (hopefully) will allow much or all of the money to be recovered in time.
EC 202, Spring 2014 Problem Set 3 University of Oregon Page 6 of 6 6. (3 points total) Listen to “Bad Bank”, episode #375 of This American Life (from 27 February 2009): [link also on Canvas] a. What does it mean for a bank to mark its assets to market? When banks mark their assets to market, they are valuing the assets that they are holding (such as foreclosed houses and other property) at the price these assets would go for on the market at that moment. If the market prices of these assets are unusually low, this will cause the bank’s balance sheets to look particularly bleak. b. What is the difference between an insolvent bank and an illiquid bank? An insolvent bank simply does not have sufficient assets to cover its liabilities: that is, it does not have enough in money or assets to pay its depositors. In contrast, the assets of an illiquid are sufficient to cover its liabilities. However, an illiquid bank has the problem that enough of its assets are frozen (that is, they cannot quickly be converted to money—for example, houses) so that it cannot pay all of its depositors now . If depositors are patient there won’t be a problem, but if depositors stage a run on an illiquid bank it will need assistance or it will fail despite having sufficient assets to cover its liabilities. c. Why—in the words of Joe LaVorgna’s “robbery note”—would the taxpayer pay one way or another? According to Joe taxpayers need to pay to bailout the banking system, giving banks as much government money as possible in the hopes of preventing widespread bank failures. The alternative, as Joe sees it, would be a possible collapse of the banking system, which would wreak far worse havoc on the real economy, causing it to suffer drastically reduced output and massive unemployment. One way or another the taxpayers would pay.