Economy 1 Bank 2 Bank 1 Assets Asset A: 10 x $10 Liabilities Assets Liabilities Debt: 50 Asset A: 6 x $10 Debt: 50 Equity: 50 CDO: 4 x $10 Equity: 50 Bank 1 Bank 2 Assets Liabilities Assets Liabilities Asset A: 5 x $10 Debt: 50 Asset A: 6 x $10 Debt: 50 Asset C: 10* $5 Equity: 50 CDO: 4 x $10 Equity: 50 (a) Which economy do you think has more systemic risk? Explain. (b) Take Economy 2. Suppose that lenders impose a leverage ratio of 2-1. Suppose further that a financial crisis causes the price of CDOs to fall to $1. What will Bank 2 have to do to restore their leverage ratio? HINT: Assume they sell off their CDOs first. (c) Let the slope of the inverse demand curve for Asset A be -1. That is, Price = B - Quantity. By how much does the price fall after Bank 2's fire sale? Show how this affects Bank 1's balance sheet. (d) How low would Bank 2's leverage ratio have to have been before the crisis to eliminate the loss spiral/fire sale after CDO prices fell to $1? Economy 2 Economy 1 Bank 2 Bank 1 Assets Asset A: 10 x $10 Liabilities Assets Liabilities Debt: 50 Asset A: 6 x $10 Debt: 50 Equity: 50 CDO: 4 x $10 Equity: 50 Bank 1 Bank 2 Assets Liabilities Assets Liabilities Asset A: 5 x $10 Debt: 50 Asset A: 6 x $10 Debt: 50 Asset C: 10* $5 Equity: 50 CDO: 4 x $10 Equity: 50 (a) Which economy do you think has more systemic risk? Explain. (b) Take Economy 2. Suppose that lenders impose a leverage ratio of 2-1. Suppose further that a financial crisis causes the price of CDOs to fall to $1. What will Bank 2 have to do to restore their leverage ratio? HINT: Assume they sell off their CDOs first. (c) Let the slope of the inverse demand curve for Asset A be -1. That is, Price = B - Quantity. By how much does the price fall after Bank 2's fire sale? Show how this affects Bank 1's balance sheet. (d) How low would Bank 2's leverage ratio have to have been before the crisis to eliminate the loss spiral/fire sale after CDO prices fell to $1? Economy 2