Explain theCAUSES OF THE FINANCIAL CRISIS, Bond Market and Government Borrowingbelow using economic terminology, economic logic, and economic reasoning

1) CAUSES OF THE FINANCIAL CRISIS

Now that we have developed an understanding of how financial markets work, we can ask some key questions: What caused thefinancial crisisthat started in 2007? How did the housing market, the stock market, and indeed the whole economy crash so suddenly? And can anything be done to avoid such crises in the future?

The first thing to realize is that financial markets are historically prone tobubbles. A bubble occurs when prices in a financial market rise for an extended period, and investors convince themselves that the increases aren't going to stop. At that point the bubble becomes self-feedingbelieving that prices will go up, investors put more money into the market, which drives the prices well above a level that is sustainable over the long run.

For example, in the late 1990s, there was a bubble in technology stocks. Many investors convinced themselves that the internet was an unstoppable force that was going to keep driving up the stock price of both existing technology firms and start-ups. For example, the stock price of Corningone of the world's biggest makers of fiber-optic cable, used for high-capacity data transmissionwent from $16 per share at the beginning of 1999, up to more than $100 per share in 2000, and then down to less than $2 a share in 2002. Fortunes can be madeand lostwith price movements like this.

The financial crisis that started in 2007 was the result, in large part, of a bubble as well. This time, the bubble occurred in the whole U.S. housing market, which represents a large part of the wealth of the country. From 1997 to 2006, the increase in housing prices far outstripped the rate of inflation. That increase, in turn, led to home buyers paying ridiculous prices for homes because they thought they would make a profit when they sold, home builders constructing more and more expensive new homes because they thought they would make a profit when they sold, and banks making questionable mortgages because even poor people could pay back their loans if they sold their homes in a rising market.

Weaknesses in financial regulation also helped contribute to the financial crisis. Regulatory agencies such as the Federal Reserve did not pay close enough attention to the rapidly evolving markets in complicated financial instruments known as derivatives. Using these derivatives, many large financial institutions were able to place big bets on the housing market, which would pay off as long as housing prices didn't fall. The financial institutions thought they had history on their side, because housing prices hadn't fallen nationwide since the Great Depression.

In the end, of course, the housing bubble burst, home prices went down, and everyone was left holding the bag. Some financial institutions, like Lehman, went bankrupt, while others came close. And the U.S. government had to borrow trillions of dollars to stimulate demand and keep the economy afloat.

In response, policymakers strengthened the regulation of the financial system. In particular, Congress passed theDodd-FrankWall Street Reform and Consumer Protection Act in 2010, which President Obama signed into law. Dodd-Frank, as it is commonly called, was eight hundred forty-eight pages long and touched every aspect of finance and insurance, including mortgages, student loans, and credit cards. In particular, the new law made special provisions for dealing with very large banks in times of crisis.

Overall, Dodd-Frank probably reduces the odds of another financial crisis. Nevertheless, there are no guarantees. Financial bubbles have happened before, and they will happen again.

2) The Bond Market

Let's apply the principles of risk, return, and diversification to one of the main ways that corporations and government borrow: thebond market. It's essential to know at least a bit about the bond market if you want to understand how today's economy works.

Let's start with some terminology. Abondis a loan that entitles the lenderthebondholderto get regular interest payments over time, and then to get back the principal at the end of the loan period. (The bond can be represented by an electronic notation or an actual piece of paper; in either case, the idea is the same.) We call the borrower thesellerof the bond; thus selling bonds is the same thing as borrowing money. The bondholder, or lender, is the purchaser of the bond.

Figure 13.7shows how a bond works. At the beginning the borrower sells the bond and receives the loan (principal). The lender buys the bond and pays out the principal. Then, over time, the borrower pays interest and eventually repays the principal.

Figure 13.7 How a Bond Works

In this diagram, the arrows represent the direction in which money moves. In the beginning the borrower sells the bond and receives money in return. The borrower has to pay interest and then pay back the principal.

Most bond sellers promise to pay a fixed amount of interest per quarter or per year for the length of the loan. For that reason bonds are also known asfixed-income securities. Bond terms usually range from 1 to 30 years, though some companies like Walt Disney and Coca-Cola have issued 100-year bonds.

The suppliers of capital in the bond market are generally big institutions such as pension funds, life insurance companies, and mutual funds. In addition, U.S. bonds are often bought by foreign investors. The users of capital in the bond market are the borrowers, the bond sellers.

All other things being equal, borrowing by selling bonds is typically cheaper than taking a loan from a bank. One reason has to do with diversification. A bank that gives a big loan to a company has to consider the possibility, however minuscule, of a default. In the bond market, however, that big loan can be broken down into a lot of smaller bonds that are sold to many different investors. And each of those investors can hold bonds from different corporations. As a result, they are diversified, so any single default has only a small impact. That makes investors more willing to buy bonds of even riskier companies, so the supply curve is pushed to the rightkeeping the interest rate lower than it would have been. Thus companies have been steadily relying more on the bond market than on borrowing from banks.

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