Economics 311: Money and Banking Midterm #2

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1 Student ID #: Economics 311: Money and Banking Midterm #2 Please answer the following questions to the best of your ability. Remember, this exam is intended to be closed books, notes, and neighbors. No programmable or financial calculators may be used on this exam. If you have any questions, please raise your hand. Be sure to show your work if you want partial credit. Points possible are in parenthesis after each question. Good Luck! Please note: many questions provide much space for their answer. Do not feel as if you need to fill this space up to receive full credit. 1. Consider two types of home purchasers: a speculator and an individual who hopes to live in a home for a long time. Both types of individuals are indistinguishable from one another. At the time of purchase, the home sells for $250,000. Over the course of the year, the home may either appreciate (80% of the time) to $287,500 or depreciate (20% of the time) to $220,000. The market interest rate for mortgages is 5%. a. Assume the speculator does not have access to funds of her own and needs to borrow all $250,000 from a bank in order to make this purchase. Further, assume that the speculator will sell the house at the end of the year. What is the speculator s expected profits of doing so? Will the speculator purchase the house? (5) b. Assume that the speculator purchased the house. Further, if the housing market deteriorates and the home is worth $220,000 at the end of the year that the bank will repossesses the home and sells it for the market value. Under theses circumstances, what is the bank s expected profit? Given this, would a bank knowingly make a loan to the speculator? (5)

2 c. If the home was purchased by a long-term resident (not the speculator), then this individual would hope to live in the house even if it depreciated. Assuming this individual pays her loan regardless of the housing market condition, what is the bank s expected profit? Given this, would a bank knowingly make a loan to a long-term home purchaser. (4) d. One option for the bank is to require all borrowers to place a down payment on the home. In essence, the bank would then lend to the buyer $250,000 D where D is the down payment. Assuming both speculators and long-term residents can afford D, what is the minimum D the bank should set to maximize its expected profits? Who borrows under these conditions? (8) e. In general, what is the impact of accepting collateral on the adverse selection problem? (6)

3 2. Suppose you are considering investing in a bank and are trying to choose which one would make the best investment. You have asked your investment adviser for information each bank you are considering, including its return on equity. Should you invest in the bank with the highest ROE? Why or why not? (8) 3. If a bank you own has no excess reserves and a sound customer comes in asking for a loan, what options are available to you to extend a loan to this customer? (8) 4. Explain how bank capital mitigates the moral hazard problem faced by bankers. (6)

4 5. Consider two firms that have potential investment projects; one safe and one risky. Each project costs $100 to undertake. The safe project returns $125 with certainty. The risky project returns $150 with probability 2/3 rds and 0 with probability 1/3 rd. Initially each firm has no funds so they must finance their projects with a single $100 bond. The bond promises repayment of $110 in one year after the project is completed. a. Suppose that information is symmetric and that savers know which firm s project is safe and which is risky. Under these conditions, which (if any) firm will receive a bond? (6) b. Suppose that information is asymmetric and that savers cannot distinguish between safe and risky projects. To which firms will savers issue bonds? (6) c. Suppose the government guarantees the firms bonds; that is the government makes the promised payment if either firm defaults. Can both firms sell bonds? What is the average cost to the government of guaranteeing a bond, assuming it does so for each firm? What is the average profit on an investment project, assuming both firms finance projects with government guaranteed bonds? Which is higher, the average cost of a bond guarantee or the average profit of a projects? Comment on the economic efficiency of such a guarantee. (10)

5 6. Suppose you are the manager of a bank that has $35 million of fixed-rate assets, $45 million of rate-sensitive assets, $20 million of fixed-rate liabilities, and $60 million of rate-sensitive liabilities. Conduct a gap analysis for this bank and explain what would happen to this bank s income given a one percent rise in interest rates. What actions could this bank take to reduce its interest rate risk? (6) 7. In his article entitled, Anatomy of a Trainwreck, Stan Leibowitz presents the following two charts: Figure 5: Prime Foreclosures Started Using these two charts, what argument was Leibowitz advancing? (6)