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Fundamentals of Multinational Finance, 4e (Moffett) Chapter 5 Current Multinational Financial Challenges: The Credit Crisis of 2007 - 2009 Multiple

Choice and True/False Questions 5.1 The Seeds of Crisis: Subprime Debt 1) Which of the following repealed the last vestiges of 1930s financial markets regulations? A) The Glass-Steagall Act B) Gramm-Leach-Bliley Financial Services Act C) The Federal Deposit Insurance Corporation Act D) The Bank Holding Company Act Answer: B Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Recognition 2) From the 1930s to the 1990s, ________ banks primarily took deposits and made loans while ________ banks did security underwriting. A) commercial; investment B) investment; commercial C) investment; savings D) commercial; saving Answer: A Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Recognition 3) Mortgage loans in the U.S. that meet the guarantee requirements for resale to Government Sponsored Enterprises and are conforming in every way are classified as ________. A) Alt-A B) subprime C) prime D) Alt-AA Answer: C Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Recognition

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4) ________ mortgage loans are generally considered low-risk but have a non-conforming element that prevents them from having the highest credit rating. A) Prime B) Alt-A C) Subprime D) Alt-B Answer: B Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Recognition 5) The ________ eliminated tax deductibility on consumer loans, but allowed tax deductibility on interest charges associated with both a primary residence and a second mortgage loan. A) Tax Reform Act of 1986 B) Garn-St-Germain Act of 1982 C) The DIDMCA of 1980 D) Gramm-Leach-Bliley Act of 1999 Answer: A Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Recognition 6) Subprime mortgages may have never exceeded 7% to 8% of all outstanding mortgage obligations by 2007, but by the end of 2008, they were the source of more than 65% of bankruptcy filings by homeowners in the United States. Answer: TRUE Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Recognition 7) Mortgage debt as a percentage of household disposable income continued to climb in the United States rapidly in the post-2000 business environment, and was a uniquely American, not global, issue. Answer: FALSE Diff: 1 Topic: 5.1 The Seeds of Crisis: Subprime Debt Skill: Conceptual 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt 1) ________ is the process of turning an illiquid asset into a liquid salable asset. A) Liquidity B) Securitization C) Diversification D) Portfolioization Answer: B Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition
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2) In its purest form, ________ essentially bypasses the traditional financial intermediaries, typically banks, to go directly to investors in the marketplace in order to raise funds. A) securitization B) the IPO C) liquidation D) diversification Answer: A Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 3) Following World War II, the United States has been one of the first major industrial countries to use securitization in its savings and loan and commercial banking systems. Answer: FALSE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 4) In post-2000 U.S. debt markets, securitized assets took two major forms, ________. A) options and futures B) debt and equity C) mortgage-backed securities and asset-backed securities D) debentures and mortgages Answer: C Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 5) From 1990 to 2007, securitized loans grew from ________ of total U.S. loans outstanding. A) 2% to 4% B) 8% to 14% C) 18% to 39% D) 50% to 75% Answer: C Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 6) From 1990 to 2007, securitized loans in the United States grew from ________. A) $4 trillion to $27 trillion B) $6 billion to $25 billion C) $6 million to $160 million D) This type of information is unavailable. Answer: A Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 7) Securitization A) provides incentives for rapid and possibly sloppy credit quality assessment.
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B) allows loan originators to focus on generating more and more fees through more loans. C) fragmented traditional banking practices by encouraging the practice of originate-to-distribute. D) all of the above Answer: D Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual 8) In general, securitization tends to improve credit quality because loans are moved away from the original lenders. Answer: FALSE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual 9) A (an) ________ is a financial intermediation device designed to allow banks to create off-balance sheet investment entities that "borrow short" and "lend long". A) asset-backed security (ABS) B) structured investment vehicle (SIV) C) mortgage-backed security (MBS) D) plain vanilla swap Answer: B Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 10) Securitization tends to strengthen the link between borrower and lender by encouraging continuous monitoring behavior by the lender. Answer: FALSE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual 11) Which of the following would be a good example of a structured investment vehicle (SIV)? A) issue commercial paper to purchase long-term notes B) issue long-term notes to purchase commercial paper C) issue long-term bonds to fund mortgage securities D) All of the above are good examples of an SIV. Answer: A Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition

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12) A ________ is a derivative instrument created from bank-originated mortgages and loans, combined with similar debt obligations into a portfolio, and then re-sold through investment banking underwriters to a variety of investors. A) Credit Default Swap (CDS) B) Special Purpose Vehicle (SPV) C) Collateralized Debt Obligation (CDO) D) Arbitrage Pricing Tranch (APT) Answer: C Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 13) Portfolio Theory has proven to be remarkably accurate in the idea that, whereas a single large subprime borrower constituted significant risk, a portfolio of subprime borrowers which was securitized did not. Answer: FALSE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual 14) CDOs are typically sold to the market in categories representing the credit quality of the borrowers in the mortgages. Generally speaking, the ________ tranches have a credit quality of AAA. ________ tranches have a quality ranging from AA to BB, and ________ tranches have ratings below BB. A) senior, equity; mezzanine B) senior, mezzanine; equity C) mezzanine; equity; senior D) equity; senior; mezzanine Answer: B Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 15) Many investing institutions had strict investment policy statements in place which required investment grade status (BBB and above) for purchase. Thus, there was additional pressure on rating agencies to give favorable ratings to CDOs. Answer: TRUE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition

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16) The ________ was a contract, a derivative, which derived its value from the credit quality and performance of any specified asset. A) Collateralized Debt Obligation (CDO) B) Arbitrage Pricing Tranch (APT) C) Special Purpose Vehicle (SPV) D) Credit Default Swap (CDS) Answer: D Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Recognition 17) One of the concerns about CDOs from the very beginning was that the CDO originator had no continuing link or responsibility to the mortgage. Answer: TRUE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual 18) The Credit Default Swap A) was designed to shift the risk of default to a third party. B) was a way to bet whether a specific mortgage or security would either fail to pay on time or fail to pay at all. C) could be used as a speculative investment or a hedge against risk. D) could be all of the above. Answer: D Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual 19) The CDS was completely outside the regulatory boundaries, having obtained unique protection as a result of the Commodity Futures Modernization Act of 2000.The CDS was in fact a position or play which had been outlawed for more than a century. Answer: TRUE Diff: 1 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Skill: Conceptual

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5.3 The Fallout: The Crisis of 2007 - 2009 1) Which of the following large U.S. firms was allowed to fail in 2008 and forced to file for bankruptcy? A) Fannie Mae B) Lehman Brothers C) Freddie Mac D) AIG Answer: B Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 2) Most commodity prices rose in the first half of 2008 but then oil prices plummeted while other commodity prices continued to rise. Answer: FALSE Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 3) Beginning in September 2008 and extending into the spring of 2009, the worlds credit markets lending of all kinds nearly stopped. The corporate lending markets demonstrated which of the following complex combination of crisis conditions? A) The risky investment banking activities undertaken post-deregulation, especially in the mortgage market, overwhelmed the banks commercial banking activities. B) The indebtedness of the corporate sector was tiered, with the biggest firms actually being extremely well positioned to withstand the crisis. The middle and lower tier companies by size, however, were heavily dependent on debt, particularly short-term debt for working capital financing. Many were now having trouble in both servicing existing debt and gaining access to new debt to stave off declining business conditions. C) All corporate borrowers were suddenly confronted by banks reducing their access to credit. D) All of the above are true. Answer: D Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 4) Traditionally Alt-A mortgages have a default rate of less than ________ but those originated in 2006 now have a default rate in excess of ________. A) 1%; 11% B) 4%; 15% C) 8%; 20% D) 10%; 25% Answer: A Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition

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5) In the face of a world-wide recession, many currencies fell against the traditional three safe-haven currencies, the dollar, the euro, and the yen, Answer: TRUE Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 6) The recession of 2007 - 2009 moved through three stages in the following order: A) 1. The failure of specific mortgage-backed securities, 2. the crisis spread to the very foundations of the organizations at the core of the global financial system, the commercial and investment banks on all continents and 3. led to a credit-induced global recession of potential depression-like depths. B) 1. The failure of specific mortgage-backed securities, 2 a credit-induced global recession of potential depression-like depths, and 3. the crisis spread to the very foundations of the organizations at the core of the global financial system, the commercial and investment banks on all continents. C) 1. The crisis started with the very foundations of the organizations at the core of the global financial system, the commercial and investment banks on all continents, 2. spread to the failure of specific mortgage-backed securities, and 3. caused a credit-induced global recession of potential depression-like depths. D) 1. A credit-induced global recession of potential depression-like depths caused 2. failure among the very foundations of the organizations at the core of the global financial system, the commercial and investment banks on all continent and finally, 3. the failure of specific mortgage-backed securities. Answer: A Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Conceptual 7) LIBOR is an acronym for ________. A) London International Banks Official Rate B) Latest International Banking Official Rate C) London Interbank Offered Rate D) Latest Interbank Option Rate Answer: C Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 8) The interbank market has historically operated ________. A) without differentiating credit premiums among qualifying participating institutions B) without discriminating by name for qualified participants. C) as a "no-name" market D) with all of the above characteristics Answer: D Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition

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9) The TED spread is the difference between A) T-bill rates and the Federal Funds rate. B) LIBOR and some measure of risk-less interest. C) the Federal Funds rate and the Discount rate. D) LIBOR and NYIBOR. Answer: B Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 10) The central bank in most countries sets the rate it lends at, it does not dictate the rate at which banks lend either between themselves or to non-bank borrowers. Answer: TRUE Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Conceptual 11) Many loan agreements with banks have market disruption clauses that allow banks to actually charge corporate borrowers their "real cost of funds," not just the published LIBOR. Answer: TRUE Diff: 1 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009 Skill: Recognition 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism 1) Which of the following do the authors suggest will aid in "pulling derivatives back from the brink"? A) renewed regulatory requirements B) increased reporting C) greater transparency in pricing and valuation D) All of the above are author suggested techniques to aid the derivative market. Answer: D Diff: 1 Topic: 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism Skill: Recognition 2) The term ________ goes far back in financial history, and indicates that if large institutions were allowed to collapse, they would take a multitude of smaller institutions with them, both financial and non-financial. A failure ripple-effect of this magnitude is simply considered unacceptable by most governments. A) "too big to fail" B) "caveat emptor" C) "collapsis disastorous" D) none of the above Answer: A Diff: 1 Topic: 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism Skill: Recognition
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3) The passage of the Financial Reform Law of 2010 changed The Federal Deposit Insurance Corporation (FDIC) protection of bank deposit accounts from the previous $250,000 to $100,000 per account. This was seen as an attempt to instill market discipline on depositors. Answer: FALSE Diff: 1 Topic: 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism Skill: Conceptual 4) As a result of the 2007 - 2009 financial crisis, Merrill Lynch was merged into ________. A) Lehman Brothers B) Bank of America C) Wells Fargo Bank D) Wachovia Bank Answer: B Diff: 1 Topic: 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism Skill: Recognition 5) Which of the following is NOT a result of the Financial Reform Law of 2010? A) An Office of Financial Research was established. B) The SEC can sue lawyers, accountants, and other professionals, who know about a deceptive act, even if they werent the wrongdoer. C) Institutions must disclose the amount of short selling in each stock. D) All of the above are characteristics of the Financial Reform Law of 2010. Answer: D Diff: 1 Topic: 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism Skill: Recognition

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Essay Questions 5.1 The Seeds of Crisis: Subprime Debt 1) Explain BRIEFLY how the repeal of the Glass-Steagall and the Bank Holding Company Acts and the passage of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 contributed to the financial crisis of 2007-2009. Answer: The Glass-Steagall Act of 1933 separated commercial banks from investment banks and insurance activities. Because commercial banking activities tend to be less risky than investment banking and insurance activities, the bank deposit insurance fund established by the formation of the FDIC worked very well for the better part of 75 years. However, business challenges changed over time and Congress stripped away portions of Glass-Steagall for two decades until it was eliminated by the Gramm-Leach-Bliley Financial Services Modernization Act of 1999. The Modernization Act had the effect of creating an environment that encouraged aggressive competition for loans by commercial banks for new and varied customers. Banks could also underwrite securities and sell insurance. Federal regulators were underprepared for the increase in new and riskier borrowers now recruited by commercial banks. Credit quality fell, riskier and often unregulated financial derivatives were written, and customer deposits were placed at greater risk. When the financial crisis began to unravel in 2007 the financial system was ill-prepared to deal with the results. Diff: 3 Topic: 5.1 The Seeds of Crisis: Subprime Debt 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt 1) Explain the process of securitization. In doing so be sure to define liquidity and the concept of originate-to-distribute and how the concept differs from traditional commercial bank lending. Answer: Securitization is the process of turning illiquid asset into a liquid salable asset. Liquid, in the field of finance, is the ability to exchange an asset for cash, instantly, at fair market value. In its purest form, securitization essentially bypasses the traditional financial intermediaries, typically banks, to go directly to investors in the marketplace in order to raise funds. As a result, it may often reduce the costs of lending and borrowing, while possibly raising the returns to investors, as the financial middleman is eliminated.The problem, however, is that securitization may degrade credit quality. As long as the lender, the originator, was "stuck" with the loan, the lender was keen to assure the quality of the loan and the capability of the borrower to repay in a timely manner. The lender had a vested interest in continuing to monitor borrower behavior over the life of the debt. Securitization, however, severed that link. Now the originator could originate and sell, not being held accountable for the ultimate capability of the borrower to fulfill the loan obligation. Critics argue that securitization provides incentives for rapid and possibly sloppy credit quality assessment. Originators could now focus on generating more and more fees through more loans, origination, while not being concerned over the actual loan performance over time. The originate-to-distribute (OTD) model was now fragmenting traditional banking risks and returns. Under the OTD framework, once the loan was made and resold, the ability for any institution trading the portfolio of loans to track and monitor borrower behavior was negligible. Diff: 3 Topic: 5.2 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt
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5.3 The Fallout: The Crisis of 2007 - 2009 1) To the best of your ability highlight the events from July 2007 through September 30, 2008 that culminated with the 777 point fall in the DJIA. Answer: In July 2007, two hedge funds at Bear Stearns holding a variety of CDOs and other mortgagebased assets failed. Soon thereafter, Northern Rock, a major British banking organization, was rescued from the brink of collapse by the Bank of England. In early September 2007, global financial markets turned to near panic, as a multitude of financial institutions on several continents suffered bank runs. Interest rates rose, equity markets fell, and the first stages of crisis rolled through the global economy. Crude oil peaked at $147/barrel in July, 2008 and then plummeted, as did nearly every other commodity price including copper, nickel, timber, concrete, and steel. As mortgage markets faltered, the U.S. Federal Reserve stepped in. On August 10, 2008, the Fed purchased a record $38 billion in mortgage-backed securities in an attempt to inject liquidity into the credit markets. On September 7, 2008, the U.S. government announced that it was placing Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) into conservatorship. In essence, the government was taking over the institutions as result of their near insolvency. Over the following week, Lehman Brothers, one of the oldest investment banks on Wall Street, struggled to survive. Finally on September 14, Lehman filed for bankruptcy - by far the largest single bankruptcy in American history. On Monday, September 15, the markets reacted. Equity markets plunged. In many ways much more important for the financial security of multinational enterprises, U.S. dollar LIBOR rates shot skywards. As a result of the growing international perception of financial collapse by U.S. banking institutions. The following day, American International Group (AIG), the U.S. insurance conglomerate, received an $85 billion injection from the U.S. Federal Reserve in exchange for an 80% equity interest. AIG had extensive credit default swap exposure. Diff: 3 Topic: 5.3 The Fallout: The Crisis of 2007 - 2009

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5.4 The Remedy: Prescriptions for an Infected Global Financial Organism 1) The authors suggest changes to several financial practices to remedy the global financial crisis. Discuss the authors' comments on the following items with regard to reducing the probability of and the severity of the effects of subsequent financial meltdowns: Debt, Securitization, Derivatives, Deregulation, and Illiquid Markets. Answer: The student needs to respond to the reasonableness of the authors' comments. They should address these issues: Debt - concern about the originate-to-distribute behavior combined with questionable credit assessments and classifications. New guidelines for credit quality and access to mortgages are already underway. Securitization - Was the financial technique of combining assets into packaged portfolios for trading the problem, or the lack of transparency and accountability for the individual elements within the portfolio? Although portfolio theory itself has been used for risk reduction since the 1960s, it was always used in the construction of assets with uncorrelated movements. In the case of mortgage-backed securities, however, the portfolio components were so similar that the only benefit was that the holder "hoped" that all the same securities would not fall into delinquency simultaneously. This was not the premise of portfolio theory. Derivatives - They are the core of financial technological innovation. But derivatives are only devices and tools, and they are not better or worse than those using them. The creation of complex mortgagebacked assets and derivative structures which ultimately made the securities nearly impossible to value, particularly in thin markets, was in hindsight a very poor choice. Renewed regulatory requirements, increasing reporting, and greater degrees of transparency in pricing and valuation will aid in pulling derivatives back from the brink. Deregulation - Certain corrections have clearly been needed from the beginning. For example, the lack of regulatory oversight and exchange trading of credit default swaps is already in the works. There are many today who argue that financial markets do indeed need to be regulated, but of course the degree and type is unclear. Illiquid Markets - This finally, will be the most troublesome. Most of the mathematics and rational behavior behind the design of today's sophisticated financial products, derivatives, and investment vehicles are based on principles of orderly and liquid markets. When the trading of highly commoditized securities or positions as clean as overnight bank loans between banks becomes the core source of instability in the system then all traditional knowledge and assumptions of finance have indeed gone out the window. Diff: 3 Topic: 5.4 The Remedy: Prescriptions for an Infected Global Financial Organism

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