ECO315 Introduction to Money and BankingWEEK6 Homework (Financia.docx

ECO315 Introduction to Money and Banking
WEEK6 Homework (Financial Crisis)
Throughout the 2008 financial crisis, there are many examples
related with the asymmetric information, the adverse problem,
the moral hazard by the principal agent problem, and the
conflicts of interest.
Find them related with following companies and financial
programs:
· Investment Bank such as Lehman Brothers and Goldman Sachs
· Credit Rating Agency
· Subprime loans to collateral debt obligations (CDO)
· Credit default swaps (CDS)
· Fannie Mae and Freddie Mac (GSE)
· House prices and foreclosures
FINANCIAL MANAGEMENT
1. If a firm substitutes fixed for variable costs, which of the
following will occur? A. The use of financial leverage will be
increased.
B. The degree of operating leverage will be increased.
C. The break-even level of output will be reduced.
D. The profits will always be higher.
2. If investors want to limit financial risk and maximize their
control of the business, which of the following
forms of business should they prefer?
A. Limited partnership
B. S corporation
C. Sole proprietorship
D. Corporation

3. A firm does not obtain financial leverage by
A. issuing preferred stock.
B. issuing common stock.
C. issuing bonds.
D. borrowing from the bank.
4. Unsuccessful use of financial leverage
A. increases earnings per share.
B. increases investors' rate of return.
C. decreases earnings per share.
D. decreases interest expense.
5. Which of these situations offers the best rationale for
organizing a business as a limited partnership?
A. Management rejects the idea of personally assuming liability
for the business.
B. You're an entrepreneur and you want two others' expertise,
former business partners, to help execute your business plan.
C. Management needs to raise money through a stock offering,
but does not want to relinquish control of the business to
stockholders.
D. You want your small new business, which is operating out of
your garage, to pay you and your partner (your spouse)
dividends for which income tax will only be paid by you or your
business, not both.
6. Which of the following is a correct statement about corporate
losses?
A. They are carried forward three years and then carried back.
B. They are carried back three years and then carried forward.
C. They offset other sources of income in prior years.
D. They are carried forward to future years.
7. Break-even analysis requires knowing the relationship
between
A. sales and total costs.

B. sales and earnings.
C. sales and assets.
D. total revenues and fixed costs.
8. If a firm produces 50,000 widgets and sells each unit for
$20.50, what is the total revenue generated by
this production?
A. $1,025,000
B. $100,250
C. $10,250
D. $10,250,000
9. If Sam's Diner has an EBIT of $350,000, what are the diner's
net earnings after paying $50,000 in
taxes and $34,000 in interest?
A. $266,000
B. $334,000
C. $311,000
D. $434,000
10. An increase of cost of capital will
A. decrease an investment's NPV.
B. Increase an investment's NPV.
C. increase an investment's IRR.
D. decrease an investment's IRR.
11.
Coupon rate = 7 percent
Average tax rate = 32%
Price of common stock = $80
Price of preferred stock = $50
Bond yield risk premium = 7%
Return of the market = 12%
Marginal tax rate = 35%
Common stock dividend (Do) = $6
Preferred stock dividend (Do) = $4

Growth rate of common stock dividend = 6%
Risk-free rate of return = 6%
Beta = 1.2
According to the information given, what is the cost of equity
using the expected growth method?
A. 13.2 percent
B. 13.95 percent
C. 12 percent
D. 14.4 percent
12. Which of the following statements about retained earnings
is correct?
A. Retained earnings are the firm's cheapest source of funds.
B. Retained earnings have the same cost as new shares of stock.
C. Retained earnings have no cost.
D. Retained earnings are cheaper than the cost of new shares.
13. The internal rate of return will be higher if the cost of
A. capital is lower.
B. the investment is lower.
C. the investment is higher.
D. capital is higher.
14.
Coupon rate = 7 percent Average tax rate = 32%
Price of common stock = $80Price of preferred stock = $50
Bond yield risk premium = 7%
Return of the market = 12%
Marginal tax rate = 35%
Common stock dividend (Do) = $6
Preferred stock dividend (Do) = $4
Growth rate of common stock dividend = 6% Risk-free rate of
return = 6%
Beta = 1.2
According to the information given, what is the cost of debt? A.
2.45 percent
B. 4.55 percent

C. 6.25 percent
D. 7.0 percent
15. NPV may be preferred to IRR because
A. IRR makes more conservative assumptions concerning
reinvesting.
B. NPV excludes salvage value.
C. IRR excludes salvage value.
D. NPV makes more conservative assumptions concerning
reinvesting.
content/enforced/354450-ECO_315_901_0950/AIG Bailout.pptx
AIG Bailout

AIG
American International Group, Inc. (AIG) is a leading
international insurance organization serving customers in more
than 130 countries. AIG companies serve commercial,
institutional, and individual customers through one of the most
extensive worldwide property-casualty networks of any insurer.
In addition, AIG companies are leading providers of life
insurance and retirement services in the United States. AIG
common stock is listed on the New York Stock Exchange and
the Tokyo Stock Exchange
Overview
Company Details

Credit Default Swaps (CDS)
Financial Crisis
Subprime mortgage collapse
Collateral Calls
Counterparties
Bailout
Post bailout scandals
Post bailout sales
3
Credit Default Swaps (CDS) and Collateralized Debt
Obligations
Credit Default Swap (CDS)
A traded derivative to which the seller is required to make a
payment to the holder of the CDS if there is a credit event for
that instrument such as bankruptcy or downgrading of the firm’s

credit rating
Collateralized Debt Obligations (CDO)
Securities that paid out cash flows from subprime mortgage-
backed securities in different tranches, with the highest tranch
paying out first, while lower ones paid out less if there were
loses

CDS
A CDS’s is basically a security on your bond that guarantee’s
your payments even if the company goes bankrupt for a fee
By the end of 2007, over $60 trillion in CDS’s sales
AIG was doing great because the were getting paid to do
nothing

Subprime Mortgages Collapse
61 Billion of their securities came from Subprime Mortgage
Loans
The housing bubble crashed in 2011 causing AIG to pay up
Collateral Calls
AIG was forced to pay collateral if decline in price’s or a
downgrade in credit rating
September 15th, 2008 Standard and Poor downgraded AIG’s
credit rating
AIG was forced to raise 14.5 Billion in collateral bringing the
total of collateral calls to 37.3 Billion

Counterparties
Because of AIG’s poor credit rating and devaluation of their
securities. AIG was forced to pay defaulted loans
The majority holders of the AIG backed securities were major
banks like Goldman Sachs, Deutsche Bank, and Bank of
America

Bailout
With AIG on the brink of bankruptcy the Federal Reserve was
forced to intervene
This was uncommon because the Federal Reserve had no
jurisdiction over insurance companies
The federal reserve pledged $85 billion to AIG, in return they
got 79.9% equity stake in AIG
A few months later the Fed pledged $38 billion more
AIG has received over $180 billion from the government
Where the money went
The money lent to AIG was used to pay of the securities
The main recipients of the cash were major banks like Goldman
Sachs, Merrill Lynch, and Bank of America
These banks used the money to invest in U.S Treasury Bills
This meant that these banks also received interest from loans

Why the Government Bailed Out AIG
The major banks like JP Morgan and Goldman Sachs, Bank of
America, and Merrill Lynch held a majority of the CDS’s
If the government did not intervene these major banks would
have incurred record loses

Uncertainty of liability
If the government would have allowed AIG to fail the loses that
AIG incurred would have not disappeared
The loses would have most certainly found itself into some
place in the financial market
However, due to the lack of regulations of CDS’s and their
complexity know one knew for sure where the loses would go
Financial Meltdown
Because it was so difficult to predict the worst-case scenario

The Federal Reserve did the only thing they could do by bailing
them out
AIG: After the Bailout Scandal
One week after receiving an $85 billion dollar bailout AIG
executives spent $440,000 on a California retreat
In 2009, AIG announced they were paying $165 million in
executive bonuses

AIG: After the Bailout Sale of Assets
In 2009,Pacific Century Group paid $500 million for a part of
AIG asset management business
In 2009, AIG sold its operations in Columbia to Banco del
Pichincha
In 2010, AIG agreed to sell its American Life Insurance Co
(ALICO) to MetLife Inc for $15.5 billion
AIG: After the Bailout Sale of Assets
In 2010, AIG sold two of their life insurance companies in
Japan for $4.2 billion
By the end of 2010, AIG announced they have raised $36.71
billion through the sale of assets to help pay back the
government

Conclusion
The government did the right thing by bailing out AIG. By
bailing them out, they protected the entire financial system. To
prevent another financial crisis of this magnitude the
government needs to regulate the securities market. AIG should
not have been selling so many securities, however without
regulations another company will do the same thing.
References
http://www.thenation.com/article/153929/aig-bailout-scandal
http://en.wikipedia.org/wiki/American_International_Group
http://www.insuranceproviders.com/aig-bailout-timeline/
http://www.reuters.com/article/2009/03/08/us-aig-

idUSTRE52624P20090308
http://www.propublica.org/article/article-aigs-downward-spiral-
1114
content/enforced/354450-ECO_315_901_0950/AIG.pptx
Role of Subprime Loan to aig
Background
AIG is an American multinational insurance corporation.
The company had 74 million global customers.
30 million of clients American based.
AIG operates in more than 130 countries. Prior to the current

market conditions, the company backed more than $298 billion
in assets globally.
AIG history dates back to 1919, when Cornelius Vander Starr
established an insurance agency in Shanghai, China.
In 1949, the company then moved to its current headquarters,
New York City.
According to the 2011 Forbes Global 2000 list, AIG was the
29th-largest public company in the world.
"AIG Insurance." Compare Insurance Quotes. Web. 18 Feb.
2012. <http://www.insuranceusa.com/AIG-Insurance.php>.
"Background: AIG - The World Technology Network." The
World Technology Network. Web. 18 Feb. 2012.
<http://www.wtn.net/2004/bio476.html>.
The Fall of AIG

“The buyer of a credit swap receives credit protection, whereas
the seller of the swap guarantees the credit worthiness of the
product. By doing this, the risk of default is transferred from
the holder of the fixed income security to the seller of the
swap.” -Investopedia
Lehman was left to fail and AIG was greatly affected by this.
What happened?
“Credit Default Swap - CDS." Investopedia. Web. 15 Feb. 2012.
<http://www.investopedia.com/terms/c/creditdefaultswap.asp>.
3
Video: “Frontline: Meltdown”
http://www.youtube.com/watch?v=iH9qMHJ-1G0
During our presentation, we played from 8:00-9:30 that
explained what happened to AIG and how it went under.
This slide was not part of our actual presentation. We just
wanted to document our video for the professor’s use.

Jaycee2270. "Frontline Inside The Meltdown Part 4 of
6." YouTube. YouTube, 01 Mar. 2009. Web. 16 Feb. 2012.
<http://www.youtube.com/watch?v=iH9qMHJ-1G0>.
Moral Hazard, Asymmetric Info & Adverse Selection
Moral hazard
AIG did not do its due diligence when buying and selling
CDS’s.
It didn’t have enough money to support commitments it made.
The company chose to oversee any major failures.
They were bailed out.
Asymmetric Information
AIG knew that they would not have enough money to cover
companies it insured with CDS’s.
Adverse selection
Bankruptcy for AIG
Possible solution…
Federal oversight! More regulations.
MBA, Julio Viskovich. "Why Did AIG Fail?" Helium. Helium,
12 Apr. 2009. Web. 13 Feb. 2012.
<http://www.helium.com/items/1411465-unethical-behavior-
and-failure-of-aig>.
Global Impact of AIG Financial Crisis

AIG was the world's largest insurer. (Too Big To Fail Theory)
80% nationalized by the U.S. government
Concerns regarding its ability to honor loans
Credit Default Swaps (CODs)
Significant institutional failures (Lehman bankruptcy)
The connection between the AIG crisis and the Lehman
bankruptcy triggered systematic wide spread concerns
Example of Impact: Major airlines and boat companies were
insured by AIG, effecting both the transportation of goods and
business travel across the globe
"Global Economic Crisis." AIG Suffers Worst Quarterly Loss In
U.S. Corporate History. Web. 15 Feb. 2012.
<http://www.globaleconomiccrisis.com/blog/archives/185>.
"AIG: The Fall and Bailout of AIG and The Economic Impact |
OnlineForexTrading.com."Online Forex Trading Broker
Reviews, Currency Trading News, and FX Software Ratings.
Web. 16 Feb. 2012.
<http://www.onlineforextrading.com/blog/aig-bailout-again/>.
AIG Worldwide Problem
AIG is not just an American Insurer, they are global agency in
over 130 countries.
AIG’s quarterly loss had an immense impact on the world

market.
Financial Institutions in the U.S, Europe and Asia all bought
these CDOs, most were tied to corporate debt and mortgage
securities.
If AIG can’t compensate these institutions then they will have
to take large losses.
If AIG were to fail, Americans could expect a global chain
reaction that would include a deeper recession and monumental
unemployment.
Web. 13 Feb. 2012.

Asia Effect
The DOW lost 300 points, which sent Asian markets to new
lows.
Asian consumers had no confidence in Asian holding
companies, even with A+ ratings.
Asia simply didn’t invest.
Asian economy also greatly affected as result.
Web. 15 Feb. 2012.

Summary
AIG is a massive player in the insurance market
Due to adverse selection, AIG went under from selling off
CDS’s, and had to be bailed out.
AIG sold CD’s knowing it would not be able to back companies
it insured.
Asia also greatly affected because people stopped investing
Markets sent to new lows, Dow lost 300 points.
Failure of AIG ultimately created an awful domino effect on the
economy on a global level in the end.
content/enforced/354450-ECO_315_901_0950/Auto
Industry1.ppt
The Automobile Crisis in America 2008-2010
*
*

Who ?
GM – received bailout
Chrysler – received bailout
Ford – did not receive bailout
*
*
Causes
2003-2008 oil price increase High costs Sub-prime mortgage
crisis
*
*
Oil Price Increase
Since 2001 we see a constant increase in the crude oil price
therefor increasing the price at the pump
Source: www.eia.gov
*
*
Oil Price increase continued

During this period of gasoline price increase American Vehicles
are very inefficient and have high gas consumption
Market share is being eaten away by companies such as Toyota
and Honda, which have a more efficient line of cars, therefor
decreasing revenues for the big American 3
*
*
Labor Costs
Americas Big Three were unable to compete with direct labor
costs connected to manufacturing.
There is no way for the U.S companies to compete with the
Asian competition.
Avg. Compensation 2007-08
Source: mjperry.blogspot.com
*
*
Labor Costs: Unions
One can argue that the UAW (United Auto Workers) and its
worker friendly practices had a direct impact on these large
costs.

The Job Bank:
The job bank forced companies who let go workers because of
technological advances to pay idled workers.
“Automakers Forced to Pay 85 to 95 percent of wages to Union
members who are not working” (source: csnnews.com)
In Asia most car companies were not unionized and no such job
bank existed.
*
*
Borrowing CostsCase Study, GM :GM was carrying a $43
billion debt burden, with nearly $3 billion per year in interest
costs. (www.WN.com)
There were disagreements between the bond holders and UAW
on how to handle this debt. This led to a stalemate and is one of
the reasons for government intervention. Many people had their
hands in these corporate bonds, defaulting would effects
hundreds of thousands of people.
*
*

Subprime Mortgage CrisisThe Sub prime mortgage crisis had a
direct effect on the consumers ability to buy these American
Brand cars.
Source: stlouisfed.org
There is a large drop off in sales during the financial crisis
*
*
Subprime Mortgage Crisis: Cont.
During the Crisis no one was buying cars which is the main
source of income for these companies. This coupled with high
borrowing and labor/miscellaneous costs would come together
to end in inevitable bankruptcy.
*
*
Government Action
Bail out #1
Emergency Economic Stabilization Act 2008- Pushed through
congress and signed by George W. Bush.
This bill is the first government reaction to the subprime
mortgage melt down

This granted 17.4 billion dollars to the auto industry with about
¾ going to GM
Bill came with conditions for executives such as no more golden
parachutes or other executive perks
*
*
Government Action Con.
Troubled US carmakers GM and Chrysler have asked the US
government for another $21.6 billion in support, on top of the
$17.4 billion already received (news.bbc.co.uk)
This happened under the Obama Administration on February 18,
2009
In return the government demanded cost cutting and serious
restructuring
Not soon after both Chrysler and GM filed for bankruptcy
*
*
Chapter 11 Bankruptcy

On April 30th, 2009 Chrysler declares bankruptcy
On June 1st, 2009 GM declared bankruptcy
Biggest US Manufacture to fail
Conditions
Both companies let go many employees and went through hefty
restructuring. Strategy was switched from gas guzzling vehicles
to hybrids and electric cars. Business plans re- evaluated.
*
*
Special Case: Ford
Ford managed to escape the financial crisis with no bail out or
bankruptcy:
Ford began its gas efficiency r and d early allowing it to enter
the market quickly with fuel efficient cross over suvs
They struck a historic deal with the UAW that lowered their
health benefit and retirement costs significantly
By putting ALL their assets up as collateral they received a $25
billion line of credit
Even though they testified for money in front of congress Ford
decided not to continue pursuing government money
*
*

Aftermath
All companies were involved in high cost cutting by:
Increasing efficiency, letting go of workers, consolidating
brands and dealerships.
The companies also switched their Business strategies:
This marked the end of an era of gas guzzling SUVs and Trucks.
All cars would strive for efficiency afterwards.
Introduction of the electric and hybrid
*
*
Aftermath Cont.
The Big Three were considerably quick to recover compared to
other industries.
All three returned to profitability very quickly
Chrysler has returned most of the government money it had
borrowed
GM is the number one car in the south east market
*
*
Aftermath Cont.

Soon after the restructuring and cost cutting phase the auto
industry has been hiring ever since, this is a sign of growth
Source: US Department of Treasury
*
*
Opinion:
After heavy group research and discussion we agree and
disagree with the government reaction to the failure of the auto
industry
We disagree about the bailout: The government should not have
bailed out the auto industry. Ford managed to cope without one
and there would be more incentive for the companies to get to
work fixing their problems. We are a free market economy, we
should’ve let the auto industry deal with the problems with no
government help.
*
*
Opinion Cont.
We agree on most aspects of the restructuring:
The switch of business plan and strategy. The way everyone

went fuel efficient to turn around their sales. Also the way the
companies, especially GM, attacked foreign developing
markets. This proved to be a winning move with the turn around
in sales.
What would have happened without a bailout?
We think that nothing different would really happen besides the
tax payers paying less for the financial industry bailout. The
recovery of the industry might have been a little longer than it
was, otherwise the auto industry would’ve went bankrupt and
restructured
*
*
In Summary
Overall the auto industry collapse was a series of unfortunate
events:
The Big Threes’ car lineups were out of date and unable to
compete with foreign companies and higher fuel price.
Unions are unfair to the corporations, they command outrageous
benefits and raise costs to unjustly high levels .
The subprime mortgage crisis came at a prefect time to deliver a
fatal blow to the industry, completely destroying demand for
cars.
After bailout packages, bankruptcy, and restructuring the auto
industry is back on its feet with a “environmental friendly”
attitude and strong sales.
*

*
content/enforced/354450-ECO_315_901_0950/Auto
Industry2.pptx
1
Auto Industry In the financial crisis
2
Introduction
The causes and impact
The damage
The solutions
Where is the industry now?
3
Headed in the Wrong Direction

The price of fuel was increasing and discouraged purchases of
sport utility vehicles (SUVs), and pickup trucks (The main
market for the “Big Three”)
There were fewer fuel-efficient models to offer to consumers to
the “Big Three” became less competitive.
Labor costs, salaries, benefits, healthcare, and pensions
continued to increase which created a disadvantage
In 2006, Consumer Reports reported that all top 10 rated
vehicles of that year were built by foreign companies.
Many consumers took out loans in order to purchase vehicles
3
4
Then the Financial Crisis Happened
Bad time to be depending on financing
The volume of cars sold in the U.S. was significantly tied to
loans. When the availability of these loans suddenly dried up in
2008 due to the subprime mortgage crisis, vehicle sales declined
dramatically
Consumer Impact
Consumers, found it difficult to obtain loans for purchase and,
driven by fear of job loss, moved aggressively to increase their
rate of saving.
The high cost and growing longevity of motor vehicles
prompted buyers to postpone purchases that they might have

otherwise made.
4
5
The Result
U.S. car sales dropped from an average 17 million a year in
2005 to 10 million in 2009.
6
The Damage
The freezing of credit markets meant cancelled orders, unpaid
supplier invoices, and ‘temporarily’ shuttered plants.
Huge debt loads, high fixed-capital costs, high labor costs, and
immense pension and health care commitments to retirees
added to the immediacy of the damage.
Investors, the bondholders and the stockholders

Common Stock and bonds declined severely
Debt swap offers were rejected by bondholders
7
The Big Three
General Motor - Number of jobs lost since recession began:
107,357
The biggest layoffs happened in February 2009, GM let go
about 50,000 people , which was almost 20% of its employees.
GM ended up filing for Chapter 11 bankruptcy protection
Ford Motor - Number of jobs lost since recession began: 15,912
Layoffs people at its core business
Moreover from Ford Motor Credit unit, showing net loss of
$228 million by the end of 2008.
Had to write down $2.1 billion in leases and car loans.
Chrysler - Number of jobs lost since recession began: 13,672
Let go 12,000 its workforce in late 2007, another 5,000
employees lost jobs couple of months later, overall about 25%
of its salaried workers were layoff
Chrysler filed for Chapter 11 bankruptcy protection.

8
Employment statistics
9
What to do… what to do
Of December 2008, three U.S. auto companies: GM, Chrysler
and Ford requested 34 billion avoid bankruptcy. The 3
companies stated that their bankruptcy would trigger 3 million
layoffs within a year, plunging the economy deeper into
recession.
10
What the government did….
January 2009, the Government used $24.9 billion of the $700
Billion bail out fund
$17.4 billion for General Motors and Chrysler
$6 billion for GMAC
$1.5 billion for Chrysler

11
Ford
Solution
s
Ford asked for $9 billion from the government, and a $5 billion
loan from the Energy Department.
Ford would accelerate development of both hybrid and battery-
powered vehicles, also to increase production of smaller cars,
close dealerships, and sell Volvo.
Ford is better off than GM or Chrysler because it had already
mortgaged its assets in 2006.

ECO315 Introduction to Money and BankingWEEK6 Homework (Financia.docx

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