ECON 143 UOP Finance Corporations and Society Problem Set

BusGen143/Econ 143/Public Policy 143/Sustain 143/
Political Science 127A/International Policy Studies 227
Finance, Corporations and Society
Fall 2023
Professor Anat Admati
Problem Set #5
Due: Sunday, November 12, 2023, 11:59 pm
Note: You can discuss the problems with classmates but you must submit your individual
write-up of the solutions. Please submit your solutions on Canvas.
1. Guarantees, Subsidies and Size
Consider Table 9.2 on page 134 of Bankers’ New Clothes. Suppose Aunt Claire agrees to
guarantee Kate’s mortgage if Kate buys a house for $1,000,000 (one million dollars). That is,
if the value of the house is less than the mortgage amount due, Aunt Claire will make up for
this difference. The bank agrees to lend to Kate for this purpose at 3% interest (with the entire
loan plus interest paid in one year). At the end of one year, Kate sells the house and pays the
mortgage (with Aunt Claire’s help if necessary). Assume that Aunt Claire can fulfil the
guarantees even if the house loses its entire value.
a) Replicate the table by calculating Kate’s cash position as well as Aunt Claire’s at the end
of one year if Kate invests $30,000 of her own money (as in the top panel) and borrows
$970,000. Calculate Kate’s return per dollar (“ROE”) in all these cases. Do the same for
the case Kate invests just $10,000 in down payment and borrows $990,000. The five
scenarios should include the same percentage changes in the value of the house (i.e.,
15%, 5%, 0%. -5% and -15%).
b) Suppose Kate has $30,000 that she can invest, and consider the following two plans
i.
invest the entire $30,000 in a $1 million house as down payment (borrowing
$970,000 at 3%),
ii.
invest $10,000 in the $1 million house (borrowing $990,000 at 3%), and
$20,000 in a Treasury bill paying 3% a year (in one payment).
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In both cases assume Kate has the guarantee from Aunt Claire (so you can refer to the
calculations you did in Part (a) above as appropriate). Calculate Kate’s cash position after
the house is sold, the mortgage is paid, and Kate receives interest on her $20,000 if she
invested it in the bond under all the five scenarios for the percentage change in the value
of the house. Calculate her return per dollar (“ROE”) in all these cases. What do you
observe?
c) If Kate can choose how much to spend on a house (up to $1 million) and how much in
down payment she would prefer to make (any amount above $10,000), can you determine
what she would choose if she has Aunt Claire’s guarantee? How would the answer change
if she does not have the guarantee?
d) What does the above discussion imply about the choice of size and funding mix for
institutions that benefit from explicit or implicit government guarantees relative to other
corporations?
2. BPI “Tutorial” on the Economics of Funding
This video is presented as a “capital 101” tutorial on a website aimed to “Stop Basel Endgame.”
The website was created by the Bank Policy Institute (BPI), which defines itself as a
“nonpartisan public policy, research and advocacy group, representing the nation’s leading
banks.” Find at least one flawed claim in the video regarding the cost of funding businesses,
corporations and banks with more equity (or “capital”) and explain why it is flawed based on
our class discussion and on the material in BNC. Make specific citations to class slides and/or
required readings in your answer.
3. Weird Lenders
Read the article “The Dangerous Role of America’s Weird Lenders-of-Next-to-Last Resort,”
Stephen Cecchetti, Kim Schoenholtz, and Lawrence White, Financial Times, August 17, 2023
(Link) and answer in no more than 150 words in total.
a. How do the Federal Home Loan Banks (FHLBs) interact with banks, what is special about
the terms of the loans they make, and what is the impact of these loans on the FDIC?
b. Why do the authors view the role of the FHLB system as dangerous?
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