The Wall Street Journal Education Program
Weekly Review & Quiz
Covering front-page articles from Aug 18-24, 2007
Professor Guide with Summaries Fall 2007
Developed by: Scott R. Homan Ph.D., Purdue University
Questions 1 – 12 from The First Section, Section A
In Time of Tumult, Obscure Economist Gains Currency
By JUSTIN LAHART
August 18, 2007; Page A1
http://online.wsj.com/article/SB118736585456901047.html
The recent market turmoil is rocking investors around the globe. But it is raising the stock of one person: a little-known economist whose views have suddenly become very popular. Hyman Minsky, who died more than a decade ago, spent much of his career advancing the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises. At a time when many economists were coming to believe in the efficiency of markets, Mr. Minsky was considered somewhat of a radical for his stress on their tendency toward excess and upheaval.
Today, his views are reverberating from New York to Hong Kong as economists and traders try to understand what's happening in the markets. The Levy Economics Institute of Bard College, where Mr. Minsky worked for the last six years of his life, is planning to reprint two books by the economist -- one on John Maynard Keynes, the other on unstable economies. The latter book was being offered on the Internet for thousands of dollars.
Christopher Wood, a widely read Hong Kong-based analyst for CLSA Group, told his clients that recent cash injections by central banks designed "to prevent, or at least delay, a 'Minsky moment,' is evidence of market failure."
Indeed, the Minsky moment has become a fashionable catch phrase on Wall Street. It refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand.
Mr. Minsky, who died in 1996 at the age of 77, was a tall man with unruly hair who wore unpressed suits. He approached the world as "one big research tank," says Diana Minsky, his daughter, an art history professor at Bard. "Economics was an integrated part of his life. It wasn't isolated. There wasn't a sense that work was something he did at the office."
She recalls how, on a trip to a village in Italy to meet friends, Mr. Minsky ended up interviewing workers at a glove maker to understand how small-scale capitalism worked in the local economy.
Although he was born in Chicago, Mr. Minsky didn't have many fans in the "Chicago School" of economists, who believed that markets were efficient. A follower of the economist John Maynard Keynes, he died just before a decade of financial crises in Asia, Russia, tech stocks, corporate credit and now mortgage debt, began to lend credence to his ideas.
Following those periods of tumult, more investors turned to the investment classic "Manias, Panics, and Crashes: A History of Financial Crises," by Charles Kindleberger, a professor at the Massachusetts Institute of Technology who leaned heavily on Mr. Minsky's work.
Mr. Kindleberger showed that financial crises unfolded the way that Mr. Minsky said they would. Though a loyal follower, Mr. Kindleberger described Mr. Minsky as "a man with a reputation among monetary theorists for being particularly pessimistic, even lugubrious, in his emphasis on the fragility of the monetary system and its propensity to disaster."
At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.
When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.
1. _________, who died more than a decade ago, spent much of his career advancing the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises.
a. Adam Smith
b. Charles Kindleberger
c. John Maynard Keynes
d. Hyman Minsky Correct
2. A fashionable catch phrase on Wall Street that refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand is called _______.
a. Smith moment
b. Dinsky moment
c. Minsky moment Correct
d. Adama moment
How a Panicky Day Led the Fed to Act
By RANDALL SMITH in New York, CARRICK MOLLENKAMP in London, JOELLEN PERRY in Frankfurt and GREG IP in Washington
August 20, 2007; Page A1
http://online.wsj.com/article/SB118755980713302186.html
Strains in financial markets had been evident for weeks, but Thursday, Aug. 16, was different.
As the day dawned in London, $45.5 billion in short-term IOUs issued outside the U.S. by corporations and others were maturing and had to be rolled over. Traders usually have buyers for such paper by lunchtime in London, around 7 a.m. in New York. On this morning, demand had dried up, and it would take the whole day to sell less than half of it, said a person familiar with the market.
At 7:30 a.m. in New York, the largest maker of mortgages in the U.S., Countrywide Financial Corp., said it was tapping $11.5 billion in bank credit lines, a sign that it was unable to raise money in financial markets as it had been.
This was a development more serious than another hedge fund running into trouble. "When you start talking about Countrywide," said one senior Wall Street executive, "that's kind of America. At the end of the day, we're talking about Mom and Pop and the right to own a home."
Just before noon New York time, near the end of the London trading day, the yen suddenly surged against the dollar, rising 2% in just minutes and crushing currency-market players who hadn't anticipated such a sharp move. On the London trading floor of Goldman Sachs Group Inc., phone lines lit up in unison, and some salesmen wielded two phones at the same time. They were shoving and grabbing each other to get in front of traders, and shouting orders to execute trades, according to eyewitnesses.
Shortly afterwards, investors began piling into the shortest-term U.S. Treasury securities, which are considered safe because they're backed by the U.S. government. The yield on three-month bills, which had been around 4%, dropped as low as 3.4%, and the gap between yields on T-bills and corporate commercial paper widened sharply. "It was an extraordinarily violent move," said Jason Evans, head of government-bond trading at Deutsche Bank. "It became clear that the market was at a point of distress and expected a response" from the U.S. Federal Reserve.
These shocks reflected one of the most perilous days for global credit markets, the circulatory system of the international economy, since the 1997-98 crisis that began in Asia, spread to Russia and Brazil and eventually to the U.S.-based hedge fund Long-Term Capital Management.
On Friday morning, following a conference call the previous evening convened by Chairman Ben Bernanke, the Fed blinked. Just 10 days after declaring that inflation was still its predominant worry, the Fed declared "downside risks to growth have increased appreciably" and hinted that it may soon cut its target for short-term rates. In an unusual move, it also encouraged banks to borrow directly from the Fed and made such loans more attractive.
In essence, the Fed is following advice that British journalist Walter Bagehot offered in his 1873 book, "Lombard Street," a copy of which Mr. Bernanke kept on a shelf when he was Princeton professor. In times of "internal discredit" -- when uncertainty leads private players to pull back -- the prescription to the central bank is: Lend freely.
A panic...is a species of neuralgia, and according to the rules of science you must not starve it," Bagehot wrote. "The holders of the cash reserve" -- today's central banks -- "must be ready...to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to 'this man and that man,' whenever the security is good."
Bolstering Confidence
This week, the Fed will find out if it did enough to bolster the confidence that was in such short supply last week, when investors refused to buy or accept as collateral securities that in normal times would be of unquestioned worth. Its critics, including those who say it is too quick to rescue imprudent lenders and borrowers, will be watching for evidence that the Fed went too far.
The initial reaction of U.S. stock and credit markets to Friday's Fed move was favorable. The interest-rate spread between U.S. government bonds and some riskier bonds shrank slightly, while the Dow Jones Industrial Average rose 1.8%. In early Tokyo trading today, stocks surged more than 3%.
It isn't clear yet how many big banks responded to the Fed's encouragement to borrow at what is known as the Fed's discount window. Hard data won't come until the Fed releases its routine tally on Thursday -- unless the Fed or the banks volunteer information. One big bank told the Fed that, though it doesn't need the money and could get it more cheaply, it will borrow $100 million today as a gesture, according to a person familiar with the bank's plans. And one Wall Street firm said it planned to offer collateral to its bank, assuming the bank in turn would offer it to the Fed as collateral for a discount-window loan.
The latest chapter in the credit crisis of 2007, rooted in the deterioration of the market for U.S. subprime mortgages and securities linked to them, represents a new test of the savvy of central banks from Frankfurt to London to Washington to Tokyo. These are the institutions in modern capitalist economies that regulate the supply of credit with the goal of keeping prices from rising too fast and preventing economic downturns from deteriorating into repeats of the Great Depression.
3. British journalist Walter Bagehot offered in his 1873 book, "Lombard Street," that in times of "internal discredit" when uncertainty leads private players to pull back the prescription to the central bank is _______.
a. Lend to the rich
b. Do not Lend
c. Lend freely Correct
d. Increase taxes
4. Central banks from Frankfurt to London to Washington to Tokyo are the institutions in modern capitalist economies that regulate the ______ with the goal of keeping prices from rising too fast and preventing economic downturns from deteriorating into repeats of the Great Depression.
a. supply of banks
b. supply of credit cards
c. supply of debit cards
d. supply of credit Correct
Illinois Tries New Tack Against Predatory Loans
By AMY MERRICK
August 21, 2007; Page A1
http://online.wsj.com/article/SB118765937527803664.html
The Illinois legislature this month passed a law that goes to the heart of the global subprime lending mess that is rattling the housing industry and shaking financial markets from Wall Street to Hong Kong.
The new law will require people in the Chicago area who want to take out a home loan with nontraditional terms -- such as prepayment penalties or interest-only payment options -- to spend an hour or two with a credit counselor so they won't be hoodwinked at the closing table.
President Bush has endorsed such educational efforts, noting in a recent press conference that in many cases "people aren't sure what they're signing up for." The new law, which would go into effect next July, comes as states across the country are rushing to address the rising foreclosure rates that threaten to expel hundreds of thousands of people from their homes.
Yet Illinois's experience to date shows how difficult it is to create even modest safeguards in the home-buying process. A previous pilot program similar to the new law was viciously attacked and rescinded in January, after only a few months. Instead of winning plaudits, the pilot program quickly became mired in charges that it would make it harder for minorities to buy homes. Mortgage brokers, fearing a loss of business, claimed that access to credit would tighten in the neighborhoods targeted by the law. Rumors flew that dozens of lenders had pulled out of the area.
One woman filed a lawsuit saying the program scared away buyers for her home in a working-class neighborhood in the city's so-called Bungalow Belt. A pastor called it "the most racist piece of legislation that we have ever experienced in Illinois."
Now that the new law is expanding the program, the nearly one dozen Department of Housing and Urban Development-approved counseling groups who will be responsible for the measure's success aren't sure they have enough resources to handle the thousands of mortgages they will be expected to review.
At least 30 states, including Illinois, have predatory-lending laws that outlaw or limit specific loan terms, fees and practices. Such laws target practices including "balloon mortgages," which are payable in full after a period of low monthly payments, and "steering," in which a broker profits by recommending a loan with unnecessarily tough terms. But there still are many abuses, and some lenders have adapted to skirt the laws.
The turmoil in the subprime-mortgage market may temporarily suppress the riskiest loan provisions, says Geoff Smith, research director of the Woodstock Institute, a Chicago-based research organization focused on housing and economic-development issues. But in the long term, he says, "you need strong consumer protections, because eventually the market will correct itself, and people will start to make speculative loans again and take much more risk."