Ch. 8 Credit Markets: Direct & Indirect Finance, Loanable Funds, and 2008 Crisis

Direct Finance

Borrowers deal directly with lenders without intermediaries.

Example of Direct Finance

Jen borrowing money from Greg for her car.

How Direct Finance Works

Businesses and governments issue bonds to investors. Investors pay the face value at purchase and redeem at maturity.

Zero-Coupon Bonds

No periodic interest; sold at a discount → redeemed for more than purchase price.

Example of Zero-Coupon Bond

Buy $900 bond → redeem $1,000 in 1 year → ~10% interest.

Corporate Bonds

Often pay semiannual interest (coupon rate).

Indirect Finance

Borrowing/lending through financial intermediaries, like banks.

Why Intermediaries Matter

Spread risk: Thousands of loans reduce default risk.

Credit Evaluation

Banks assess borrowers, reducing risk of non-payment.

Divide Loans

Pool deposits to fund multiple borrowers with different needs.

Match Time Preferences

Align savers' and borrowers' desired loan lengths.

Interest Rate Role

Reward for saving: Higher rates → more saving. Cost for borrowing: Higher rates → less borrowing.

Equilibrium in Loanable Funds

Borrowers and lenders agree on interest rates and loan amounts.

Government Intervention

Can cause shortages (e.g., usury laws).

Examples of Interest Rates

US government bonds: ~4.6%, Mortgage loans: ~6.8%, Credit cards: high due to risk, unsecured nature, administrative costs.

Market Shifts

Increase in savings: Supply ↑ → interest rates ↓ → encourages investment.

Increase in Demand for Loans

Interest rates ↑ → more funds supplied.

Key Players in Loanable Funds Market

Federal Reserve: Can create money → lower interest rates temporarily.

US Government Role

Borrows heavily → increases demand for funds → raises interest rates.

Crowding Out

Government borrowing → reduces private investment.

Direct Crowding Out

Private spending reduced by government spending.

Indirect Crowding Out

Higher interest rates → businesses/consumers borrow less.

Value Creation in Credit Markets

Enable investment: Borrow to start a business → generate income.

Efficient Resource Allocation

Move funds to those with skills, motivation, or opportunities.

Example of Value Creation

Hot dog stand: Borrowing allows earlier income creation.

Leveraged Buyouts

Buying undervalued assets → reallocating resources to higher-value use.

Bankruptcy

Reallocates resources from poorly managed firms to more productive owners.

Bastiat's Lessons in Credit

Government actions can raise interest rates by reducing supply of loanable funds.

Savings and Spending

Can increase value, but it comes from reallocating resources efficiently.

Taxes on Savings

Can reduce economic activity, even if they only transfer money between groups.

2008 Financial Crisis Trigger

Collapse in housing prices.

Root Causes of 2008 Crisis

Poor Fed policies dating back to the Great Depression.

Key Institutions in Crisis

Fannie Mae & Freddie Mac: Bought home loans → encouraged lending.

Crisis Mechanism

Housing bubble → defaults → mortgage-backed securities lose value → financial system destabilized.

Government Intervention in Crisis

Attempted to prevent bankruptcies but sometimes reduced resource reallocation efficiency (e.g., GM bailout).