Chapter Two: An Economic

Analysis of Financial Structure

3.1. Basic Puzzles About Financial Structure Around
the World

 The Financial system is complex in structure and function

throughout the world.
 It includes many different types of institutions: banks,
insurance companies, mutual funds, stock and bond markets,
and so on…all of which are regulated by government.
 A healthy and vibrant economy requires a financial
system that moves funds from people who save, to
people who have productive investment opportunities.
The bar chart in Figure below shows how Canadian, Germany,
Japan, and the United States businesses financed their activities
using external funds from 1870s to 2000s.
The Bank Loans category is made up
primarily of loans from depository institutions.
 Nonbank Loans is composed primarily of
loans by other financial intermediaries.
 The Bonds category includes marketable debt
corporate bonds and
securities such as
commercial paper.
Stock consists of new issues of new equity
(stock market shares).
 The financial system channels billions of dollars
per year from savers to people with productive
investment opportunities.
 If we take a close look at financial structure all
over the world, we find eight basic
puzzles that we need to solve in order to
understand how the financial system works.
1. Stocks are not the most important source of
external financing for businesses.
 Why is the stock market is less important
than other source of financing ?
2. Issuing marketable debt and equity securities is not the
primary way in which businesses finance their operations.
Stocks and bonds combined (27%), make up the total
share of marketable securities, supply less than one-
third of the external funds corporations need to
finance their activities.
Why don’t businesses use marketable securities more

extensively to finance their activities?

3. Indirect finance, which involves the activities of
financial intermediaries, is many times more
important than direct finance, in which businesses
raise funds directly from lenders in financial
markets.
Of the 27% share of stocks and bonds as a source of
external financing for businesses, only a small fraction
of newly issued corporate bonds, commercial paper,
and stocks are sold directly to households. The rest of
these securities are bought primarily by financial
intermediaries such as insurance companies, pension
funds, and mutual funds.
 Why are financial intermediaries and indirect finance so
important in financial markets?...... Transaction Costs
4. Financial intermediaries, particularly banks, are the
most important source of external funds used to finance
businesses.
The primary source of external funds for businesses
throughout the world are loans made by banks and other
nonbank financial intermediaries such as insurance
companies, pension funds, and finance companies (56% in the
United States, but over 70% in Japan, Germany, and Canada).
The same is true in other industrialized countries.
In developing countries, banks play an even more important
role in the financial system than they do in the industrialized
countries.
 What makes banks so important to workings of the financial
system?
5.The financial system is among the most heavily
regulated sectors of the economy.
The financial system is heavily regulated in
developing and all developed countries.
Governments regulate financial markets
primarily to promote the provision of
information, and to ensure the soundness
(stability) of the financial system.
 Why are financial markets so extremely regulated throughout the
world?
6. Only large, well-established corporations have easy access to
securities markets to finance their activities.
Individuals and smaller businesses that are
not well established are less likely to raise
funds by issuing marketable securities.
Instead, they most often obtain their
financing from banks.
 Why do only large, well known corporations have the ability to raise funds in
the security markets?
7. Collateral is a prevalent feature of debt
contracts for both households and businesses.
Commercial and farm mortgages, for which

property is pledged as collateral, make up one-

quarter of borrowing by nonfinancial businesses;
corporate bonds and other bank loans also often
involve pledges of collateral.
Why is collateral such an important feature of debt contract?
8. Debt contracts typically are extremely
complicated legal documents that place
substantial restrictions on the behavior of the
borrower.
Many think of a debt contract as a simple I Owe You
that can be written on a single piece of paper. The
reality of debt contracts is far different, however.
In all countries, bond or loan contracts typically are
long legal documents with provisions (called
restrictive covenants) that restrict and specify
certain activities that the borrower can engage in.
Why are debt contracts are so complex and restrictive?
3.2. Transaction Cost and Asymmetric Information
1.Transaction Costs
Transaction costs are a major problem in financial markets.

Transaction costs are the time and money spent in carrying

out financial transactions.

 They include contracting costs, brokerage fees,
commission....etc.
 Transaction costs are a major problem in financial markets. They

are specially too high for ordinary people.

If one try to avoid the transaction costs of large number of small
transactions, he/she has to put all his/her eggs in one basket, and
the inability to diversify will result to a lot of risk…..Risk vs T.cost….
 Financial intermediaries help in reducing transaction costs and allow small savers
and borrowers to benefit from the existence of financial markets through:
1. Economies of Scale
One solution to the problem of high transaction costs is to bundle the funds

of many investors together so that they can take advantage of economies of

scale, the reduction in transaction costs per dollar of investment as the size
(scale) of transactions increases.
Economies of scale exist because the total cost of carrying out a transaction in

financial markets increases only a little as the size of the transaction grows.
For example, the cost of arranging a purchase of 10000 shares of stock is not

much greater than the cost of arranging a purchase of 50 shares of stock.

 Eg. Mutual Funds
The presence of economies of scale in financial markets helps

explain why financial intermediaries developed and have

become such an important part of our financial structure.
The clearest example of a financial intermediary that
arose because of economies of scale is a mutual
fund.
A mutual fund is a financial intermediary that sells shares to

individuals and then invests the proceeds in bonds or stocks.

Because it buys large blocks of stocks or bonds, a mutual fund can

take advantage of lower transaction costs.

2. Expertise
Financial intermediaries also arise because they are

better able to develop expertise to lower transaction

costs.
Their expertise in computer technology enables them to
offer customers convenient services like being able to
call a toll-free number for information on how well their
investments are doing and to write Cheques on their
accounts.
3.3. Asymmetric Information: Adverse
Selection and Moral Hazard
A, Asymmetric Information
Asymmetric information is a situation that arises when one
party’s insufficient knowledge about the other party involved
in a transaction makes it impossible to make accurate
decision when conducting the transaction.
 A borrower has better information about his
future income than the lender
 Managers know more about health of the
company than stockholders
The presence of asymmetric information leads to adverse

selection and moral hazard problems.

B, Adverse Selection
Adverse selection problem occurs before the transaction

 Because of asymmetric information problem of

adverse selection, the potential buyer of stocks or
bonds can’t distinguish between good firms with
high expected profits and low risk and bad firms
with low expected profits and high risk.
Thus the parties who are the most likely to

produce undesirable outcome are most likely to

want to engage in the transaction.

Big risk takers might be the most

eager to take out the loan because

they know that they are unlikely to
pay it back.
C, Moral Hazard
Moral hazard arises after the transaction cost.

The risk that the borrower will engage in activities that

are undesirable from the lender’s point of view because

they make it less likely that the loan will be paid back.
The borrower who obtain the loan engage in activity

with greater return and risk as he is playing with

someone else’s money.
Because moral hazard lowers the probability that the loan
will be repaid, lenders may decide that they would rather not
make a loan.
3.4.The Lemons Problem: How Adverse Selection
Influences Financial Structure
A particular characterization of how the adverse selection

problem interferes with the efficient functioning of a

market was outlined in a famous article by Nobel Prize
winner George Akerlof.
It is called the lemons problem because it resembles the

problem created by lemons in the used-car market.

Potential buyers of used cars are frequently unable to

assess the quality of the car; that is, they can’t tell
whether a particular used car is a car that will run
well or a lemon that will continually give them
grief.
 The price that a buyer pays must therefore reflect the

average quality of the cars in the market, somewhere

between the low value of a lemon and the high value
of a good car.
The owner of a used car, by contrast, is more likely to know

whether the car is a peach or a lemon.

If the car is a lemon, the owner is more than happy to sell it at

the price the buyer is willing to pay, which, being somewhere

between the value of a lemon and a good car, is greater than
the lemon’s value.
 However, if the car is a peach, the owner knows that the car is

undervalued at the price the buyer is willing to pay, and so the

owner may not want to sell it.
As a result of this adverse selection, few good used cars will

come to the market.

3.4.1.Lemons in the Stock and Bond Markets
Suppose that you want to invest in stock, but unable to distinguish

between good firms with high expected profits and low risk and bad
firms with low expected profits and high risk.
If the owners or managers of a good firm have better information

than you and know that they are a good firm, they know that their
securities are undervalued and will not want to sell them to you at
the price you are willing to pay.
The only firms willing to sell you securities will be bad firms

(because his price is higher than the securities are worth). You are
not stupid that; you do not want to hold securities in bad firms, and
hence you will decide not to purchase securities in the market.
You will also buy a bond only if its interest rate is high enough

to compensate you for the average default risk of the good and
bad firms trying to sell the debt.
The knowledgeable owners of a good firm realize that they will

be paying a higher interest rate than they should, and so they

are unlikely to want to borrow in this market.
 Only the bad firms will be willing to borrow, and because

investors like you are not eager to buy bonds issued by bad
firms, they will probably not buy any bonds at all.
Few bonds are likely to sell in this market, and so it will

not be a good source of financing……… Fact 1 and Fact 2

3.4.2.Tools to Help Solve Adverse Selection Problems
In the absence of asymmetric information, the lemons

problem goes away.

Similarly, if purchasers of securities can distinguish

good firms from bad, they will pay the full value of
securities issued by good firms, and good firms will sell
their securities in the market.
The securities market will then be able to move funds

to the good firms that have the most productive

investment opportunities.
Some of the tools to mitigate Adverse Selection

Problems include:
1. Private Production and Sale of Information

The solution to the adverse selection problem in

financial markets is to eliminate asymmetric
information by furnishing people supplying funds with
full details about the individuals or firms seeking to
finance their investment activities.
One way to get this material to saver-lenders is to have
private companies collect and produce information that
distinguishes good from bad firms and then sell it.
The system of private production and sale of information does

not completely solve the adverse selection problem in securities

markets, however, because of the so-called free-rider
problem.
The free-rider problem occurs when people who do not pay for

information take advantage of the information that other

people have paid for.
Those who didn’t pay for the information may follow those who

paid for and purchase the same securities and get equal profit
with those who paid for the information…… Free Riding….
This situation may discourage those who pay for

information and they refrain from paying for

information produced by private firms.
This in turn weakened the ability of private firms to

produce information and profit from selling information.

The weakened ability of private firms to profit from

selling information will mean that less information is

produced in the marketplace, and so adverse selection
(the lemons problem) will still interfere with the efficient
functioning of securities markets.
2. Government Regulation to Increase Information
The government could, for instance, produce
information to help investors distinguish good from
bad firms and provide it to the public free of charge.
It is not always effective as government affiliated firms may

be favored.
A second possibility applied by most governments

throughout the world is for the government to regulate

securities markets in a way that encourages firms to
reveal honest information about themselves so that
investors can determine how good or bad the firms are.
 Governments regulations require firms selling
securities to have independent audits, in which
accounting firms certify that the firm adheres to
standard accounting principles and discloses
information about sales, assets, and earnings.
Although government regulation lessens the adverse selection

problem, it does not eliminate it.

Even when firms provide information to the public about their sales,

assets, or earnings they still have more information than investors.

There is a lot more to knowing the quality of firms than statistics can

provide.

Bad firms have an incentive to make themselves look like good firms

(Window Dressing) because this would enable them to fetch high

price for their securities.

However, disclosure requirements do not always work

well, as the recent collapse of Enron and accounting

scandals at other corporations, such as WorldCom.

Asymmetric information problem of adverse selection

in the financial market helps explain why the financial

markets are among the most heavily regulated sectors
in the economy…….... (Fact 5).
3. Financial Intermediation
Will you buy used Cars from the used car Dealer

him/herself?
Will you fully depend on information you get from

medias about the Used Car to be sold by the Dealer?

What if you purchase from an intermediary, a used-car

dealer who purchases used cars from individuals and

resells them to other individuals?
Just as used-car dealers help solve adverse selection problems in

the automobile market, financial intermediaries play a

similar role in financial markets.
A financial intermediary such as a bank becomes an expert in

producing information about firms so that it can sort out good

credit risks from bad ones.
Then it can acquire funds from depositors and lend them to the

good firms.
Because the bank is able to lend mostly to good firms, it is able

to earn a higher return on its loans than the interest it has to pay
to its depositors.
An important element in the bank’s ability to profit from the

information it produces is that it avoids the free-rider problem

by primarily making private loans rather than by purchasing
securities that are traded in the open market.
Because a private loan is not traded, other investors cannot

watch what the bank is doing and bid up the loan’s price to
the point that the bank receives no compensation for the
information it has produced.
 The bank’s role as an intermediary that holds mostly non-

traded loans is the key to its success in reducing asymmetric

information in financial markets.
Financial intermediaries in general, and banks in

particular because they hold a large fraction of non-

traded loans, should play a greater role in moving
funds to corporations than securities markets do.
Our analysis thus explains facts ……3 and …..4: why

indirect finance is so much more important than

direct finance and why banks are the most important
source of external funds for financing businesses.
Another important fact that is explained by the analysis here

is the greater importance of banks in the financial systems of

developing countries.
When the quality of information about firms is better,

asymmetric information problems will be less severe, and it

will be easier for firms to issue securities.
Information about private firms is harder to collect in

developing countries than in industrialized countries;

therefore, the smaller role played by securities markets
leaves a greater role for financial intermediaries such as
banks.
A corollary of this analysis is that as information about firms

becomes easier to acquire, the role of banks should decline.

The better known a corporation is, the more information

about its activities is available in the marketplace and it is

easier for investors to evaluate the quality of the corporation
and determine whether it is a good firm or a bad one.
The analysis explains ………fact 6, which questions why

large firms are more likely to obtain funds from securities

markets, a direct route, rather than from banks and financial
intermediaries, an indirect route.
4. Collateral and Net worth
Adverse selection interferes with the functioning of financial

markets only if a lender suffers a loss when a borrower is

unable to make loan payments and thereby defaults.
Collateral, property promised to the lender if the borrower

defaults, reduces the consequences of adverse selection

because it reduces the lender’s losses in the event of a default.
The presence of adverse selection in credit markets
thus provides an explanation for why collateral is an
important feature of debt contracts ………(fact 7).
Net worth (also called equity capital), the difference

between a firm s assets (what it owns or is owed) and

its liabilities (what it owes), can perform a similar role
to collateral.
If a firm has a high net worth, then even if it engages

in investments that cause it to have negative profits

and so defaults on its debt payments, the lender can
take title to the firm’s net worth, sell it off, and use the
proceeds to recoup some of the losses from the loan.
3.5.How Moral Hazard Affects the Choice
Between Debt and Equity Contracts

Moral Hazard in Equity Contracts: The Principal-Agent Problem

Equity contracts are subject to a particular type of moral

hazard called the principal agent problem.

 The stockholders who own most of the firm's equity (the

principals) are not the same people as the managers of the

firm who may own only a small fraction of the firm they work
for (the agents of the owners).
The principal-agent problem would not arise if there were no

separation of ownership and control- that is the owner is

the manager.
This separation of ownership and management involves

moral hazard.
The managers in control (the agents) may act in their own

interest rather than in the interest of the owners (principals)

because the managers have less incentive to maximize
profits than stockholders do.
Thus, the managers may
1) Not provide a quick and friendly service to the
firm’s customers
2) Spend money unnecessarily on decoration and
artificial issues
3) Waste time in their own personal leisure
4) Not be honest with the firm’s owner
5) Divert funds for their own personal use,
6) Pursue corporate strategies that enhance their
own personal power but do not increase the
firm’s profitability.
• The principal-agent problem, which is an example of
moral hazard, is a result of lack of information about
the actions of managers; a manager has more
information about his activities than the stockholder
does, asymmetric information.
 This problem would not arise if the owners of the

firm had complete information about what the

managers were up to and could prevent wasteful
expenditures and fraud.
3.5.1.Tools to Help Solve the Principal-Agent Problem

1.Producing of Information: Monitoring

 One way for stockholder to reduce this moral hazard problem is to

monitor the firm’s activities through different monitoring process such as

auditing and a continuous evaluation of management.

The problem is that monitoring process can be costly in terms

of time and money; what Economists Name Costly State

Verification.
 Costly state verification makes equity contract less

desirable………….. Fact 1
Because it is expensive to monitor, the free rider problem occurs

which decreases the possibility to monitor the firm properly.

 If you know that other stockholders are paying to monitor the

activities of the firm you hold shares in, you can take a free ride
on their activities and save yourself some expenses.
 The problem occurs when every stockholder think the same.

The result is no one will spend any resources to monitor the

firm.

This explains, in part, why equity is not the

most important element in our financial
structure too…..…..Fact 1
2. Government Regulation to increase information
As with adverse selection, the government has an incentive

to try to reduce the moral hazard problem created by

asymmetric information, which provides another reason why
the financial system is so heavily regulated……….. Fact 5.
Governments pass laws to impose stiff criminal penalties on

people who commit the fraud of hiding and stealing profits.

However, these measures can only be partly effective.

 Fraudulent managers have the incentive to make it

very hard for government agencies to find or prove
fraud.
3. Financial Intermediation
 Financial intermediation has the ability to avoid the free-rider problem in

the face of moral hazard, and this is another reason why indirect finance is
so important…….. Fact 3
One financial intermediary that helps reduce the moral hazard
arising from the principal agent problem is the venture capital
firm.
 Venture capital pools the resource of their partners and use the funds to
help new entrepreneur to establish new business firm.
 They receive an equity share in the new business and puts some of its
own people in the management team of the new firm so that they
can keep close watch on the firm’s activities.
4. Debt Contracts
Moral hazard arises with an equity contract, which is a claim on

profits in all situations, whether the firm is making or losing money.

Debt contract is an agreement whereby the borrower pays the lender a

fixed amount at periodic intervals.

As long as the lender receives the agreed amount, he does not care

whether the firm is making profit or suffering a loss- does not care about
moral hazard
 The less frequent need to monitor the firm, and thus the lower cost
of state verification, helps explain why debt contracts are used more
frequently than equity contracts to raise capital
 Fact 1
3.6.How Moral Hazard Influences Financial
Structure in Debt Markets
Even with the advantages over equity contract, debt

contracts are still subject to moral hazard.

 Because a debt contract requires the borrower to pay out a fixed

amount and lets him keep any profits above this amount,
then borrower has an incentive to take on investment projects
that are riskier than the lenders would like.
As the Borrower may Sow in Risky projects it is inevitable

to worry as to where the lender’s cash would go.

3.6.1.Tools to Help Solve Moral Hazard in Debt Contract

1.Net Worth and Collateral

When the net worth is high or the collateral is

valuable, the risk of moral hazard will be highly

reduced because the borrower himself have a
lot to lose.
Fact 7
2. Monitoring and Enforcement of
Restrictive Covenants
Lenders can ensure that the borrower uses the fund for the

purpose it has been agreed upon by writing provisions

(restrictive covenants) into the debt contract that restrict the
borrower’s activities in order to reduce moral hazard.
 Then the lenders can monitor the borrower’s activities to see

whether he is complying with the restrictive covenants or

not.
There are four types of restrictive covenants:

1.Covenants to discourage undesirable behaviour….covenants to

restrict investment in certain risky sectors

2.Covenants to encourage desirable behaviour… covenants that

require to have high net worth, reserving certain assets relative
to firm size
3.Covenants to keep collateral valuable… Covenant that require to
keep collaterals in good condition
4.Covenants to provide information……Restrictive covenants
also require a borrowing firm to provide information about its
activities periodically in the form of quarterly financial
statements.
3. Finance Intermediation
Although restrictive covenants help reduce the moral

hazard problem, they do not eliminate it completely.

 Borrower may be clever enough to find loopholes in

restrictive covenants that make them ineffective.

A restrictive covenant is meaningless if the borrower can

violate it knowing that the lender won’t check up or is

unwilling to pay for legal recourse.
3.7.Financial Crisis and the Aggregate Economic Activity
A financial crisis is a major disruption in financial markets

that is characterized by a sharp decline in asset prices and the

failure of many financial and nonfinancial firms.
Financial crises primarily result from information problems.

Financial crises arise when disruptions to the financial system

(from whatever source) cause such a large surge in adverse

selection and moral hazard problems that financial markets
are unable to channel funds efficiently from savers to
investors.
Because monitoring and enforcement of restrictive
covenants are costly, the free rider problem arises in the
debt securities (bond) market just as it does in the stock
market.
financial intermediaries, particularly banks, have the ability

to avoid the free-rider problem as long as they primarily

make private loans.
Private loans are not traded, so no one else can free-ride on

the intermediary’s monitoring and enforcement of the

restrictive covenants.
………………..Fact 3 and 4
For example, the United States experienced
major financial crises in 1819, 1837, 1857, 1873,
1884, 1893, and 1907, in the first three years of
the "Great Depression" (1929-1939), and in
2007-2011.
Financial crises in relatively well developed countries such

as the U.S. tend to be triggered by FOUR TYPES OF

FACTORS:

(1) Increases in Interest Rates

(2) Increases in Lender Uncertainty

(3) Asset Market Effects on Balance Sheets

(4) Problems in the Banking Sector
In emerging market countries (e.g., Mexico, Argentina,

Thailand) tend to be triggered by these four factors PLUS

ONE ADDITIONAL FACTOR:
(5) Government Fiscal Imbalances.
(1) Increases in Interest Rates
Individuals and firms with the riskiest investment projects are

those who are willing to pay highest interest rates

If market interest rates are driven up because of increased

demand for credit or because of a decline in the money supply

Good credit risks are less likely to want to borrow

Bad credit risks are still willing to borrow

Because of the resulting increase in adverse selection, lenders

will no longer want to make loans

The decline in lending will lead to a decline in investment and

aggregate economic activity

An increase in interest rates also leads to higher interest

payments and a decline in firms’ cash-flow

With less cash flow, the firm has fewer internal funds and must

raise funds from an external source, e.g. bank, which does not
know the firm as its owners or managers know it.
Bank can not be sure if the firm will invest in safe projects or

instead take on big risk and then unlikely to pay back the loan
and hence, the bank may choose not to lend even for firms with
good risks to undertake investments which further affects
economic activity
Suppose the market for loanable funds is currently in a

demand=supply equilibrium at some interest rate i*,

Suddenly, for some reason, there is a leftward shift in the

supply curve for loanable funds. That is, at each interest

rate level, lenders are less willing than before to supply
loanable funds.
Consequently, at the original interest rate level i*, there is

now an excess demand for loanable funds.

Such a situation is referred to as a credit crunch.
In this case, adverse selection may become a problem.

Lenders, anticipating this adverse selection effect, may

then become discouraged from lending, which would

shift the supply curve even further to the left.
 The result could be a substantial decline in

investment, hence dimmed prospects for economic

growth and development.
2. Increases in Lender Uncertainty
A dramatic increase in uncertainty in financial markets,

perhaps due to the failure of a prominent financial and

nonfinancial institutions, a recession, or a stock market
crash, makes it harder for lenders to screen good from
bad credit risk
The resulting makes lenders less willing to lend, which

leads to a decline in lending, investment, and aggregate

economic activity.
3. Asset Market Effects on Balance Sheets (Real Net Worth)
A sharp decline in the stock market is one factor that can cause a

serious deterioration in firms’ balance sheets

 A decline in the stock market means that net worth of

corporations has fallen, because share prices are the valuation of

corporation’s net worth
 The net worth of corporations play similar role as a collateral

 When the value of a collateral declines, it provides less

protection to lenders
 Because lenders are less protected, they decrease their lending,
which in turn causes investment and aggregate output decline
4. Problems in the Banking Sector ( Bank Panics)
 Banks play a major role in financial markets because they

provide information-producing activities

The state of bank’s balance sheet has an important effect on

bank lending
If banks suffer a deterioration in their balance sheet and so

have a contraction in their capital, they will have fewer

resources to lend and bank lending will decline.
The contraction in lending then leads to a decline in

investment spending, which slows economic activity.

Banks will start to fail and fear can spread from one bank to another,
causing even healthy banks to go under
 The multiple bank failures that result are known as a bank panic

In a panic, depositors, fearing for the safety of their deposits and not

knowing the quality of banks’ loan portfolios, withdraw their

deposits to the point that the bank fail
The failure of a large number of bank in a short time period means

that there is a loss of information production in financial markets

and a direct loss of bank’s financial intermediations
The decrease in bank lending during a financial crisis decreases the

supply of funds available to borrowers, which leads to higher interest

rates
5. Government Fiscal Imbalances
Government fiscal imbalances (budget deficits) are a particular

problem for many emerging market economies.

Government fiscal imbalances can lead to increased fears of

default on the government debt, forcing the government to sell

any new bond issue to banks rather than to private investors
(assuming government can exert sufficient pressure on banks
to buy its bonds).
3.7.1.Subprime Crisis 2007-2011
Subprime refers to a classification of borrowers who are

less likely to pay back a loan or, in other word, not

creditworthy are therefore, considered to be high risk for
the lenders.
The borrowers will have to carry higher interest rate for

the subprime loan.

Many experts and economists believe it came about

though the combination of a number of factors in which

subprime lending played a major part.
The Causes of Subprime Crisis

1. Regulatory Policies
 In 1977, the increment in house ownerships has been
stimulated by the Community Reinvestment Act which
inspired the commercial banks and any other saving
associations to extend loans in order to support the home
possession.
Similarly, the American Dream Down Payment Act of 2003

has been announced with an aim to allow about $200 million

per year to support the low income Americans and minorities
with tarnished credit as well as to expand the limitation of loan
for the first time home buyers.
The policy force the banks to take risk by lending to people

who are not credit worthy.

2. Effect of Decline in Interest Rates
Furthermore, after dot com crisis and 9/11 tragedy, the policy

to boost the troubled economy by reduction of interest rate

was continually announced by Federal Reserve Board.
Declining in interest rate was reduced from 6.5 percent to

eventually to 1 percent in late of 2004.

 Despite the reduction the interest rate played an important

role in stimulation of investment and employment, it also

encouraged and extended the risk taking behaviour of banks
and financial institutions.
3. Credit Rating Agencies