Consider an economy with two consumer banks (one commercial and one investment) and an insurance company. East Westeros Savings Bank, the commercial bank, holds $300M in deposits, $50M in vehicle loans, $60M in student loans, $150M in repos loaned to the investment bank (Ditcher, Quick, and Hyde) and $150M in housing loans. They face a 10% reserve requirement and are holding $20M in excess reserves. The other bank in the economy is an investment bank called Ditcher, Quick, and Hyde LLP, who owe $150M in repos to East Westeros Savings Bank, and own $30M in equities and $120M in mortgage-backed securities. The insurance company, Post Malone Mutual, has sold credit default swaps on the mortgage backed securities owned by Ditcher, Quick, and Hyde AND the repos owned by East Westeros, and currently has $100M in reserves.

1. Write out the T-Accounts for each of the two banks. Be sure to carefully classify the assets and liabilities of each bank, and note the net worth (bank capital).

2. Does Post Malone Mutual have enough money to cover their insurance contracts if they had to pay out the entirety of the contract? Is so, how much extra reserves would they have? If not, how large would their bailout need to be to stay solvent?

3. Suppose that the housing market collapses and the value of housing loans (held by Ditcher, Quick, and Hyde) fall in value by 70% and mortgage-backed securities (held by Dewey, Cheatham, and Howe) fall in value by 40%. Show the effects of this drop in a table. Are the banks still solvent? Be sure to account for changes in the value of debt owed between banks!

4. Calculate the amount that Post Malone Mutual must pay to each bank. Assume that they must satisfy their obligations to Ditcher, Quick, and Hyde before they can pay East Westeros Savings Bank.

5. After paying out this insurance, what happens to both banks? Show this in a T-Account. Are they both still solvent?

Answer rating: 100% (QA)

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