Page 269 - Krugmans Economics for AP Text Book_Neat

Loan-backed Securities Loan-backed securities, assets created by pooling individ-
ual loans and selling shares in that pool (a process called securitization), have become ex-
tremely popular over the past two decades. While mortgage-backed securities, in which
thousands of individual home mortgages are pooled and shares sold to investors, are
the best-known example, securitization has also been widely applied to student loans,
credit card loans, and auto loans. These loan-backed securities trade on financial mar- Section 5 The Financial Sector
kets like bonds and are preferred by investors because they provide more diversification
and liquidity than individual loans. However, with so many loans packaged together, it
can be difficult to assess the true quality of the asset. That difficulty came to haunt in-
vestors during the financial crisis of 2007–2008, when the bursting of the housing bub-
ble led to widespread defaults on mortgages and large losses for holders of “supposedly
safe” mortgage-backed securities, causing pain that spread throughout the entire fi-
nancial system.
Stocks A stock is a share in the ownership of a company. A share of stock is a financial
asset from its owner’s point of view and a liability from the company’s point of view. Not
all companies sell shares of their stock; “privately held”
companies are owned by an individual or a few partners,
who get to keep all of the company’s profit. Most large
companies, however, do sell stock. For example, as this
book goes to press, Microsoft has nearly 9 billion shares
outstanding; if you buy one of those shares, you are en-
titled to one-nine billionth of the company’s profit, as
well as 1 of 9 billion votes on company decisions.
Why does Microsoft, historically a very profitable
company, allow you to buy a share in its ownership?
Why don’t Bill Gates and Paul Allen, the two founders © PhotoSpin, Inc/Alamy
of Microsoft, keep complete ownership for them-
selves and just sell bonds for their investment spending
needs? The reason, as we have just learned, is risk: few individuals are risk -tolerant
enough to face the risk involved in being the sole owner of a large company.
Reducing the risk that business owners face, however, is not the only way in which
the existence of stocks improves society’s welfare: it also improves the welfare of in-
vestors who buy stocks (that is, shareowners, or shareholders). Shareowners are able
to enjoy the higher returns over time that stocks generally offer in comparison to
bonds. Over the past century, stocks have typically yielded about 7% after adjusting
for inflation; bonds have yielded only about 2%. But as investment companies warn
you, “Past performance is no guarantee of future performance.” And there is a down-
side: owning the stock of a given company is riskier than owning a bond issued by the
same company. Why? Loosely speaking, a bond is a promise while a stock is a hope: by
law, a company must pay what it owes its lenders (bondholders) before it distributes
any profit to its shareholders. And if the company should fail (that is, be unable to pay
its interest obligations and declare bankruptcy), its physical and financial assets go to
its bondholders—its lenders—while its shareholders typically receive nothing. So, al-
though a stock generally provides a higher return to an investor than a bond, it also
carries higher risk.
The financial system has devised ways to help investors as well as business owners si-
multaneously manage risk and enjoy somewhat higher returns. It does that through
the services of institutions known as financial intermediaries.

Financial Intermediaries
A loan-backed security is an asset
A financial intermediary is an institution that transforms funds gathered from created by pooling individual loans and selling
many individuals into financial assets. The most important types of financial inter- shares in that pool.
mediaries are mutual funds, pension funds, life insurance companies, and banks. About three- A financial intermediary is an institution
quarters of the financial assets Americans own are held through these intermediaries that transforms the funds it gathers from
rather than directly. many individuals into financial assets.

module 22 Saving, Investment, and the Financial System 227