Assignment: TERM PAPER

Part 2 of the Term Paper is optional for some students.

1. Students who did not submit Part 1 of the paper will have their score on Part 2 counted as their overall paper score.

2. Students who received a C or D on Part 1 will receive the higher of their scores on Part 1 and Part 2 counted as their overall term paper score. If they fail to do Part 2, their scores from Part 1 and 2 will be averaged together.

3. Students who received an A or B on Part 1 will have the higher of their scores on Part 1 and Part 2 plus 10 points counted as their overall term paper score. The score on Part 2 must be at least a B to receive the 10 point bonus. If they do not turn in a paper their score on Part 1 will be counted as their overall paper score.

Readings for paper:

1. The Big Short by Michael Lewis.

Introduction:

In non-capitalist countries like Communist China (described in MacGregor's The Party) there is one dominant way of getting rich. One must be a member of the ruling elite and use that membership to gain an unfair advantage in the marketplace. The unfair advantage can take many forms, exclusion of foreign competitors, e.g. keeping Google and Gmail out of the Chinese market, a monopoly on the ownership of a natural resource, destruction of competitors through bureaucratic action, preferential access to credit, or simply jailing competitors. In the few cases, where people in non-capitalist countries get rich without an unfair advantage, being a member of the ruling elite (or at least bribing one of them) is required to maintain and protect that wealth. Non-members have no chance of getting and staying wealthy.

In capitalist free market societies, ordinary people can get and stay rich on their own. One way is to invent a new product or a more efficient way of producing an existing one. An example of the latter, described in The Frackers, is technological innovations in oil production which lowered the cost of extracting oil in certain geologic rock formations. Once the technological innovation was discovered people used the free market to capture a portion of the innovation's value making themselves rich. Drilling rights that were worth little without the new technology were bought and when the technologies benefits became widely known, the new owners profited greatly from producing oil cheaply using the new technology and from the capital appreciation of their drilling rights. Ordinary people with no political power or connections got rich.

A second way is by betting/investing on new products that will be highly demanded or a new technology that will lower the cost of producing existing products. Those who bought Microsoft stock or Google stock before they dominated the operating system and search engine markets profited greatly without actually inventing any new technology or creating a new product. Early investors got rich not by creating new products or discovering new technologies themselves, they got rich by anticipating which products and technologies would ultimately succeed and using financial markets to bet on them.

A related way of getting rich is described in The Big Short. The Big Short tells the story of how economically savvy investors predicted how demand for a good would change in the future and used financial markets to bet on their prediction.

A key feature of this story is how these investors used exotic financial instruments to create leverage, i.e. used exotic financial instruments so that for each $1 they bet they would win hundreds or thousands of dollars if they were proved correct.

The Big Short is the story of how a good understanding of economic theory was used by ordinary people to make themselves fabulously wealthy in a free market capitalist system.

Paper Assignment.

Download the Microsoft Word document from Canvas.

On the first page is a chart showing inflation adjusted housing prices from 1996 to 2012 and a supply and demand graph showing the U.S. housing market in 2000.

Part 1. Using the draw tools in Word, show what happened to the demand for housing by drawing the demand for housing in 2005, 2006, and 2009. Explain what caused demand to change over this period.

Part 2. If one wanted to speculate in the sub-prime mortgage bond market, explain the difference between buying a sub-prime mortgage, buying a sub-prime mortgage bond, and buying a sub-prime credit default swap (CDS) and how these financial instruments can be used to bet for profit.

Part 3. Explain the concept of leverage and how it applies to credit default swaps.

Part 4. Consider the players described in The Big Short. These include the large Wall Street firms and insurance companies AIG, Deustche Bank, Lehman Brothers, Merrill Lynch, Bear Stearns, Citibank, and Charlie Ledley of Cornwall Capital, Steve Eismann of FrontPoint Partners, Michael Burry, Greg Lippman, etc. Describe the nature of speculation in the sub-prime mortgage market and identify who was betting on what.

Part 5. In the end, U.S. taxpayers ended up paying almost a trillion dollars to bail out various Wall Street financial institutions. What role did government regulation of financial markets play in the events described in The Big Short. Consider the Do Nothing Policy discussed in lecture and apply it to the events described in The Big Short.