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What bonds are commonly called "junk bonds"? Why innovations in computer technology
helped the "junk bonds" market?
Answer: Junk bonds are the bonds whose credit rating is below BBB. Before the advent of
computers and advanced telecommunications, it was difficult to acquire information about the
financial situation of firms that might want to sell securities. Because of the difficulty in
screening out bad from good credit risks, the only firms that were able to sell bonds were very
well-established corporations that had high credit ratings. Before the 1980s, then, only
corporations that could issue bonds with ratings of BBB or above could raise funds by selling
newly issued bonds. With the improvement in information technology in the 1970s, it became
easier for investors to acquire financial information making it easier to screen out bad from good
risks.
Diff: 2 Type: SA Page Ref: 245 - 246
Skill: Recall
Objective List: 11.2 Examine financial innovation and the growth of the "shadow banking
system"
How banks suffered a decline in income advantages on uses of funds (assets) due to financial
innovation?
Answer:
a. The commercial paper market: information technology improvements have made it easier for
corporations to issues securities directly to the public. Business customers find it now cheaper to
go to the commercial paper market instead of going to banks to finance short-term credit needs.
Thus, before 1970 nonfinancial commercial paper equalled 5 percent of commercial bank loans,
whereas the figure has risen to 20 percent today.
b. The rise of the junk bond market has also eaten into banks' loan business. Improvements in
information technology have made it easier for corporations to sell their bonds directly to the
public, thereby bypassing banks.
c. Improvement s to computer technology have also led to securitization. Computers enable other
financial institutions to originate loans because they can now accurately evaluate credit risk with
statistical methods, while computers have lowered transaction costs, making it possible to bundle
these loans and sell them as securities. When default risk can easily be evaluated with computers,
banks no longer have an advantage in making loans.
Diff: 3 Type: SA Page Ref: 250
Skill: Recall
Objective List: 11.2 Examine financial innovation and the growth of the "shadow banking
system"