The Financial Crisis: A Preliminary View 2009 JRCLS Annual Conference Harvard Law School February 14, 2009

1. The Financial Crisis: A Preliminary View2009 JRCLS Annual ConferenceHarvard Law SchoolFebruary 14, 2009 Randall D. Guynn Head of the Financial Institutions Group Davis Polk & Wardwell

2. The Financial Crisis: A Preliminary View • Background • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers

3. Background – How did we get here? • Same pattern as almost every other mania, panic and crash before this one: • Cheap credit → • Excessive optimism → • Pricing bubble (real estate and commodities) → • Bubble pops (price collapse that is still collapsing) → • Extreme uncertainty about “true” asset values → • Excessive (or wise?) pessimism

4. Background – How did we get here? (Cont’d) • The financial sector is the most immediate and hardest hit • Characteristics of financial institutions • High leverage • Illiquid long-term assets • Extremely short-term liabilities (e.g., demand deposits) • These characteristics make financial institutions susceptible to “runs on the bank” • Run on a bank (or other FI) will result in sudden and unexpected death spiral • FIs are different from widget companies, which typically slide slowly into bankruptcy • FIs almost always fail suddenly and unexpectedly • This time is no different from the past • Main Street vs. Wall Street

5. Background – How did we get here? (Cont’d) • Rational response makes things worse • Circle the wagons • Increase and hoard cash • Reduce amount of credit extended • Otherwise reduce leverage • Inverse money multiplier effect • Results in severe contraction of credit throughout the system • Hurts everyone – FIs, widget companies, consumers • Negative externality like air pollution

6. Background – How did we get here? (Cont’d) • Inverse money multiplier magnifies contraction of credit (money) • Money multiplier: M * 1/R, where M = amount deposited in a single bank and R = fractional reserve requirement • Amplifies expansion of credit in normal times when banks are permitted and choose to hold only a fraction of cash reserves to satisfy demand deposit claims • Magic of money multiplier in normal times: Assume 10% reserve requirement (R), every $100 deposited in a bank will multiply by 10 times into $1,000 of credit throughout system • Tragedy of inverse money multiplier: If banks are legally required or choose to circle the wagons during a financial crisis, so that reserves grow from 10% to 20%, the amount of credit available in the system will shrink by 50% or $500, not by 10% or $100

7. Background – How did we get here? (Cont’d) • Historical precedents • 1700 BC: Joseph in Egypt • Seven Years of Plenty, Seven Years of Famine (Gen 41) • By the end, Joseph had bought all the herds of cattle and “all the land of Egypt” for Pharaoh in exchange for food (Gen 47:13-26) • 1637: Collapse in tulip prices → banking crisis in Europe • Banking Panic of 1837 (caused failure of Kirtland Safety Society) • Banking Panic of 1907 (JP Morgan restores confidence) • The 1929 Crash and the Great Depression (1930s) • Savings & loan crisis of the late 1980s and early 1990s • Precipitated by collapse in the price of agricultural commodities, oil and real estate • The Global Financial Crisis of 2008

8. Background – How did we get here? (Con’d) • What was different this time? • Global macro economic factors • Excess savings in rapidly developing countries (China) invested in debt of industrialized countries, driving down interest rates • Cheap exports from developing countries (esp. China, India) kept inflation low • Increased productivity kept inflation low • U.S. housing and monetary policy, GSEs and securitization drove down housing interest rates • Excessive optimism and cheap credit resulted in real estate bubble, spike in consumer debt and financial institution leverage • Increased demand from developing countries resulted in bubbles in commodities prices

9. The Financial Crisis: A Preliminary View • Introduction • Symptoms • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers

10. Introduction – How bad is it likely to be? (Cont’d) • Who knows? • This crisis is far worse than the S&L crisis of the late 1980s and early 1990s • Will it be as bad or worse than the Great Depression?

11. Introduction – How bad is it likely to be? • Factors that made things worse (or better?) this time • The very instruments that helped manage credit risk, reduce the cost of credit and increase the availability of credit • Securitizations of mortgage loans (e.g., mortgage-backed securities) • Securitizations of securitizations (e.g., collateralized debt obligations, or CDOs, and CDO-squared) • Credit default swaps (CDSs) • Excessive confidence (as it now turns out) in financial models • Failure of rating agencies to update credit rating models with changes in the marketplace • Mark to market or model (or “fair value”) accounting rules

12. Super Senior AAA AAA AAA BBB AA A Equity BBB Resi Real-Estate-Related Securities Home Owners Originators/Lenders Securitization (Underwriters) Re-Securitization: CDO CDO2 Investors 100% 11% Hedge Funds AAA Banks Pension Funds 28% 8.6% AA 20% A Other Inv. Banks 11% BBB 7% Residual/Equity 0% 7% 1) Lender makes mortgage loan to home owners 2) Lender issues secured certificates backed by loans 3) Bonds backed by mortgages created in the primary market 4) Investments may become re-securitized (bonds based on bonds) 5) New CDOs can be created from “select” tranches of existing CDOs with a further “re-rating” of risk 6) Investors buy customized financial instruments

13. The Financial Crisis: A Preliminary View • Introduction • Symptoms • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers

14. Timeline of Significant Events Summer 2007 – Summer 2008 • Spring 2008 • Continued collapse in real estate prices • Continued large CDO markdowns • Rescue of Bear Stearns by JPM • Fed discount window opened to I-banks • Treasury blueprint • Summer 2007 • Real estate prices start to collapse • Spike in early delinquencies of 2006-2007 subprime mortgages Summer 2007 Summer 2008 • Fall 2007 • Leveraged credit market dries up • Billions of MBS/CDO markdowns • Summer 2008 • Interbank credit markets locking up • Spike in oil / agricultural prices • Fannie, Freddie, FI mkt caps plummet • Fed as fin markets stability regulator • Indymac fails • Treasury gets authority to rescue Fannie/Freddie • Winter 2007-2008 • Sovereign wealth funds to the rescue • Rescue of Northern Rock by UK govt

15. Spike in Early Subprime Loan Delinquencies Recent Vintages Show Very Poor Underwriting Source: Federal Reserve staff circulations from First American Loan Performance data

16. Residential Housing Bubble and Collapse Source: Standard & Poor’s

17. Timeline of Significant Events Summer 2007 – Summer 2008 • Spring 2008 • Continued collapse in real estate prices • Continued large CDO markdowns • Rescue of Bear Stearns by JPM • Fed discount window opened to I-banks • Treasury blueprint • Summer 2007 • Real estate prices start to collapse • Spike in early delinquencies of 2006-2007 subprime mortgages Summer 2007 Summer 2008 • Fall 2007 • Leveraged credit market dries up • Billions of MBS/CDO markdowns • Summer 2008 • Interbank credit markets locking up • Spike in oil / agricultural prices • Fannie, Freddie, FI mkt caps plummet • Fed as fin markets stability regulator • Indymac fails • Treasury gets authority to rescue Fannie/Freddie • Winter 2007-2008 • Sovereign wealth funds to the rescue • Rescue of Northern Rock by UK govt

18. Timeline of Significant Events (Cont’d) September 2008 • Weekend 1 • Freddie, Fannie bailout • Weekend 4 • Citigroup rescues Wachovia • Fortis, Dexia are nationalized • Weekend 2 • Lehman Bros fails • Merrill Lynch sells itself to BofA September 2008 October 2008 • Week 3 • AIG rescued • Treasury proposes $750bn EESA/TARP • Primary reserve money market fund “breaks the buck” • Treasury announces guaranty program for money market funds • SEC temporary ban on short sales • Sept 30 • House rejects EESA/TARP • Dow falls record 778 pts, $1.3 trillion • Weekend 3 • Treasury releases EESA/TARP bill • MS, GS become bank holdcos • WaMu fails, JPM buys all deposits

19. Timeline of Significant Events (Cont’d) October 2008 • Week 1 • Senate approves EESA / TARP • House reconsiders and President signs; EESA / TARP enacted • FDIC insurance coverage increased to $250,000 • Week 2 • Fed announces Commercial Paper Funding Facility (CPFF) • U.K. announces bank rescue package • Treasury announces bank capital purchase program (policy shift) • FDIC announces Temporary Liquidity Guarantee Program (TLGP) November 2008 October 2008 • Week 3 • Swiss National Bank makes $54 bn loan to UBS • Germany passes €500 bn rescue package • Week 4 • First wave of regional banks eligible for Treasury’s capital purchase program are identified • National City rejected – purchased by PNC with help of CPP money

20. Timeline of Significant Events (Cont’d) November 2008 • Week 1 • Barack Obama elected President • Democratic sweep of Congress • Week 2 • Fed, Treasury announce expanded investment in AIG, $150 billion • Democrats urge aid for auto makers November 2008 October 2008 • Week 3 • Amex becomes BHC • Treasury announces that troubled asset purchase program is on hold; stock market drops 20% in two weeks; financial stocks plummet even further • CIT applies to become a BHC • Hartford, Genworth, Lincoln National acquire thrifts and apply for TARP • GMAC announces that it applied to become BHC • Week 4 • Citigroup receives additional $20 billion from TARP plus government guarantee of a $306 billion pool of troubled assets • Fed announces $200 bn TALF program • Fed announces $100 bn GSE debt purchase program

21. Timeline of Significant Events (Cont’d) December 2008 – February 2009 • December 2008 • TARP loans $17.4 bn to GM and Chrysler • Madoff ponzi scheme revealed – est $50 bn in potential losses • Fed approves CIT’s and GMAC’s applications to become BHCs • TARP gives $6 bn in financial assistance to GMAC • Consumer spending plummets • Unemployment spikes • January 2009 • BofA receives additional $20 bn in TARP investment and a $118 bn guarantee of troubled assets • Bush Administration requests TARP II on behalf of President Elect Obama • Obama inauguration • Geithner confirmed as new Treasury Secretary • UK announces asset guarantee scheme • Germany announces good bank / bad bank scheme November 2008 October 2008 • February 2009 • New limits on executive compensation for FIs who receive TARP money in future • COP, SIG reports on TARP • SEC roasted for missing Madoff ponzi scheme • Fed revises TALF program • Geithner announces TARP II plans • Obama $800 bn stimulus bill

22. Spike in Unemployment Source: Bureau of Labor Statistics

23. The Financial Crisis: A Preliminary View • Introduction • Symptoms • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers

24. TARP and Other Government Relief Programs • TARP I • Capital Purchase Program ($250 billion) • Systemically Significant Failing Institutions Program (AIG) • Targeted Investment Program (Citi, BofA) • Asset Guarantee Program (Citi, BofA) • Automotive Industry Program (GM, Chrysler) • TALF Program (with NY Fed) • TARP II • Good bank / bad bank? • Asset purchases? • Treasury’s $50 billion temporary money market guarantee

25. TARP and Other Government Relief Programs • Other Government Relief Programs • FDIC • Temporary increase in deposit insurance to $250,000 • Temporary Debt Guarantee Program • Temporary Transaction Account Guarantee Program • Federal Reserve • Primary Dealer Credit Facility • Term Auction Facility • Temporary Securities Lending Facility • Commercial Paper Funding Facility • Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility • Money Market Investor Funding Facility • Term Asset-Backed Securities Loan Facility (TALF) (non-recourse)

28. TARP I — Evolution • Initially, the TARP facility was expected to be used to purchase mortgages and other real-estate related assets. • Asset purchases were intended to establish reliable market values for these illiquid assets. • Instead, TARP’s first use was a Capital Purchase Program (CPP) meant to recapitalize the U.S. banking system. • Two Fundamental Public Policy Shifts • Asset Purchase Program to the CPP • Control for Moral Hazard vs. Encourage Public Confidence • On November 12, 2008, Treasury officially announced that the development of an Asset Purchase Program was on hold.

29. The Financial Crisis: A Preliminary View • Introduction • Symptoms • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers

30. Legal, Regulatory and Policy Issues and Reactions • What is the source of Treasury’s, the Fed’s or the FDIC’s legal authority for taking control of or investing in private-sector financial institutions? • Fannie and Freddie Conservatorship and Financial Assistance: Expressly authorized by new federal statute enacted on July 30, 2008 • Fed Actions: Section 13(3) of the Federal Reserve Act grants power to lend to anyone under “unusual and exigent circumstances” (first time power exercised since 1932) • AIG: Section 13(3) of Federal Reserve Act • $750 billion TARP (EESA) • Would Raise Serious Legal Issues in the Absence of Express Congressional Authorization • See the Steel Seizure Cases (1952), in which the Supreme Court held that President Truman’s seizure of steel mills during the Korean War was unconstitutional because unauthorized by Congress • 31 USC 9102 – Prohibition on federal agency acquiring corporation without express statutory authority

31. Legal, Regulatory and Policy Issues and Reactions (Cont’d) • Precedents • Reconstruction Finance Corporation (1932): Established by express Congressional action to recapitalize the troubled U.S. banking industry during the Great Depression. Dissolved in 1957. • Resolution Trust Corporation (1980s): Established by express Congressional action to resolve failed savings associations. Later dissolved. • Government initially followed policy to wipe out common and preferred shareholders and senior debt as a condition to government assistance • Common shareholders in Indymac, Bear Stearns, Freddie, Fannie, Lehman, AIG and WaMu mostly or completely wiped out • Pros: Reduces moral hazard • Cons: Deters new money when a financial institution needs it most; encourages strategic behavior by senior debt counterparties

32. Legal, Regulatory and Policy Issues and Reactions (Cont’d) • Government shifted policy under TARP from asset purchase program to capital purchase program • Government also shifted policy from trying to limit moral hazard caused by intervention to restoring public confidence • Only minor dilutive impact on common shareholders • Pari passu with existing preferred stock • Junior to senior and subordinated debt • Rationale: When we find ourselves on the edge of a cliff looking down, we can worry about moral hazard tomorrow. Today’s issue is restoring public confidence to encourage new and existing equity investment from private sector • The most FAQs have become: Is $700 billion enough? Why not just nationalize the banks?

33. Perfect Storm for More Regulation

34. Legal, Regulatory and Policy Issues and Reactions (Cont’d) • Regulatory Response - More regulation • Likely a lot more and harsh • Main Street vs. Wall Street • Fed will likely become the systemic risk regulator • System-wide regulatory consolidation and rationalization more likely • Treasury Blueprint • Federal insurance charter and regulator • CDS clearing house and other regulation of CDS and OTC derivatives • Merger of CFTC and SEC • Merger of OTS and OCC • Scapegoating • E.g., FBI investigations of the management of recently failed or bailed out companies

35. The Financial Crisis: A Preliminary View • Introduction • Symptoms • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers

36. Interesting Factoids • Weekend work: rescues almost always happen on weekends when markets are closed • Window is from the close of U.S. markets on Friday until the opening of the Asian markets on Sunday night (U.S. time) • Freddie and Fannie • One of the few “genuine” conservatorships in U.S. history (other conservatorships are virtually all really “pass-through” receiverships / conservatorships to simulate a “bridge bank” device) • Powers exercised were only one month old • AIG • Too big and too entangled globally to fail • Not previously regulated by the Fed; almost exclusively regulated by the states or foreign insurance regulators

37. Interesting Factoids (Cont’d) • Morgan Stanley / Goldman Sachs • Unprecedented “one-day” conversions into bank holding companies • Instantly ranked among the five largest bank holding companies in the U.S. • Citigroup / Wachovia • First use of the “systemic risk” exception to the “least-cost resolution” condition for an FDIC-assisted open bank transaction • Stampede to Become a BHC: MS, GS, AMEX, CIT, GMAC • Stampede for TARP funds • Insurance companies buy thrifts to become S&LHCs to qualify for TARP money • Hartford, Genworth, Lincoln National • Auto-industry bailout

38. The Financial Crisis: A Preliminary View • Introduction • Symptoms • How did we get here? • How bad is it likely to be? • Timeline of Significant Events • TARP and Other Government Relief Programs • Legal, Regulatory and Political Issues and Reactions • Interesting Factoids • Questions and Answers