Credit, Capital, and Collateral Lessons for Banks, and Those Who Supervise Them

1. C. Tannenbaum Federal Reserve Bank of Chicago Community Bankers Symposium November, 2009 Credit, Capital, and CollateralLessons for Banks, and Those Who Supervise Them

2. Any views expressed here are the author’s, and not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System

3. A Hypothesis: While the extent and magnitude of the recent financial crisis were certainly unexpected, the groundwork for such an event was formed gradually over the past generation by evolution in the financial services industry.

4. Banking in 1970 • The “rule of threes” • Heavily regulated • Interest rate ceilings • Branch banking restrictions • Limited product sets • Consistently profitable • Stable employment

5. Three-Month Treasury Bill Rates Source: Federal Reserve

6. Paradise Lost Interest Rates Spike Depositors Look Elsewhere More Risks Taken Direct Delivery of Assets to Investors Strain on Traditional Sources of Bank Profit

7. Growth of Securitization Markets Source: SIFMA

8. Most Debt is Provided by SourcesOutside of the Banking System Source: Federal Reserve

9. Earnings Move Outside the Margin Source: Federal Reserve

10. Reflections • Growing earnings in the originate to sell system meant doing more deals every year • In some areas, it appears that incentives were misaligned • Capital rules accelerated the trend • Oversight of the “shadow system” was largely left to the markets • When the music was playing, everyone danced…and when it stopped…

11. The Crisis Dynamic Markets Reverse Pressure to Sell Capital Depleted, Risk Appetite Falls Did technology take the place of perspective? Rumor Travels Faster Than Fact Margin, Collateral Calls Rating Downgrades

12. Lessons Learned: Credit Markets • Bankers, investors and rating agencies should have been asking a lot more questions • In some cases, firms gave away both sources of repayment (cash flow and collateral) • Models got way ahead of themselves • Past is not always prologue; models should not assume so • Procyclical features: reinforces upside, deepens downside

13. The Role of Collateral Asset Cash Secured Lender Asset Pledge Cash Secured Lender Asset Pledge • On the way up: leverage supports asset prices • When it breaks, unwinds violently

14. How This “Trickled Down” to Community Banks • Some had invested in complex securities • Some relied on selling assets into the credit markets (i.e. home mortgages) • Some had adjusted pricing/underwriting to compete with large organizations • Some had increased reliance on secured and wholesale funding sources • The financial crisis caused a severe recession

15. Real GDP Growth Source: BEA

16. Labor Market Trends Nonfarm Payroll Employment(change, thousands) Unemployment Rate (percent of labor force) Source: BLS

17. Unemployment and CRE Source: REIS/TWR

18. Vacancy and Rents Source: REIS/TWR

19. Loan Quality: No Green Shoots Source: Call Reports

20. Senior Loan Officer SurveyNet Percent of Respondents: CRE Loans Source: Federal Reserve

21. District Provision ExpensesPercent of Total Assets Source: Call Reports

22. Two Areas of Focus • Points of departure from recent history

23. Reserve Coverage Still in Downward Trend Source: Call Reports

24. The Strain on Capital • Earnings under pressure • Markets less receptive • Government support was popular a year ago, a stigma now? • The dreaded “denominator effect”

25. Return on AssetsSeventh District Community Banks Source: Call Reports

26. Major Sources and Uses of CapitalSeventh District Community Banks

27. Number of Banks Less than Well-CapitalizedSeventh District

28. Trends in Bank LendingYear over Year Change in Total Loans Source: Federal Reserve

29. Assets of Commercial Banks Ratio of Loans & Leases to Total Assets (All Commercial Banks, SA) Ratio of Cash to Total Assets (All Commercial Banks, SA)

30. What Was the Stress Test? • A simultaneous capital exam of the 19 largest US bank holding companies • An exercise to determine whether systemically important institutions can withstand a severe recession • A review chartered by the Treasury Department and carried out by all major banking regulators • An endurance test for 200 well-meaning people without personal lives to speak of • All of the above

31. Considering a More Adverse Scenario

32. Why Should Firms Do Stress Tests? Good management practice: increases the chance of having adequate reserves in challenging environments A useful component of an overall capital planning effort for firms contemplating CPP retirement Past rules of thumb for capital buffers (1% above minimums) no longer as valuable Stock analysts are doing them; better to get out in front of the message The journey is as valuable as the destination All of the above!

33. Differentiating Loan Portfolios C&I Rating Industry Collateralization ABL Margin Lending Loan Size Small Business CRE LTV DSCR Property Type Owner -Occupancy Geography Mortgage 1st/2nd Geography LTV Primary/Broker Origination FICO Score

34. Looking Ahead: Capital “Waterfalls” Well-capitalized minimum: 6%

35. What Now? • The banking system cannot possibly re-intermediate all of the credit that has been created • Securitization still has a multitude of benefits: • Lower costs of capital • Portfolio diversification • Enhanced liquidity • Risk tailoring • The key question: what is the “new normal?”

36. Asset-Backed Securities Issuance

37. In the Meantime…Federal Reserve Assets

38. Designed to Sunset

39. Lessons Learned:Banks and Supervisors • The business cycle is not dead: beware of “pricing for perfection” • Risk can accumulate in the financial system and come home to our balance sheets • Liquidity can evaporate more quickly than capital • Risk management discipline cannot be compromised • Follow-up: re-capitalize, revitalize, re-privatize

40. C. Tannenbaum Federal Reserve Bank of Chicago Community Bankers Symposium November, 2009 Credit, Capital, and CollateralLessons for Banks, and Those Who Supervise Them