The Financial Crisis: Causes and Consequences

The Financial Crisis:Causes and Consequences Michael S. Pagano, Ph.D., CFA June 14-16, 2009 1

Course Overview Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

Financial Institutions: The “Heart” of an Economy Financial Institutions Commercial Banks Securities Firms Insurance Companies Investment Managers Borrowers Corporations Households Savers Households Corporations Cash Cash Loan, Bond & Equity Contracts Deposits, Insurance Policies, ST Debt, Bonds & Equity Bank Assets Bank Liabilities

The Negative Effects of Bad Loans on a Bank’s Balance Sheet Bank’s Key Asset is the TRUST of its Investors Cash Securities Loans Net Fixed Assets Total Assets Deposits Short-term Debt Long-term Bonds Preferred Stock Common Equity Total Liabilities & Shareholders Equity

Quick Quiz: What is the Effect of a $10 Increase in Loan Loss Reserves? 8 0 90 Deposits 82 Short-term Debt 10 Preferred Stock 0 Common Equity 8 Tot. Liab. & S.E. 100 Cash 5 Securities 20 Net Loans 65 Net F.A. 10 Tot. Assets 100 55 90

From Bank Run to Bank Panic: Asset Write-Downs can spread BANK AAA BANK BBB Cash Securities Loans Net F.A. Total Assets Deposits S.T. Debt Common Equity Tot. Liab. & S.E. Cash Securities Loans Net F.A. Total Assets Deposits S.T. Debt Common Equity Tot. Liab. & S.E.

Originate & Distribute vs. Make & Hold: “Elongated” Financial Intermediation Cash Cash Commercial Banks Borrowers Savers Mortgages Bank Deposits Borrowers Savers Cash Cash Cash Cash Money Manag-ers Investment Banks CB’s Fixed Income Funds (NAV) Mort-gages Pools of Mortgages SIVs & CDOs Traditional “Old-School” Make & Hold Business Model: “Elongated” or “New-School” Originate & Distribute Model:

A Basic Balance Sheet with Leverage Leverage Factor = Assets / Equity Assets Priority of Re-Payment Debt Profit / Loss on Asset Equity

Mortgage Gives Homeowners 5x’s Leveraged Returns Return on Equity = 25% [(Return on Assets - Interest Expense) / Equity] = 25% [($9.00 - $4.00) / $20] = 25% House $100 Gain on House = 9% Mortgage Debt $80 Interest Rate = 5% Equity $20

Mortgage Securitization Creates “MBS” and Leverage Last Loss Low Risk Low Yield D Pool of Mortgage Debts Super Senior AAA MBS Loss Position Credit Risk Yield D HOME OWNERS D D D AAA MBS D AA MBS D A MBS D BBB MBS BB MBS D B MBS D Equity D First Loss High Risk High Yield

Collateralized Debt Obligation (“CDO”)– More Leverage Last Loss Low Risk Low Yield MBS WALL ST BANKS MBS Pool of AA, A, BBB MBS Super-Senior AAA CDO Loss Position Credit Risk Yield MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS AAA CDO MBS B CDO MBS Equity MBS First Loss High Risk High Yield

Credit Default Swaps – Infinite Leverage Like an insurance contract that pays in the event of default. FASB requires mark-to-market valuation. Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value. Protection Buyer Protection Seller Premium Payments • Tends to own reference asset • Hedging or going “short” • Benefits when reference asset price DECREASES • Does not usually own reference asset • Going “long” • Benefits when reference asset price INCREASES, max at Par Payment upon Default of Reference Asset Reference Asset can be a MBS, CDO, Bond, or Loan

Sub-prime Mortgage 20X’s Leverage Increasing Leverage Homeowner 20X’s House $100 Mortgage Debt $95 Equity $5

Pooled into MBS – 30X’s Leverage Increasing Leverage Mort. Securitiz 30X’s Mortgage Debt $95 MBS $91.8 Homeowner 20X’s House $100 Mortgage Debt $95 Equity $3.2 Equity $5

Pooled into CDO – 50X’s Leverage CDO Structure 50X’s Increasing Leverage MBS $91.8 CDO $90.0 Equity $1.8 Mort. Securitiz 30X’s Mortgage Debt $95 MBS $91.8 Homeowner 20X’s House $100 Mortgage Debt $95 Equity $3.2 Equity $5

CDS on CDO – Infinite Leverage Credit Default Swap ∞ CDO $90.0 CDS on CDO $90.0 CDO Structure 50X’s Increasing Leverage MBS $91.8 CDO $90.0 Equity $0 Equity $1.8 Mort. Securitiz 30X’s Mortgage Debt $95 MBS $91.8 Homeowner 20X’s House $100 Mortgage Debt $95 Equity $3.2 Equity $5

In-Class Exercise: Compare and Contrast the Make & Hold and Originate & Distribute Models You can consider the two types of FI models and their impact on the: Speed / velocity of lending Availability of credit in the economy Bank’s credit culture Executive compensation Role of regulators Profitability, Riskiness, & Growth of FIs Future of commercial banking Discuss these issues in small groups and report back to the class.

2007-2008 Subprime Mortgage Mess in brief Unintended Consequences: in 1990s, Clinton administration pushed for greater credit access for lower income borrowers. Regulatory Loopholes: in 1999, Citigroup and others agreed to underwrite more risky mortgages if they could be kept off-balance sheet. Perfect Storm hits: low interest rates and 2002-07 recovery loosens credit standards further and investors “stretch” for higher yields. Incentives Misaligned: lenders/brokers, investment bankers, rating agencies, fixed income investors, hedge funds, politicians all have incentive to “turn a good idea into a bad one!”

Sub-prime Loan Delinquencies Increase Greatly Failures in the origination process come home to roost. Rating agencies, mono-line insurance companies, Investment Banks, and investors did not anticipate this level of loss.

Foreclosures Push Home Prices Down Further …and delinquent sub-prime homeowners are forced into foreclosure.

Money Market Investors Go on Strike The difference between overnight rates and 3 month rates sky-rockets to 3.50% (normally 0.15%). Fed Funds vs. LIBOR. No borrowing / lending in the short term markets– Liquidity vanishes! This is precisely what Sectretary of Treasury was reacting to with bail-out.

Bond Investors Go on Strike Too Corporations could not borrow in the long term institutional bond markets. Hedge funds that bought bonds on leverage are forced to unwind

U.S. Bank Lending Standards to Large Firms Banks significantly restrict lending to Corporations. Corporations begin to draw on revolving credit facilities that were arranged pre-crisis. Massive cutbacks and lay-offs follow swiftly.

Bank Lending Standards for Residential Mortgages A Bail Out for Main Street !? Sub-prime and Mid-prime borrowers find it harder to get credit.

FNMA Guarantees Mortgages behind MBS D Pool of Mortgage Debts Super Senior Aaa / AAA D HOME OWNERS D D FNMA Guarantees Principal and Interest Payments D Aaa / AAA D Aa2 / AA D A2 / A D Baa2 / BBB Ba2 / BB D B2 / B D Equity D

FNMA’s Total Leverage is 85.7X’s Assets = $883bn Equity = $44bn “Book” Leverage = 20.1X’s Guarantees = $2.9tn Total Leverage = 85.7X’s Write-downs in 2007 Inability to raise capital Fed injects $100bn Stock falls to near $0 CDS volatile as mkt not sure about Government guarantee

AIG Sells Default Protection on Super Senior CDO MBS WALL ST BANKS MBS Pool of AA, A, BBB MBS Super-Senior AAA CDO AIG Sells Protection Referenced to Super Senior CDO MBS MBS MBS MBS MBS AAA CDO MBS MBS AA CDO MBS A CDO MBS BBB CDO MBS BB CDO MBS B CDO MBS Equity MBS

AIG Sells Default Protection on Super Senior of CDO (cont.) AIG gets annual premium of 0.15% on $527 billion (or $790 mil per year). As mortgage losses mount and as investors stop buying MBS and CDO… Mark-to-market of Super Senior CDO goes down AIG is forced to post additional Collateral. Protection Buyer Protection Seller Premium Payments Banks Holding Super Senior CDO AIG Payment upon Default of Reference Asset Reference Asset is Super Senior CDO

AIG’s Total Leverage is 16.6X’s Assets = $1.06tn Equity = $95.8bn “Book” Leverage = 11.1X’s CDS on Super Senior = $527bn Total Leverage = 16.6X’s Write-downs of $12bn in 2007 MTM and Collateral Calls Fed Loan of $85bn, now higher. Stock falls to near $0 CDS skyrockets to 25%

Major FI’s Dupont Ratios: ROE = ROA x Leverage (EM)

In-Class Exercise: What is Citi’s Leverage Ratio and Dupont Ratio (ROE = ROA x EM)? 2008 OBS Arrangements: LC’s, Lines, LN Comm. 1,460,000 CDOs, CLOs, ABCPCs 97,300 Municipal Sec. TOBs 30,100 Total OBS: 1,587,400

Remedies for the Crisis Fed Liquidity for Fin. Institutions (FIs) beyond traditional Commercial Banks Too-Big-To-Fail (TBTF) Bailouts (Fannie, Freddie, AIG, Citi) Increased Deposit Insurance ($250K / account) $700 Bil. Troubled Asset Relief Program (TARP) Federal Guarantees: Commercial Paper, FI Debt, Money Market Funds Major Investment Banks (GS, MS) become BHCs Public-Private Joint Ventures: TALF and PPIP

U.S. Government Programs –source: Goldman Sachs 2009 report $6 trillion so far (with total commitments up to $13 trillion) The Federal Reserve Bank = $1.877 trillion Term Auction Facility (TAF): loanable funds to depository FIs FX Swaps Commercial Paper Funding Facility (CPFF): buys CP directly from issuers Term Sec. Lending Facility (TSLF): funds to primary dealers / sec. firms FDIC = $968 billion Deposit Insurance & Money Market Fund Guarantees Temporary Liquidity Guarantee Program (TLGP): g’ty for unsec. FI debt U.S. Treasury = $3.310 trillion CPP (Commercial Paper financing for Bank Conduits) AIFP (Autos) TARP and others (Bank preferred, AIG, TALF and PPIP)

TALF – Term Asset-Backed Securities Loan Facility Asset-backed securities (ABS) are a key source of funding for consumer credit and small business loans (“shadow banking system”). ABS issuance has almost completely stopped as investors back away. The Federal Reserve announced the creation of TALF with a $200 bil. facility to support investors purchasing securities backed by pools of: Student loans Auto loans Credit card loans Small business administration guaranteed loans

TALF – Term Asset-Backed Securities Loan Facility (cont.) Last Loss Low Risk Low Yield ABS WALL ST BANKS ABS Pool of AAA ABS backed by consumer or small business loans Loan from Federal Reserve Bank Loss Position Credit Risk Yield ABS ABS ABS ABS ABS ABS ABS ABS ABS ABS Private Investors ABS ABS ABS First Loss High Risk High Yield

PPIP – Public Private Investment Program Goal: Potential to relieve financial institutions from troubled asset classes, create private market pricing transparency and increase asset prices. Legacy Loan Program Intention is to remove “toxic” loans from bank balance sheets Joint equity investment by U.S. Treasury and private investors FDIC provides guarantee for up to 6:1 leverage on debt issued by PPIP vehicle Legacy Securities Program Expansion of TALF into securities issued before 2009 Applies to MBS originally rated AAA Potential to enhance TALF leverage through U.S. Treasury loan

PPIP – Public Private Investment Program Last Loss Low Risk Low Yield Loan Loan Pool of Bank Loans FDIC Guaranteed Debt (up to 6:1 leverage) Loss Position Credit Risk Yield Loan BANKS Loan Loan Loan Loan Loan Loan Loan Loan Loan Private Investors U.S. Treasury Loan Loan Loan First Loss High Risk High Yield

In-Class Exercise: What Consequences (and Opportunities) are related to the Crisis and these Remedies? You can consider the effects on the following areas: U.S. Economy (e.g., growth, inflation, employment) Global Economy (Americas, Europe, Asia) Financial Markets (U.S. and International) Regulation of Financial Institutions Profitability, Riskiness, & Growth of FIs New Business models? Discuss these issues in small groups and report back to the class.

Some Possible Consequences Reduced Appetite for Risk by FIs Lower Financial Leverage (De-Leveraging) LessProfitability (ROE = ROA * Leverage) Tighter Regulation of Financial Institutions Limits on Executive Pay Above Factors suggest Slower Growth and Less Innovation in the long-run Government Stimulus might be inflationary

Conclusion – Crisis can lead to Opportunities! Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc. “When it’s raining porridge, you’ll find John’s dish right side up!” ---Lucy Rockefeller. On her brother, John D. Rockefeller.

The Financial Crisis: Causes and Consequences