Crisis of 2007-2008

1. Crisis of 2007-2008

2. Trends in US Banking

3. Decline of Glass-Steagal Act • In 1927, interstate banking eliminated. • In 1933, Glass-Steagal act created FDIC and separated banking business from securities business. During 1990’s, these regulations were eliminated and US banks had a wave of consolidation and concentration.

4. Bank Holding Companies • Bank holding companies have a corporate structure in which a parent company owns many subsidiaries in different financial industries. • Subsidiaries engage in banking, securities, real estate and insurance business. • Subsidiaries are separate legal entities so the bankruptcy of one does not mean losses for the other. • Losses at one subsidiary do result in losses for shareholders of the holding company. • Banks mostly protected from risk of sister companies. Advantages: Protects depositors & bank capital from market risk. One stop shopping can help build relationships.

5. Shadow Banking System • Over the last 30 years, competitors to banks in providing traditional banking services. • The competitors include • Investment Banks • Mutual Funds • Hedge Funds

6. Decline in Advantage in Providing Liquidity • One of banks biggest source of comparative advantage is their ability to provide liquid assets for depositors. • New Competition: Money Market Mutual Funds – Mutual funds that are redeemable at a fixed price by writing checks. Mutual funds invest in money markets. These are essentially checking accounts issued by non-financial institutions that pay interest.

7. Decline in Advantage in Providing Credit • Another of banks comparative advantage is their ability to provide loans quickly and provide credit to small or new firms. • New Competition • Commercial Paper: Short-term corporate bonds. Many firms that relied on banks for short-term loans now issue commercial paper. • Junk Bonds: Bonds issued by firms with non-investment grade credit ratings. Many firms that relied on banks for credit now issue junk bonds.

8. Financial Commercial Paper • Commercial paper has not only offered competition for banks loan business, …but also offers a source of financing for banks competitors. • MMMF’s and others buy commercial paper with funds deposited by customers. • Banks following Citibank also set up SIV’s financed with money market borrowing (asset backed commercial paper) to purchase long-term assets.

9. Financing of Investment Banks October 2004 – SEC lifts capitalization rules for large broker-dealers M. Brunnermeier, Princeton U. Slides.

10. I-Banks switched to more S-T lending. Ex. In 2000, Equity to Assets at Morgan Stanley was 4.6%, in May 2008 was 1.1%

11. If you can’t beat‘em, join’em • Banks have taken advantage of reduced information costs to find new sources of profits. • Securitization – The process of transforming illiquid assets into marketable securities. Banks will take a portfolio of loans (such as mortgages) and “bundle” them. They will then issue securities with a promise to pass on the repayment of the loans to the owners of the securities. • Off-Balance Sheet Activities – Banks provide promises of lines of credit to firms that participate in securities markets.

12. Housing Bubble www.calculatedrisk.com

13. Rapid Growth of Mortgage Lending

14. Causes? • Low Interest Rates • Real Interest Rates – Saving Glut • ST Rates Fed • Limits on Growth in Desirable Locations • Securitization • Decline in Lending Standards

15. Savings Glut: Low Real Interest Rate

16. TIPS Bond • Treasury Inflation Protected Securities • Bond issued by US Treasury (UK and France offer similar). Principal and coupon payments are indexed to inflation. • Offer a way to protect against inflation risk.

17. TIPS Rate: Discount Bond Example • TIPS Bond • Calculate Yield to Maturity • Calculate Average Return Average inflation between t and t+T, πt:t+T

18. Arbitrage says that if risk neutral expected returns of TIPS should equal returns of non inflation protected bonds. Or the calculated yield on TIPS bonds equals the real interest rate. • If people are averse to inflation risk, then the TIPS rate is below real interest rate.

19. Monetary Policy • .

20. Securitization: FDIC Statistics on Banking: All FDIC Institutions

22. Banks Increase Holdings of Real Estate Holdings

23. CMO: Collateralized Mortgage Obligations Sample • An SPV is set up to purchase mortgages and issue bonds which pay out in tranches. Tranches are orderings of payments in terms of seniority. Each tranche is has its own credit rating. M. Brunnermeier, Princeton U. Slides. Commercial and Investment Banks often set up SPV Special purpose vehicle: Quasi-independent company set up to manage asset.

24. Collateralized Debt Obligations • A special purpose vehicle that buys quantities of debt securities (often MBS or CMO tranches) that might be low rated and turn it into tranches some of which might be better rated. SPV Senior Tranche AAA BBB Securities Junior Tranche BBB Securities AAA tranches may have paid higher returns than typical AAA securities. Attractive to institutions restricted to AAA BBB Securities

25. Reasons for CMO’s & CDO’s • GSE’s are limited in terms of the size of mortgages they could buy. Part of the mandate of GSE’s is enhancing lending to poorer households, but at various times there were limits on sub-prime mortgages that could be purchased by GSE’s. • Certain institutions by charter need to invest in AAA securities. • Banks held many of the “super” senior tranches in their own accounts.

26. Declining Lending Standards • Subprime Lending – Borrowers without requisite credit rating. • Option ARM • Interest Only Mortgages • Negative Equity Mortgages • NINA Verification Mortgages • Alt-A (Good Credit Score, NI verification)

27. Advance of Subprime • Between 1998-2003, 10% of new loans were sub-prime • In 2004, 28% of new loans, in 2005, 36%, and in 2006, 40%.

28. Sample Definition (Wikipedia) FNMA prime loans go to borrowers with • a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723), • a debt-to-income ratio no greater than 45% (meaning that no more than 45% of gross income pays for housing and other debt), and • a combined loan-to-value ratio of 90% (meaning that the borrower is paying a 10% down payment).

29. Sub-prime Lenders • An industry of financial intermediaries that specialized in making mortgage loans pre-packaged for securitization arose. • Many of these specialized in the sub-prime market. • Typically, these were sold to SPV’s rather than GSE’s.

30. End of Housing Bubble • In 2005, housing prices reached a peak. • However, by reducing lending standards and increasing reliance on sub-prime lending, mortgage lending continued to grow. • By 2007, housing prices began to fall.

31. Increasing Loan Losses Credit performance worse at sub-prime lenders. Mortgage losses estimated at $1.4 trilion by IMF

32. Valuation • Although many MBS, CMO, and CDO’s have shown increased defaults but for many these may not yet be large, rising risk of have impacted their value. • Discount factor for future cash flows • Rising risk premium has reduced price of the assets.

33. Mark to Market Accounting • For easily traded securities, current accounting practice suggests valuing assets on books at the current market price. • Problem: A change in valuation of assets will affect capital (assets – liabilities). Restrictive covenants which require minimum capital may be violated if value of assets drop. • Lenders may have option to recall loans if covenants violated.

34. Liquidity of CMO’s and CDO’s • There is much uncertainty and asymmetric info in CMO’s. Difficult for a potential investor to evaluate quality of the mortgage loan bundle while bundler/seller may have better idea. • Increased risk has generated lemon’s problem. • Wide bid/ask spreads makes it difficult to reasonably implement M2M accounting.

35. Issues • Capitalization: Banks and other holders of mortgage backed securities are likely to take large losses on defaults. • Liquidity: MMMF are supposed to be safe investments; once risk becomes known MMMF‘s pull out of commercial paper market go into treasuries. • Complexity: CDO’s and CMO’s are complicated instruments; difficult to tell good from bad. In hard times, adverse selection may make selling them w/o huge discount problematic. • Business cycle issue. Large contraction in consumption and investment likely to make default rates rise.

36. Rates Rise Fed Board of Governors

37. Commercial Paper Market Dries Up

38. March 2008 • Bear Stearns acquired by J.P. Morgan with Fed help. . • September 2008, • FNMA & FHLMC placed in conservatorship. • Merrill Lynch acquired by Bank of America • Lehman Brothers declared bankruptcy • AIG received emergency loan from Federal Reserve.[176] which acquired a 79.9% equity • Washington Mutual (WaMu), seized November 2008, US government guarantees ads of Citigroup

39. Interbank Rates Hall (Stanford) and Woodward

40. Policy Responses

41. Standard Monetary Policy Response

42. Non-standard Response • Discount rate reduced to 50 basis point above target in September 2007 and now 25 basis points above. • Also in HK • Fed now pays interest on reserve deposits. • Quantitative easing has pushed effect rate below target.

43. Programs for Expanding Monetary Liabilities • Term Auction Facility – Auction Reserves to banks, banks use GSE MBS other securities as collateral. • Primary Credit Dealer Facility – Direct lending to securities funds. • Term Securities Loan Facility – Fed swaps T-Bills for GSE MBS • ABCP MMMF Liquidity Facility – Fed lends to MMMF using ABCP as collateral. • CP Funding Facility – Direct lending for purchases of CP. • MM Investor Funding Facility – Purchase assets from MMMFs

44. Direct Bailouts from FED • September 2008: Federal Reserve makes direct loans to AIG insurance (> US$85 Billion • AIG sold CDS on CDO’s and CMO’s. Because AIG had AAA credit rating, counterparties were willing to pay for insurance w/o collateral. • When possibility of losses increased and AIG lost AAA credit rating, collateral requirements caused liquidity crisis at AIG. • November 2008: Federal Reserve writes credit insurance on US$300 Billion in Citibank CDO’s.

45. Balance Sheets of U.S. Federal Reserve Billion US$, 12-2004, Federal Reserve Annual Report

49. Financing • At first, FED would sell Treasury bills to sterilize credit issued to financial institutions to keep the monetary base from expanding. • September 2008 - Treasury Supplementary Financing – Treasury would sell bills, deposit cash at the FED and this could be used for lending to financial system. • November 2008 More direct lending into bank reserve accounts and direct purchases of assets.