The Financial Crisis: A Preliminary View
2009 JRCLS Annual Conference
Harvard Law School
February 14, 2009
Randall D. Guynn
Head of the Financial Institutions
Group
Davis Polk & Wardwell
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
2
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
3
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
4
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
5
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
6
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
7
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
8
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
9
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?
10
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
11
Real-Estate-Related Securities
Home
Owners
Originators
/Lenders
Securitization Re-Securitization:
(Underwriters)
CDO
100%
28%
Super
Senior
AAA
AA
8.6%
AA
A
BBB
Resi
A
BBB
7%
Residual/Equity
0%
1) Lender makes
mortgage loan
to home
owners
2) Lender issues
secured
certificates
backed by loans
AAA
Hedge
Funds
BBB
Pension
Funds
Equity
Other
Inv.
Banks
AAA
20%
11%
Investors
11%
AAA
Banks
CDO2
3) Bonds backed by
mortgages
created in the
primary market
7%
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 “rerating” of risk
6) Investors buy
customized
financial
instruments
12
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
13
Timeline of Significant Events
Summer 2007 – Summer 2008
Spring 2008
Summer 2007
•Continued collapse in real estate prices
• Real estate prices start to collapse
•Continued large CDO markdowns
• Spike in early delinquencies of
2006-2007 subprime mortgages
•Rescue of Bear Stearns by JPM
•Fed discount window opened to Ibanks
Summer 2008
Summer 2007
•Treasury blueprint
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
Winter 2007-2008
•Sovereign wealth funds to the
rescue
•Rescue of Northern Rock by UK
govt
•Fed as fin markets stability regulator
•Indymac fails
•Treasury gets authority to rescue
Fannie/Freddie
14
Spike in Early Subprime Loan Delinquencies
Recent Vintages Show Very Poor Underwriting
Source:
Federal Reserve staff circulations from
First American Loan Performance data
15
Residential Housing Bubble and Collapse
S&P / Case-Schiller Home Price Index
200
190
180
170
160
150
140
130
120
110
100
2000
2001
2002
2003
2004
2005
2006
2007 Q3-2008
Source: Standard & Poor’s
16
Timeline of Significant Events
Summer 2007 – Summer 2008
Spring 2008
Summer 2007
•Continued collapse in real estate prices
• Real estate prices start to collapse
•Continued large CDO markdowns
• Spike in early delinquencies of
2006-2007 subprime mortgages
•Rescue of Bear Stearns by JPM
•Fed discount window opened to Ibanks
Summer 2008
Summer 2007
•Treasury blueprint
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
Winter 2007-2008
•Sovereign wealth funds to the
rescue
•Rescue of Northern Rock by UK
govt
•Fed as fin markets stability regulator
•Indymac fails
•Treasury gets authority to rescue
Fannie/Freddie
17
Timeline of Significant Events (Cont’d)
September 2008
Weekend 1
•Freddie, Fannie bailout
Weekend 4
•Citigroup rescues Wachovia
•Fortis, Dexia are
nationalized
Weekend 2
•Merrill Lynch sells itself to
BofA
October 2008
September 2008
•Lehman Bros fails
Week 3
•AIG rescued
•Treasury proposes $750bn
EESA/TARP
Sept 30
•Primary reserve money market fund
“breaks the buck”
•Treasury announces guaranty
program for money market funds
•House rejects EESA/TARP
•Dow falls record 778 pts, $1.3
trillion
•SEC temporary ban on short sales
Weekend 3
•Treasury releases EESA/TARP bill
•MS, GS become bank holdcos
•WaMu fails, JPM buys all deposits
18
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)
November 2008
October 2008
• U.K. announces bank rescue package
• Treasury announces bank capital purchase program (policy
shift)
• FDIC announces Temporary Liquidity Guarantee Program
(TLGP)
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
19
Timeline of Significant Events (Cont’d)
November 2008
Week 1
• Barack Obama elected President
• Democratic sweep of Congress
Week 2
November 2008
• Fed, Treasury announce expanded
investment in AIG, $150 billion
October 2008
• Democrats urge aid for auto makers
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
20
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
• Consumer spending plummets
• Unemployment spikes
January 2009
November 2008
October 2008
• TARP gives $6 bn in financial
assistance to GMAC
• 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
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
21
Spike in Unemployment
8.0
Unemployment Rate %
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
1998
2000
2002
2004
2006
2008
Source: Bureau of Labor
Statistics
22
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
23
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
24
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)
25
26
27
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.
28
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
29
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
30
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
31
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?
32
Perfect Storm for More Regulation
33
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
34
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
35
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
36
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
37
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
38