Crisis of 2007-2008
Trends in US Banking
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.
Bank Holding Companies
•
Bank holding companies have a corporate structure in
which a parent company owns many subsidiaries in
different financial industries.
1.
2.
3.
4.
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.
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
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 nonfinancial institutions that pay interest.
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 noninvestment grade credit ratings. Many firms that
relied on banks for credit now issue junk bonds.
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 longterm assets.
Financing of Investment Banks
October 2004 – SEC lifts
capitalization rules for large
broker-dealers
M. Brunnermeier, Princeton U. Slides.
I-Banks switched to more S-T
lending.
Financing of Broker Dealers
45.00%
Ex. In 2000,
Equity to
Assets at
Morgan
Stanley was
4.6%, in May
2008 was 1.1%
40.00%
35.00%
25.00%
20.00%
15.00%
10.00%
5.00%
Finl. Assets-Finl. Liabilities
Repo Finance
2
08
Q
4
20
07
Q
2
20
07
Q
4
20
06
Q
2
20
06
Q
4
20
05
Q
2
20
05
Q
4
20
04
Q
2
20
04
Q
4
20
03
Q
2
20
03
Q
4
20
20
02
Q
-5.00%
02
Q
2
0.00%
20
% of Assets
30.00%
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.
Housing Bubble
www.calculatedrisk.com
Rapid Growth of Mortgage Lending
all sectors home mortgages asset
12000000
11000000
10000000
9000000
8000000
7000000
6000000
5000000
2
4
2
4
2
4
2
4
2
4
2
4
2
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
2
2
3
3
4
4
5
5
6
6
7
7
8
0
0
0
0
0
0
0
0
0
0
0
0
0
20
20
20
20
20
20
20
20
20
20
20
20
20
Causes?
• Low Interest Rates
– Real Interest Rates – Saving Glut
– ST Rates Fed
• Limits on Growth in Desirable Locations
• Securitization
• Decline in Lending Standards
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Savings Glut: Low Real Interest Rate
10 Year Fixed Rate
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
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.
TIPS Rate: Discount Bond Example
• TIPS Bond
– Calculate Yield to Maturity
1  ytmtTIPS
T
,T
FACE VALUE
PRICEtTIPS
– Calculate Average Return
1  itTIPS
,T
(1   t:t T )T  FACE VALUE
T
PRICEtTIPS
Average inflation between t and t+T, πt:t+T
TIPS
 1  itTIPS

1

ytm

,T
t ,T  (1   t :t T )
• 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.
TIPS
E
TIPS
 1  it ,T  E[1  itTIPS
]

1

ytm
(1


)

ytm
 rt ,T

,T
t ,T 
t:t T
t ,T
• If people are averse to inflation risk, then
the TIPS rate is below real interest rate.
  it ,T   tE:t T   ytmtTIPS
,T   rp
Monetary Policy
• .
Loans Serviced for Others
6500000000
6000000000
5500000000
5000000000
4500000000
4000000000
3500000000
3000000000
2500000000
2000000000
2001
2002
2003
2004
2005
2006
2007
2008
US$
Securitization: FDIC Statistics on Banking: All FDIC Institutions
Share of Mortage Assets Held By
120.00%
100.00%
80.00%
Other
ABS
GSE
60.00%
Bank FI's
40.00%
20.00%
Q
2
20
08
Q
4
20
07
Q
2
20
07
Q
4
20
06
Q
2
20
06
Q
4
20
05
Q
2
20
05
Q
4
20
04
Q
2
20
04
Q
4
20
03
Q
2
20
03
Q
4
02
20
20
02
Q
2
0.00%
Banks Increase Holdings of Real
Estate Holdings
Bank RE Based Securities
1,200,000,000
1,000,000,000
800,000,000
600,000,000
400,000,000
200,000,000
0
2001
2002
2003
2004
MBS
2005
CMO
2006
2007
2008
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
M. Brunnermeier, Princeton U. Slides.
seniority. Each
Commercial and Investment Banks
tranche is has its own often set up SPV
credit rating. Special purpose vehicle: Quasiindependent company set up to
manage asset.
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.
Senior Tranche AAA
BBB Securities
SPV
Junior Tranche
BBB Securities
BBB Securities
AAA tranches may have paid
higher returns than typical
AAA securities. Attractive to
institutions restricted to AAA
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.
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)
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%.
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).
Sub-prime Lenders
• An industry of financial intermediaries that
specialized in making mortgage loans prepackaged for securitization arose.
• Many of these specialized in the sub-prime
market.
• Typically, these were sold to SPV’s rather
than GSE’s.
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.
Increasing Loan Losses
Deliquency Rates All Commercial Banks
Credit
performance
worse at subprime lenders.
7
6
5
%
4
3
2
1
19
91
19 .25
92
19 .50
93
19 .75
95
19 .00
96
19 .25
97
19 .50
98
20 .75
00
20 .00
01
20 .25
02
20 .50
03
20 .75
05
20 .00
06
20 .25
07
20 .50
08
.7
5
0
Residential
All
Mortgage losses
estimated at
$1.4 trilion by
IMF
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
itDF  itRISKFREE  Risk Premiumt
• Rising risk premium has reduced price of
the assets.
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.
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.
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.
Rates Rise
Fed Board of Governors
Commercial Paper Market Dries Up
• 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
Spread over 1-Month Treasury Bill Rate, Percentage
Points
Interbank Rates
4.0
3.5
LIBOR--large
banks
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Jul-01
Federal funds--small
Jul-02
Jul-03
Hall (Stanford) and Woodward
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Policy Responses
Standard Monetary Policy
Response
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.
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
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$300 Billion in Citibank CDO’s.
Balance Sheets of U.S. Federal Reserve
Liabilities
Monetary Base
Federal Reserve Notes
Deposits of Depository Institution
Nonbase Liabilities
Deposts of U.S. Treasury
Other
Assets
Foreign Currency Assets
US Government Securities
Discount Loan
Other Assets
719.4
24
5.9
37.8
21.4
725.6
0.4
63.8
Billion US$, 12-2004, Federal Reserve
Annual Report
Assets
Gold certificate account
Special drawing rights certificate account
Coin
Securities, repurchase agreements, term auction
credit, and other loans
Securities held outright
U.S. Treasury (1)
Bills (2)
Notes and bonds, nominal (2)
Notes and bonds, inflation-indexed (2)
Inflation compensation (3)
Federal agency (2)
Repurchase agreements (4)
Term auction credit
Other loans
Net portfolio holdings of Commercial Paper
Funding Facility LLC (5)
Net portfolio holdings of Maiden Lane LLC (6)
Items in process of collection
Bank premises
Other assets (7)
Wednesday
19-Nov-08
11,037
2,200
1,648
Change Since
Wednesday
21-Nov-07
0
0
470
1,272,929
488,926
476,425
18,423
410,491
41,071
6,440
12,501
80,000
415,302
288,702
438,201
-290,744
-303,245
-248,596
-60,493
4,160
1,684
12,501
25,000
415,302
288,644
270,879
26,919
1,115
2,178
599,780
270,879
26,919
-3,250
64
560,932
Change Since
Wednesday
21-Nov-07
42,240
67,526
1,182,538
609,525
63,133
508,956
87
837
-346
-1,702
Liabilities
Federal Reserve notes, net of F.R. Bank holdings
Reverse repurchase agreements (8)
Deposits
Depository institutions
U.S. Treasury, general account
U.S. Treasury, supplementary financing account
Foreign official
Other
Deferred availability cash items
Other liabilities and accrued dividends (9,10)
Wednesday
19-Nov-08
828,617
102,909
1,209,231
630,492
68,457
508,956
183
1,143
2,742
4,194
Total liabilities
2,147,694
1,290,257
Capital accounts
Capital paid in
Surplus
Other capital accounts
20,373
17,166
3,453
2,284
1,709
-35
Total capital
40,992
3,959
2008-07
2008-02
2007-09
2007-04
2006-11
2006-06
2006-01
2005-08
2005-03
2004-10
2004-05
2003-12
2003-07
2003-02
2002-09
2002-04
2001-11
2001-06
2001-01
Monetary Base, SA, BA
1200000
1100000
1000000
900000
800000
700000
600000
500000
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.
Effective
Target
Discount
Deposit
11/18/2008
11/11/2008
11/4/2008
10/28/2008
10/21/2008
10/14/2008
10/7/2008
9/30/2008
9/23/2008
9/16/2008
9/9/2008
9/2/2008
8/26/2008
8/19/2008
8/12/2008
8/5/2008
7/29/2008
7/22/2008
7/15/2008
7/8/2008
7/1/2008
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Interbank Market
iIBR
iDW
iTGT
S
iDEPO
D
Reserve Accounts
Quantitative Easing
iIBR
iDW
iTGT
S
iDEPO
D
Reserve Accounts
Purposes of Quantitative Easing
• Fed supports lending in Money Market
eases liquidity crunch.
• Fed accepts CDO’s and CMO’s as
collateral to increase liquidity in this
market and reduce lemon’s problem.
• Fed absorbs risk of bank assets increasing
capital cushion for other bank creditors to
increase interbank lending.
Possible Side Effects
• Direct transfer of resources to banking
sector.
• In the future, if there are losses, the
central bank may need to increase the
money supply.
TARP
• Troubled Asset Relief Program
– Original plan, U.S. treasury by CDOs and
CMO’s and add liquidity to the market, narrow
spreads and improve balance sheets.
– Current plan, US treasury buys preferred
stock on generous terms from banks and Ibanks and increase their capitalization.
Stock Market
50
20
2000
1981
Price-Earnings Ratio
40
16
1929
35
14
30
25
12
Price-Earnings Ratio
1901
1966
10
20
8
15
6
1921
10
5
0
1860
18
Long-Term Interest Rates
45
4
Long-Term Interest Rates
1880
1900
2
1920
1940
Year
1960
1980
2000
0
2020
Global Spillovers
• Many banks in Europe took large positions in
CDO’s and many European countries have
offered deposit guarantees.
• American investment banks were large buyers in
equity markets especially in Japan and there
bankruptcy may have hurt demand for stocks
and reduced liquidity.
• Banks earnings decline bringing down value of
bank stocks directly.
Iceland Crisis
Chinese Banking System
•
•
Dominated by Four State Owned Deposit Money Taking
Banks (Industrial and Commercial, Construction Bank, Agricultural
Bank, Bank of China) (Deposit Money Bank)
Other types of banks:
1. Joint-Stock Commercial Bank (CITIC Industrial Bank,
Bank of Communications, Everbright)
2. City Commercial Bank (Bank of Shanghai, Bank of
Beijing, Bank of Tianjian)
3. Credit Cooperatives (Collective Banks – Urban and
Rural)
4. Policy Banks (Export Import Bank, China Development
Bank)
Distribution of Assets: PRC
Share of Assets: China
70
60
50
40
30
20
10
0
SOE Commerical State Policy Bank
Joint Stock
Credit Cooperative City Commercial
Bank
Commercial Bank
Bank
Source: Mckinsey Global Institute
Characteristics of China’s
financial market.
• Bank lending (especially by big 4) has
traditionally been channeled to State Owned
Enterprises (SOE’s) for policy reasons
rather than traditional profit.
• SOE sector is declining.
• As a result, many of the loans made by
Chinese banks go bad.
Importance as a Store of Wealth
• Chinese savers have limited options for
storing their wealth.
– Bond markets are limited and mutual funds
rare.
– Stock markets not transparent and volatile.
– Capital account closed. No legal foreign assets.
• As a result, huge share of savings
channeled to the banking sector.
Deposits are major channel for
saving in PRC
Bank Deposits as Share of GDP
200.0%
180.0%
160.0%
140.0%
120.0%
100.0%
80.0%
60.0%
40.0%
20.0%
0.0%
China
USA
Banks on the Eve of Reform
• Problem
– Many loans are made on a noncommercial basis. A large share of
loans are non-performing.
Banking System in 2002/2004:
(Source: Asian Wall Street Journal {2002}/ BusinessWeek {2004})
Big Four Banks
Industrial & Commercial Bank of
China
Bank of China
China Construction Bank
Agricultural Bank of China
Official
NPL
Ratio
21.56%
18.07%/
5.46%
11.92%/
3.08%
30.07%
Reasons that NPL’s fell so fast
– [AMC’s] Asset Management Companies
have purchased Yuan 1.4 Trillion worth
of bad loans from banks.
– Credit Management : Banks have
improved their lending practices.
– More Loans- Banks have gone on a
lending binge and fresh loans may not
have gone bad yet.
Share Sales
• Central government has a policy to make
many of the banks publicly listed
companies.
• Banks will sell shares to investors and the
shares will trade in HK and must meet HK
corporate governance standards.
• State will retain majority control.
• Foreign banks will take strategic stakes to
help transfer their expertise.
Regulation
• Chinese Banking Regulatory Commission
formed to regulate banking system in 2006.
• People’ Bank of China still regulates interest
rates especially deposit rates and prime rates
though banks set lending rates by
creditworthiness.
• Foreign banks can set up operations in 8 large
cities and can since 2006 accept deposits in
Renminbi.
Final Exam
•
•
•
•
•
•
Date: Thursday December 18
Time: 8:30-11:30
Venue: LG1
Bring calculator, writing instrument
Format: Same as practice exam, mid-term
Coverage: Cumulative – Guidance (2/3
after the mid-term).