“Take $700 billion and call me in the morning: An academic dissection of our financial adventures”

1. “Take $700 billion and call me in the morning: An academic dissection of our financial adventures” (Hypotheses from a microeconomic perspective) Daniel A. Rogers Associate Professor of Finance Portland State University Presented at the University Club of Portland, 10/28/2008

2. The Banking Industry • VERY competitive • Federal Reserve: 1,704 insured US-chartered commercial banks with at least $300 million in assets (6/30/08) • $10.46 trillion in aggregate assets ($8.88 trillion domestic) • 1,506 banks at 6/30/05 with $7.88 trillion in assets • Office of Thrift Supervision: 829 private sector thrifts and 479 holding companies overseeing 445 thrifts • $1.51 trillion in aggregate assets • What is the implication of “heavy competition”?

3. Competition constrains value creation associated with growth • Definition: economic profits  return on capital (ROC) greater than cost of capital • High competition  approximately zero economic profits • Zero economic profits  equity investors are indifferent between company growth vs. dividends • Implies “zero growth opportunities • Hypothesis 1: banks operate in an environment close to “zero growth opportunities”

4. Present value of growth opportunities (PVGO): An illustration for banks • PVGO can be estimated from forward P/E and cost of equity • Some observations for Washington Mutual and Citigroup • March 2004: WM = -12.7%; C = 13.6% • December 2004: WM = 3.6%; C = -2.4% • March 2005: WM = 5.8%; C = 0% • September 2005: WM = 2.2%; C = 6% • December 2005: WM = 1.8%; C = 5.9% • March 2006: WM = 2.4%; C = 5.1% • September 2006: WM = -6.5%; C = 2.1% • April 2007: WM = -23.1%; C = -9.2%

5. Why do banks “grow” if no (economically) profitable growth opportunities? • Possible explanations: • Access to new markets • Reduces risk through diversification • Increase economies of scale • Incremental improvement in ROC • Incentives for managers to grow bank • Hypothesis 2: Bank growth through certain avenues increase risk • By definition, growth through entrance to subprime lending market increased risk! • Equity markets pay attention to risks and risk management policies when “bad risk” has already appeared

6. The role of risk and risk management in the financial crisis • “Standard” bank business model: • Borrow short-term at low rates, lend longer-term at higher rates  net interest margin • Take on credit risk, manage interest rate risk • Competitive advantage: evaluating credit risk • More recent bank businessmodel: • More emphasis on fee-based business • Selling credit risk to increase asset base • Allows for growth, but less emphasis on evaluating credit risk • Securitizations and credit derivatives

7. Growth in credit derivatives

8. Credit derivatives • Over-the-counter (OTC) market • Accounted for only 0.7% of notional value of derivative contracts in June 2001 (BIS) • Has grown to about 10% of derivatives market by end of 2007 • Dominated by big players • Almost no demand outside financial sector • Only $879 billion of the $57.9 trillion in notional value is held by non-financial instituions • Risk is not dispersed through the system through trading • Major counterparty risk (example: Lehman Brothers) • Bigger growth in recent years compared to other derivative markets

9. The role of incentives

10. Illustration of CEO incentives • Incentives of option-based compensation • Value-increasing incentives, BUT • Risk-taking incentives as well (and these can be perverse!) • If market and governance does not always recognize risk, this combination can be problematic • Kerry Killinger (WaMu CEO until 9/7/08) • Combined 2006-07 compensation • $2 mil salary + $0 bonus • $2.9 mil in restricted stock • $8.2 mil in options • Holdings of WaMu equity claims • 1.28 million shares of stock • 5.70 million vested options (exercise prices range from $16.96 to $43.33) • 0.75 million unvested options (exercise prices range from $42.17 to $44.67)

11. Summary and Questions • Traditional banking model has gone by the wayside because of: • Incentives to grow despite limited capability to create value • Encouraged by escalation of option-based compensation • Ease of passing along risk through securitizations and derivatives • Combination of these factors are major contributors to failure of banking system • Where were the boards during the subprime boom? • Failure of Sarbanes-Oxley • How complicit is government social policy of increasing home ownership? • Or was this driven by too much housing speculation? • Why did the home price bubble follow the technology bubble so quickly? • Is there an incentive problem in the money management industry (too much emphasis on getting in on the “hot” market)?