The Banking Crisis: What’s Happening and What’s It Going to Cost?

1. The Banking Crisis:What’s Happening and What’s It Going to Cost? Patrick Honohan Trinity College Dublin (Institute for International Integration Studies and Department of Economics) 1st October 2008

2. 14th Sep 2007 Northern Rock 24th Sep 2008 Bank of East Asia

3. Outline • What went wrong? • Survivors and failures • Government rescues

4. What went wrong? • Perennial sources of bank fragility • This time it’s different? And so it is…but not in a good way • The distinctive feature this time: new formal risk management models and procedures (within banks, rating agencies and regulators) generated over-confidence • Followed by revulsion when they proved inadequate

5. The usual suspects • Over-optimism (inexpensive risk-pricing) especially in the housing market (US, UK, Ireland, etc.) • This was encouraged by and embodied in financial innovation • Maturity transformation (though this almost a definition of banking. • The crisis was preceded by rapid credit growth – a classic danger sign both at the level of individual banks and at the level of the system as a whole. • Principal-agent problems have emerged as they always do when innovation is intense. • Regulatory arbitrage has been to the fore, as in the past • Depositor runs (wholesale and retail) have precipitated dramatic reactions from the authorities.

6. Role of dishonest and predatory lending • A mixture of horror stories from parts of the US, mostly by nonbank mortgage originators. There are laws against this sort of thing, but enforcement/conviction is hard. • Subprime should have been a boon to those excluded from mortgage lending…instead it turned into a nightmare for too many • “Originate to distribute” model is not really new, nor is predatory lending • The ramped-up securitization model, using rating agencies as a seal of approval to enable US mortgages to be funded by lenders all over the world was a key to the rapid growth in subprime (honest and dishonest)

7. Overconfidence in ratings and models • Elaborate risk management models were poorly understood by users, but widely used to justify lending where traditional protections were absent. • Securitization practices built around packaging and repackaging bundles of mortgages in such a way as to get AAA ratings on the maximum volume of funding. • Rating agencies worked with issuers to design the packages that would do the trick – so many of the AAA packages were close to the edge. (Agency/conflict of interest). • Also, the agencies used optimistic assumptions on average defaults, and on the correlation between defaults in different regions. There was insufficient relevant historic data to validate these assumptions. • Even modest house price declines drastically lowered the likely repayments on these AAA tranches.

8. The mortgage-backed securities story illustrates the fact that… …big losses in this crisis are due to long-standing issues (especially incentive effects, moral hazard) but activated by (banker and regulator) overconfidence in the new formal risk management techniques Now there’s revulsion: no confidence in anyone’s risk models; little interbank lending and trading in complex securities

9. Interbank and riskfree rates (3-month) (LIBOR-OIS) October 2005-September 2008 Interbank rate (4.05) “Policy rate” (OIS) (1.73) Source: Bloomberg

10. 2. Survivors and failures • Previous banking crises around the world generated huge fiscal (taxpayer) costs • In the early stages of this crisis (i.e. until about mid-September), despite big reported bank losses, the taxpayer had not been implicated in a big way. • To see why, we look at the different categories of bank that suffered losses.

11. Systemic Crises 1970-2008: Fiscal costs and GDP per head 60 50 40 Fiscal costs % GDP 30 20 10 0 0 5 10 15 20 25 30 GDP per head $000 PPP (1997) Honohan (2008)

12. Reported credit losses at big banks, 2007-8 (US$ billion)

13. Banks hit by losses fall into four failure categories • Diversified survivors • Gambled and lost • Too opaque to survive • Over-leveraged mortgage lenders

14. Banks hit by losses fall into four failure categories • Diversified survivors UBS, Citigroup, Barclays…. • Gambled and lost Sachsen, IKB, IndyMac • Too opaque to survive in the market Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis • Over-leveraged mortgage lenders Fannie and Freddie, HBOS, Northern Rock (?), Bradford&Bingley

15. Banks hit by losses fall into four failure categories • Diversified survivors UBS, Citigroup, Barclays…. • Gambled and lost Sachsen, IKB, IndyMac • Too opaque to survive in the market Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis • Over-leveraged mortgage lenders Fannie and Freddie, HBOS, Northern Rock (?), Bradford&Bingley

16. Four cases: • UBS • 2nd Largest Bank in the World by Total assets, end-2006 • Winner of Euromoney magazine’s “Global Best Risk Management House” award for excellence in 2005. • Sachsen • Newest of the German regional banks • With a wholesale operation in Dublin’s offshore financial centre • Northern Rock • Winner of International Financing Review’s prestigious “Financial Institution Group Borrower of the Year” award for 2006 • GSEs (Fannie Mae and Freddie Mac) • Combined liabilities greater than ⅓ of US GDP in 2007.

17. Four cases: • UBS • Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance • Despite huge losses, no government bailout needed (just) and it was able to replenish capital • Sachsen • Business model unknowingly based on large under-priced guarantee of bought-in AAA tranches of US MBS (rogue sub) • Removal in 2005 of explicit government guarantee mattered • Northern Rock • Had funded (over-rapid) growth with wholesale financing: dependent on continued funding at assumed spreads • Lending originated by NR itself – liked by borrowers • GSEs • Mesmerized by the complexities of trying to hedge prepayment risk, they ignored the basics of credit risk / housing bubble • Lenient capital regulation meant they had little cushion

18. Four cases: • UBS • Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance • Despite huge losses, no government bailout needed (just) and it was able to replenish capital • Sachsen • Business model unknowingly based on large under-priced guarantee of bought-in AAA tranches of US MBS (rogue sub) • Removal in 2005 of explicit government guarantee mattered • Northern Rock • Had funded (over-rapid) growth with wholesale financing: dependent on continued funding at assumed spreads • Lending originated by NR itself – liked by borrowers • GSEs • Mesmerized by the complexities of trying to hedge prepayment risk, they ignored the basics of credit risk / housing bubble • Lenient capital regulation meant they had little cushion

19. Four cases: • UBS • Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance • Despite huge losses, no government bailout needed (just) and it was able to replenish capital • Sachsen • Business model unknowingly based on large under-priced guarantee of bought-in AAA tranches of US MBS (rogue sub) • Removal in 2005 of explicit government guarantee mattered • Northern Rock • Had funded (over-rapid) growth with wholesale financing: dependent on continued funding at assumed spreads • Lending originated by NR itself – liked by borrowers • GSEs • Mesmerized by the complexities of trying to hedge prepayment risk, they ignored the basics of credit risk / housing bubble • Lenient capital regulation meant they had little cushion

20. Four cases: • UBS • Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance • Despite huge losses, no government bailout needed (just) and it was able to replenish capital • Sachsen • Business model unknowingly based on large under-priced guarantee of bought-in AAA tranches of US MBS (rogue sub) • Removal in 2005 of explicit government guarantee mattered • Northern Rock • Had funded (over-rapid) growth with wholesale financing: dependent on continued funding at assumed spreads • Lending originated by NR itself – liked by borrowers • GSEs • Mesmerized by the complexities of trying to hedge prepayment risk, they ignored the basics of credit risk / housing bubble • Lenient capital regulation meant they had little cushion

21. Four cases: • UBS • Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance • Despite huge losses, no government bailout needed (just) and it was able to replenish capital • Sachsen • Business model unknowingly based on large under-priced guarantee of bought-in AAA tranches of US MBS (rogue sub) • Removal in 2005 of explicit government guarantee mattered • Northern Rock • Had funded (over-rapid) growth with wholesale financing: dependent on continued funding at assumed spreads • Lending originated by NR itself – liked by borrowers • GSEs • Mesmerized by the complexities of trying to hedge prepayment risk, they ignored the basics of credit risk / housing bubble • Lenient capital regulation meant they had little cushion

22. Four cases: • UBS • Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance • Despite huge losses, no government bailout needed (just) and it was able to replenish capital • Sachsen • Business model unknowingly based on large under-priced guarantee of bought-in AAA tranches of US MBS (rogue sub) • Removal in 2005 of explicit government guarantee mattered • Northern Rock • Had funded (over-rapid) growth with wholesale financing: dependent on continued funding at assumed spreads • Lending originated by NR itself – liked by borrowers • GSEs • Mesmerized by the complexities of trying to hedge prepayment risk, they ignored the basics of credit risk / housing bubble • Lenient capital regulation meant they had little cushion

23. Common features of the cases Causes • High leverage (even before the crisis) • Heavy reliance on market liquidity and/or accuracy and precision of formal internal risk models and external ratings • even minor model errors or higher funding spreads could generate solvency issues

24. Key financials for four cases To end-September 2008

25. Why it’s hard to predict ultimate costs of Category 4 failures

26. US House Prices 1987-2008

27. Irish House Prices 1997-2008 ESRI/Irish Permanent series: all

28. Based on Dept of Env series: new houses

29. 3. Government rescues (1) Before AIG; Sep 22 • Rather low government costs • Some US banks closed with losses to uninsured creditors (Indybank, Lehman, WaMu) • Shareholders liability enforced • more or less • and management changes in most cases. • (Limited) deposit insurance not a constructive player • Problem of the partially insured

30. Government rescues (2) After AIG • Open bank assistance case-by-case • US: Wachovia—FDIC takes second-loss exposure (not “least cost principle”) • BEL/NLD/FRA/LUX: Injections of government equity (Fortis, Dexia, Glitnir) • Nationalization • AIG (shareholders retain 20%) • Government-guaranteed bank borrowing • Hypo RE bank • Troubled asset relief program • Buys “toxic” assets at above market prices in the hope that their value will prove higher • Removes some of the opaqueness/uncertainty, but fails to give government a share in the upside for shareholders • Blanket deposit insurance (Ireland) • Needs intensified supervision • And some limitations on abuse of this guarantee to build market share

31. Identified fiscal costs: Order of magnitude

34. Read on… www.tcd.ie/iiis (publications…discussion papers)

35. 3-month Interbank rate (LIBOR) % per annum

36. Difference between Interbank and US Treasury Bill rate

37. Irish Life & Permanent Anglo Irish Bank

38. Bank of Ireland AIB