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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.

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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.


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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.


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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


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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.


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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.


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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.


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Financing of Investment Banks

October 2004 – SEC lifts capitalization rules for large broker-dealers

M. Brunnermeier, Princeton U. Slides.


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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%


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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.


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Housing Bubble

www.calculatedrisk.com



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Causes?

  • Low Interest Rates

    • Real Interest Rates – Saving Glut

    • ST Rates Fed

  • Limits on Growth in Desirable Locations

  • Securitization

  • Decline in Lending Standards



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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.


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TIPS Rate: Discount Bond Example

  • TIPS Bond

    • Calculate Yield to Maturity

    • Calculate Average Return

Average inflation between t and t+T, πt:t+T


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Monetary Policy should equal returns of non inflation protected bonds. Or the calculated yield on TIPS bonds equals the real interest rate.

  • .




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CMO: Collateralized Mortgage Obligations Institutions

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.


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Collateralized Debt Obligations Institutions

  • 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


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Reasons for CMO’s & CDO’s Institutions

  • 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.


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Declining Lending Standards Institutions

  • 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)


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Advance of Subprime Institutions

  • Between 1998-2003, 10% of new loans were sub-prime

  • In 2004, 28% of new loans, in 2005, 36%, and in 2006, 40%.


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Sample Definition (Wikipedia) Institutions

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).


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Sub-prime Lenders Institutions

  • 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.


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End of Housing Bubble Institutions

  • 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.


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Increasing Loan Losses Institutions

Credit performance worse at sub-prime lenders.

Mortgage losses estimated at $1.4 trilion by IMF


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Valuation Institutions

  • 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.


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Mark to Market Accounting Institutions

  • 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.


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Liquidity of CMO’s and CDO’s Institutions

  • 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.


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Issues Institutions

  • 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.


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Rates Rise Institutions

Fed Board of Governors



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  • March 2008 Institutions

    • 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


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Interbank Rates Institutions

Hall (Stanford) and Woodward


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Policy Responses Institutions



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Non-standard InstitutionsResponse

  • 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.


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Programs for Expanding Monetary Liabilities Institutions

  • 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


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Direct Bailouts from FED Institutions

  • 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.


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Balance Sheets of U.S. Federal Reserve Institutions

Billion US$, 12-2004, Federal Reserve Annual Report


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Financing Institutions

  • 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.


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Interbank Market Institutions

iIBR

iDW

iTGT

S

iDEPO

D

Reserve Accounts


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Quantitative Easing Institutions

iIBR

iDW

iTGT

S

iDEPO

D

Reserve Accounts


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Purposes of Quantitative Easing Institutions

  • 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.


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Possible Side Effects Institutions

  • Direct transfer of resources to banking sector.

  • In the future, if there are losses, the central bank may need to increase the money supply.


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TARP Institutions

  • 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 I-banks and increase their capitalization.


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Stock Market Institutions


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Global Spillovers Institutions

  • 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.


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Iceland Crisis Institutions


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Chinese Banking System Institutions

  • 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:

    • Joint-Stock Commercial Bank (CITIC Industrial Bank, Bank of Communications, Everbright)

    • City Commercial Bank (Bank of Shanghai, Bank of Beijing, Bank of Tianjian)

    • Credit Cooperatives (Collective Banks – Urban and Rural)

    • Policy Banks (Export Import Bank, China Development Bank)


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Distribution of Assets: PRC Institutions

Source: Mckinsey Global Institute


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Characteristics of China’s financial market. Institutions

  • 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.


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Importance as a Store of Wealth Institutions

  • 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.



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Banks on the Eve of Reform Institutions

  • Problem

    • Many loans are made on a non-commercial basis. A large share of loans are non-performing.


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Banking System in 2002/2004: Institutions(Source: Asian Wall Street Journal {2002}/ BusinessWeek {2004})


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Reasons that NPL’s fell so fast Institutions

  • [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.


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Share Sales Institutions

  • 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.


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Regulation Institutions

  • 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.


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Final Exam Institutions

  • 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).


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