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The Financial Crisis: Causes and Consequences. Michael S. Pagano, Ph.D., CFA June 14-16, 2009. 1. Course Overview. Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc.

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the financial crisis causes and consequences

The Financial Crisis:Causes and Consequences

Michael S. Pagano, Ph.D., CFA

June 14-16, 2009

1

course overview
Course Overview

Part 1 – Foundations of Financial Intermediation

Part 2 – Securitization and Financial Leverage

Part 3 – The Credit Crisis

Part 4 – Case Studies: FNMA, AIG, Citi, etc.

Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

financial institutions the heart of an economy
Financial Institutions: The “Heart” of an Economy

Financial Institutions

Commercial Banks

Securities Firms

Insurance Companies

Investment Managers

Borrowers

Corporations

Households

Savers

Households

Corporations

Cash

Cash

Loan, Bond & Equity Contracts

Deposits, Insurance Policies, ST Debt, Bonds & Equity

Bank Assets

Bank Liabilities

the negative effects of bad loans on a bank s balance sheet
The Negative Effects of Bad Loans on a Bank’s Balance Sheet

Bank’s Key Asset is the TRUST of its Investors

Cash

Securities

Loans

Net Fixed Assets

Total Assets

Deposits

Short-term Debt

Long-term Bonds

Preferred Stock

Common Equity

Total Liabilities & Shareholders Equity

quick quiz what is the effect of a 10 increase in loan loss reserves
Quick Quiz: What is the Effect of a $10 Increase in Loan Loss Reserves?

8

0

90

Deposits 82

Short-term Debt 10

Preferred Stock 0

Common Equity 8

Tot. Liab. & S.E. 100

Cash 5

Securities 20

Net Loans 65

Net F.A. 10

Tot. Assets 100

55

90

from bank run to bank panic asset write downs can spread
From Bank Run to Bank Panic: Asset Write-Downs can spread

BANK AAA

BANK BBB

Cash

Securities

Loans

Net F.A.

Total Assets

Deposits

S.T. Debt

Common Equity

Tot. Liab. & S.E.

Cash

Securities

Loans

Net F.A.

Total Assets

Deposits

S.T. Debt

Common Equity

Tot. Liab. & S.E.

course overview7
Course Overview

Part 1 – Foundations of Financial Intermediation

Part 2 – Securitization and Financial Leverage

Part 3 – The Credit Crisis

Part 4 – Case Studies: FNMA, AIG, Citi, etc.

Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

originate distribute vs make hold elongated financial intermediation
Originate & Distribute vs. Make & Hold: “Elongated” Financial Intermediation

Cash

Cash

Commercial Banks

Borrowers

Savers

Mortgages

Bank Deposits

Borrowers

Savers

Cash

Cash

Cash

Cash

Money Manag-ers

Investment Banks

CB’s

Fixed Income Funds (NAV)

Mort-gages

Pools of Mortgages

SIVs & CDOs

Traditional “Old-School” Make & Hold Business Model:

“Elongated” or “New-School” Originate & Distribute Model:

a basic balance sheet with leverage
A Basic Balance Sheet with Leverage

Leverage Factor = Assets / Equity

Assets

Priority of Re-Payment

Debt

Profit / Loss on Asset

Equity

mortgage gives homeowners 5x s leveraged returns
Mortgage Gives Homeowners 5x’s Leveraged Returns

Return on Equity = 25%

[(Return on Assets - Interest Expense) / Equity] = 25%

[($9.00 - $4.00) / $20] = 25%

House

$100

Gain on House =

9%

Mortgage Debt

$80

Interest Rate =

5%

Equity

$20

mortgage securitization creates mbs and leverage
Mortgage Securitization Creates “MBS” and Leverage

Last

Loss

Low

Risk

Low

Yield

D

Pool of Mortgage Debts

Super Senior

AAA MBS

Loss Position

Credit Risk

Yield

D

HOME

OWNERS

D

D

D

AAA MBS

D

AA MBS

D

A MBS

D

BBB MBS

BB MBS

D

B MBS

D

Equity

D

First

Loss

High

Risk

High

Yield

collateralized debt obligation cdo more leverage
Collateralized Debt Obligation (“CDO”)– More Leverage

Last

Loss

Low

Risk

Low

Yield

MBS

WALL

ST

BANKS

MBS

Pool of AA, A, BBB MBS

Super-Senior

AAA CDO

Loss Position

Credit Risk

Yield

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

AAA CDO

MBS

B CDO

MBS

Equity

MBS

First

Loss

High

Risk

High

Yield

credit default swaps infinite leverage
Credit Default Swaps – Infinite Leverage

Like an insurance contract that pays in the event of default.

FASB requires mark-to-market valuation.

Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value.

Protection Buyer

Protection Seller

Premium Payments

  • Tends to own reference asset
  • Hedging or going “short”
  • Benefits when reference asset price DECREASES
  • Does not usually own reference asset
  • Going “long”
  • Benefits when reference asset price INCREASES, max at Par

Payment upon Default of Reference Asset

Reference Asset can be a MBS, CDO, Bond, or Loan

sub prime mortgage 20x s leverage
Sub-prime Mortgage 20X’s Leverage

Increasing Leverage

Homeowner 20X’s

House

$100

Mortgage Debt

$95

Equity $5

pooled into mbs 30x s leverage
Pooled into MBS – 30X’s Leverage

Increasing Leverage

Mort. Securitiz 30X’s

Mortgage Debt

$95

MBS

$91.8

Homeowner 20X’s

House

$100

Mortgage Debt

$95

Equity $3.2

Equity $5

pooled into cdo 50x s leverage
Pooled into CDO – 50X’s Leverage

CDO Structure 50X’s

Increasing Leverage

MBS

$91.8

CDO

$90.0

Equity $1.8

Mort. Securitiz 30X’s

Mortgage Debt

$95

MBS

$91.8

Homeowner 20X’s

House

$100

Mortgage Debt

$95

Equity $3.2

Equity $5

cds on cdo infinite leverage
CDS on CDO – Infinite Leverage

Credit Default Swap ∞

CDO

$90.0

CDS on CDO

$90.0

CDO Structure 50X’s

Increasing Leverage

MBS

$91.8

CDO

$90.0

Equity $0

Equity $1.8

Mort. Securitiz 30X’s

Mortgage Debt

$95

MBS

$91.8

Homeowner 20X’s

House

$100

Mortgage Debt

$95

Equity $3.2

Equity $5

in class exercise compare and contrast the make hold and originate distribute models
In-Class Exercise: Compare and Contrast the Make & Hold and Originate & Distribute Models

You can consider the two types of FI models and their impact on the:

Speed / velocity of lending

Availability of credit in the economy

Bank’s credit culture

Executive compensation

Role of regulators

Profitability, Riskiness, & Growth of FIs

Future of commercial banking

Discuss these issues in small groups and report back to the class.

course overview19
Course Overview

Part 1 – Foundations of Financial Intermediation

Part 2 – Securitization and Financial Leverage

Part 3 – The Credit Crisis

Part 4 – Case Studies: FNMA, AIG, Citi, etc.

Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

2007 2008 subprime mortgage mess in brief
2007-2008 Subprime Mortgage Mess in brief

Unintended Consequences: in 1990s, Clinton administration pushed for greater credit access for lower income borrowers.

Regulatory Loopholes: in 1999, Citigroup and others agreed to underwrite more risky mortgages if they could be kept off-balance sheet.

Perfect Storm hits: low interest rates and 2002-07 recovery loosens credit standards further and investors “stretch” for higher yields.

Incentives Misaligned: lenders/brokers, investment bankers, rating agencies, fixed income investors, hedge funds, politicians all have incentive to “turn a good idea into a bad one!”

sub prime loan delinquencies increase greatly
Sub-prime Loan Delinquencies Increase Greatly

Failures in the origination process come home to roost.

Rating agencies, mono-line insurance companies, Investment Banks, and investors did not anticipate this level of loss.

foreclosures push home prices down further
Foreclosures Push Home Prices Down Further

…and delinquent sub-prime homeowners are forced into foreclosure.

money market investors go on strike
Money Market Investors Go on Strike

The difference between overnight rates and 3 month rates sky-rockets to 3.50% (normally 0.15%). Fed Funds vs. LIBOR.

No borrowing / lending in the short term markets– Liquidity vanishes!

This is precisely what Sectretary of Treasury was reacting to with bail-out.

bond investors go on strike too
Bond Investors Go on Strike Too

Corporations could not borrow in the long term institutional bond markets.

Hedge funds that bought bonds on leverage are forced to unwind

u s bank lending standards to large firms
U.S. Bank Lending Standards to Large Firms

Banks significantly restrict lending to Corporations.

Corporations begin to draw on revolving credit facilities that were arranged pre-crisis. Massive cutbacks and lay-offs follow swiftly.

bank lending standards for residential mortgages
Bank Lending Standards for Residential Mortgages

A Bail Out for Main Street !?

Sub-prime and Mid-prime borrowers find it harder to get credit.

course overview27
Course Overview

Part 1 – Foundations of Financial Intermediation

Part 2 – Securitization and Financial Leverage

Part 3 – The Credit Crisis

Part 4 – Case Studies: FNMA, AIG, Citi, etc.

Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

fnma guarantees mortgages behind mbs
FNMA Guarantees Mortgages behind MBS

D

Pool of Mortgage Debts

Super Senior

Aaa / AAA

D

HOME

OWNERS

D

D

FNMA

Guarantees Principal and Interest Payments

D

Aaa / AAA

D

Aa2 / AA

D

A2 / A

D

Baa2 / BBB

Ba2 / BB

D

B2 / B

D

Equity

D

fnma s total leverage is 85 7x s
FNMA’s Total Leverage is 85.7X’s

Assets = $883bn

Equity = $44bn

“Book” Leverage = 20.1X’s

Guarantees = $2.9tn

Total Leverage = 85.7X’s

Write-downs in 2007

Inability to raise capital

Fed injects $100bn

Stock falls to near $0

CDS volatile as mkt not sure about Government guarantee

aig sells default protection on super senior cdo
AIG Sells Default Protection on Super Senior CDO

MBS

WALL

ST

BANKS

MBS

Pool of AA, A, BBB MBS

Super-Senior

AAA CDO

AIG Sells Protection Referenced to Super Senior CDO

MBS

MBS

MBS

MBS

MBS

AAA CDO

MBS

MBS

AA CDO

MBS

A CDO

MBS

BBB CDO

MBS

BB CDO

MBS

B CDO

MBS

Equity

MBS

aig sells default protection on super senior of cdo cont
AIG Sells Default Protection on Super Senior of CDO (cont.)

AIG gets annual premium of 0.15% on $527 billion (or $790 mil per year).

As mortgage losses mount and as investors stop buying MBS and CDO…

Mark-to-market of Super Senior CDO goes down

AIG is forced to post additional Collateral.

Protection Buyer

Protection Seller

Premium Payments

Banks Holding Super Senior CDO

AIG

Payment upon Default of Reference Asset

Reference Asset is Super Senior CDO

aig s total leverage is 16 6x s
AIG’s Total Leverage is 16.6X’s

Assets = $1.06tn

Equity = $95.8bn

“Book” Leverage = 11.1X’s

CDS on Super Senior = $527bn

Total Leverage = 16.6X’s

Write-downs of $12bn in 2007

MTM and Collateral Calls

Fed Loan of $85bn, now higher.

Stock falls to near $0

CDS skyrockets to 25%

in class exercise what is citi s leverage ratio and dupont ratio roe roa x em
In-Class Exercise: What is Citi’s Leverage Ratio and Dupont Ratio (ROE = ROA x EM)?

2008 OBS Arrangements:

LC’s, Lines, LN Comm. 1,460,000

CDOs, CLOs, ABCPCs 97,300

Municipal Sec. TOBs 30,100

Total OBS: 1,587,400

course overview35
Course Overview

Part 1 – Foundations of Financial Intermediation

Part 2 – Securitization and Financial Leverage

Part 3 – The Credit Crisis

Part 4 – Case Studies: FNMA, AIG, Citi, etc.

Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

remedies for the crisis
Remedies for the Crisis

Fed Liquidity for Fin. Institutions (FIs) beyond traditional Commercial Banks

Too-Big-To-Fail (TBTF) Bailouts (Fannie, Freddie, AIG, Citi)

Increased Deposit Insurance ($250K / account)

$700 Bil. Troubled Asset Relief Program (TARP)

Federal Guarantees: Commercial Paper, FI Debt, Money Market Funds

Major Investment Banks (GS, MS) become BHCs

Public-Private Joint Ventures: TALF and PPIP

u s government programs source goldman sachs 2009 report
U.S. Government Programs –source: Goldman Sachs 2009 report

$6 trillion so far (with total commitments up to $13 trillion)

The Federal Reserve Bank = $1.877 trillion

Term Auction Facility (TAF): loanable funds to depository FIs

FX Swaps

Commercial Paper Funding Facility (CPFF): buys CP directly from issuers

Term Sec. Lending Facility (TSLF): funds to primary dealers / sec. firms

FDIC = $968 billion

Deposit Insurance & Money Market Fund Guarantees

Temporary Liquidity Guarantee Program (TLGP): g’ty for unsec. FI debt

U.S. Treasury = $3.310 trillion

CPP (Commercial Paper financing for Bank Conduits)

AIFP (Autos)

TARP and others (Bank preferred, AIG, TALF and PPIP)

talf term asset backed securities loan facility
TALF – Term Asset-Backed Securities Loan Facility

Asset-backed securities (ABS) are a key source of funding for consumer credit and small business loans (“shadow banking system”). ABS issuance has almost completely stopped as investors back away.

The Federal Reserve announced the creation of TALF with a $200 bil. facility to support investors purchasing securities backed by pools of:

Student loans

Auto loans

Credit card loans

Small business administration guaranteed loans

talf term asset backed securities loan facility cont
TALF – Term Asset-Backed Securities Loan Facility (cont.)

Last

Loss

Low

Risk

Low

Yield

ABS

WALL

ST

BANKS

ABS

Pool of AAA

ABS backed by consumer or small business loans

Loan from Federal Reserve Bank

Loss Position

Credit Risk

Yield

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

Private Investors

ABS

ABS

ABS

First

Loss

High

Risk

High

Yield

ppip public private investment program
PPIP – Public Private Investment Program

Goal: Potential to relieve financial institutions from troubled asset classes, create private market pricing transparency and increase asset prices.

Legacy Loan Program

Intention is to remove “toxic” loans from bank balance sheets

Joint equity investment by U.S. Treasury and private investors

FDIC provides guarantee for up to 6:1 leverage on debt issued by PPIP vehicle

Legacy Securities Program

Expansion of TALF into securities issued before 2009

Applies to MBS originally rated AAA

Potential to enhance TALF leverage through U.S. Treasury loan

ppip public private investment program41
PPIP – Public Private Investment Program

Last

Loss

Low

Risk

Low

Yield

Loan

Loan

Pool of Bank Loans

FDIC Guaranteed Debt

(up to 6:1 leverage)

Loss Position

Credit Risk

Yield

Loan

BANKS

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Private Investors

U.S. Treasury

Loan

Loan

Loan

First

Loss

High

Risk

High

Yield

in class exercise what consequences and opportunities are related to the crisis and these remedies
In-Class Exercise: What Consequences (and Opportunities) are related to the Crisis and these Remedies?

You can consider the effects on the following areas:

U.S. Economy (e.g., growth, inflation, employment)

Global Economy (Americas, Europe, Asia)

Financial Markets (U.S. and International)

Regulation of Financial Institutions

Profitability, Riskiness, & Growth of FIs

New Business models?

Discuss these issues in small groups and report back to the class.

some possible consequences
Some Possible Consequences

Reduced Appetite for Risk by FIs

Lower Financial Leverage (De-Leveraging)

LessProfitability (ROE = ROA * Leverage)

Tighter Regulation of Financial Institutions

Limits on Executive Pay

Above Factors suggest Slower Growth and Less Innovation in the long-run

Government Stimulus might be inflationary

conclusion crisis can lead to opportunities
Conclusion – Crisis can lead to Opportunities!

Part 1 – Foundations of Financial Intermediation

Part 2 – Securitization and Financial Leverage

Part 3 – The Credit Crisis

Part 4 – Case Studies: FNMA, AIG, Citi, etc.

Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

“When it’s raining porridge, you’ll find John’s dish right side up!”

---Lucy Rockefeller. On her brother, John D. Rockefeller.