The Banking Crisis:
What’s Happening and What’s
It Going to Cost?
Dr. Clive Vlieland-Boddy
14th Sep 2007
Northern Rock
24th Sep 2008
Bank of East Asia
Outline
• What went wrong?
• Survivors and failures
• Government rescues
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
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 usual suspects
• 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.
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)
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.
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
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.
Reported credit
losses at big
banks, 2007-8
(US$ billion)
Banks hit by losses fall into four
failure categories
• Diversified survivors
• Gambled and lost
• Too opaque to survive
• Over-leveraged mortgage lenders
Banks hit by losses fall into four
failure categories
1. Diversified survivors
UBS, Citigroup, Barclays….
2. Gambled and lost
Sachsen, IKB, IndyMac
3. Too opaque to survive in the market
Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis
4. Over-leveraged mortgage lenders
Fannie and Freddie, HBOS, Northern Rock (?), Bradford & Bingley
Banks hit by losses fall into four
failure categories
1. Diversified survivors
UBS, Citigroup, Barclays….
2. Gambled and lost
Sachsen, IKB, IndyMac
3. Too opaque to survive in the market
Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis
4. Over-leveraged mortgage lenders
Fannie and Freddie, HBOS, Northern Rock (?), Bradford&Bingley
Four cases:
1. 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.
2. Sachsen
– Newest of the German regional banks
– With a wholesale operation in Dublin’s offshore financial
centre
3. Northern Rock
– Winner of International Financing Review’s prestigious
―Financial Institution Group Borrower of the Year‖ award for
2006
4. GSEs (Fannie Mae and Freddie Mac)
– Combined liabilities greater than ⅓ of US GDP in 2007.
Four cases:
1. 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
2. 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
3. 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
4. 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
Four cases:
1. 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
2. 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
3. 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
4. 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
Four cases:
1. 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
2. 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
3. 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
4. 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
Four cases:
1. 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
2. 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
3. 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
4. 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
Four cases:
1. 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
2. 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
3. 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
4. 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
Four cases:
1. 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
2. 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
3. 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
4. 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
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
Key financials for four cases
US$ billion
Sachsen N Rock UBS GSEs
Gross assets* 110 198 1924 4353
Equity** 2 3 41 71
Leverage 58 59 47 61
Reported losses† 2 2 44 16
Liquidity supports 23 56 0
Solvency supports 4 7 25
Exchange rate conversion for all figures is at end-2006 exchange rates
*including off-balance sheet mortgage book; end-2006 **end-2006
†Reported credit-related losses 2007 and 2008H1 sFrom official sources
To end-September 2008
Why it’s hard to predict ultimate costs of Category
4 failures
US House Prices 1987-2008
Irish House Prices 1997-2008
450
400
350
300
250
200
150
100
50
0
97
98
99
00
01
02
03
04
05
06
07
08
ESRI/Irish Permanent series: all
Irish Real New House Prices 1970-2008
4
3.5
Index, 1970=1
3
2.5
2
1.5
1
0.5
1970 1975 1980 1985 1990 1995 2000 2005
Based on Dept of Env series: new houses
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
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 shar
in the upside for shareholders
• Blanket deposit insurance (Ireland)
– Needs intensified supervision
– And some limitations on abuse of this guarantee to build market share
Identified fiscal costs: Order of magnitude
US$ bn Basis
(a) Identified institutions
Equity injections Fortis 16 BEL, NLD, LUX govt equity
IKB 11 KfW Statement
Dexia 8 BEL, FRA, LUX govt equity
Bradford & Bingley 7 Government equity
Northern Rock 7 Government equity
Sachsen 4 Total Government shield
Roskilde 1 Danish National Bank equity
Glitnir 1 Iceland government equity
Dep Insur payouts Bradford & Bingley 26
IndyMac 9 FDIC
15 other FDIC 1 FDIC
Intended fiscal support FNM & FRE 25 CBO
Hypo RE ?? Govt liquidity guar up to $63 bn
Ireland 6 banks ?? Blanket guarantee
Central bank collateral Bear Stearns 4 ? Loss on NY Fed $29 bn facility
AIG 15 Special loan
Others ?? Relaxation of collateral standards
(b) Future failing institutions
(c) Asset purchases from going concerns ?? US Government plan
(d) Distressed borrower assistance
Overall total 135++
Examples Protects small Avoids disruption
depositors of bankruptcy
Closure (possible Lehman,
transfer of good Indybank, WaMu, Only if insured No
business). Bradford&Bingley
Wachovia, Bear
Assisted merger Yes Yes
Stearns
Fortis, Dexia,
Equity injection Yes Yes
Glitnir, Roskilde
AIG, Northern
Nationalization Yes Yes
Rock, Sweden
Bear
Loan on weak
Stearns/Morgan, Yes Yes
collateral
Hypo RE
Ireland, Japan,
Blanket guarantee Yes Yes
Finland, etc.
Assistance to
Chile Yes Yes
borrowers
Asset purchase US Proposal Yes Yes
Effect on Limits future risky Protects interest
shareholders behaviour of taxpayer
Closure (possible
transfer of good Bad Yes Yes
business).
Assisted merger Bad Yes Maybe
Equity injection Depends on price Maybe Maybe
Nationalization Usually bad Maybe Maybe
Loan on weak
Good No No
collateral
Blanket guarantee Good No No
Assistance to
Good No No
borrowers
Asset purchase Very Good No No
Read on…
www.tcd.ie/iiis
(publications…discussion papers)
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Anglo Irish Bank
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