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The Banking Crisis

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					    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
                   15th September
                   2008. Filed for
                   bankruptcy
                   protection



$182b bailout by
US government
of one of the
biggest
Insurance
Companies
                  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)
3-month Interbank rate (LIBOR)




                                 % per annum
Difference between Interbank and US Treasury Bill rate
Irish Life & Permanent




Anglo Irish Bank
 Bank of Ireland




AIB

				
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