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Credit and Finance PowerPoint Presentation Federal Deposit Insurance Corporation

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Credit and Finance PowerPoint Presentation Federal Deposit Insurance Corporation Powered By Docstoc
					Credit and Finance: Leverage and
              Risk of
       Financial Institutions

       Professor Glenn Yago
          Milken Institute
              2009
                                   1
Overview




           2
                                   Subprime mortgage meltdown timeline
                                                                  December 2006–October 2008
                                                                             Oct. 24, 2007:                               Mar. 16, 2008:
   Dow Jones U.S. Financial Index                                            Merrill announces
                                                                                                    Mar. 11, 2008:
                                                                                                    Fed offers troubled   JP Morgan Chase                    Sept. 29, 2008:
                                                                                                                                                                                     Oct. 3, 2008:
                                                           Sept. 30, 2007:                                                                                                           President Bush
                                                                             $7.9 billion in                              offers to buy Bear                 Citigroup
  700   Feburary–March 2007:
                                   Aug. 6, 2007:           NetBank goes      subprime write-
                                                                                                    banks as much as
                                                                                                                          Stearns; Fed                       agrees to buy
                                                                                                                                                                                     signs Emergency
                                                                                                    $200 billion in                                                                  Economic
                                   American Home           bankrupt.         downs, surpassing                            introduces Primary                 Wachovia.
        More than 25 subprime                                                                       loans; Fed                                                                       Stabilization Act,
                                   Mortgage files for                        Citi’s $6.5 billion.                         Dealer Credit Facility.
        lenders declare                                                                             introduces Term                                          Sept. 23, 2008:         authorizing
                                   bankruptcy.
        bankruptcy.                                                                                 Securities Lending            Mar. 18, 2008:             Washington              bailout of
                                                                                                    Facility.                     Fed cuts                   Mutual is               $700 billion.
  600                                                                                                                             discount rate to           seized by FDIC.         Also, Citigroup
                                                                                                                                  2.5%; Fed funds                                    sues after
                                                                                                                                  rate to 2.25%.                                     Wachovia agrees
                                                                                                                                         April. 30, 2008:     Sept. 16, 2008:
                                                                                                                                                                                     tie-up with Wells
                                                                                                                                         Fed cuts             Fed loans AIG
                                                                                                                                                                                     Fargo.
                                                                                                                                         discount rate to     $85 billion.
                                       Apr. 2007:
  500     Dec. 2006:
                                       New Century, a
                                                                                      Dec. 12, 2007:                                     2.25%; Fed funds                                       Oct. 12, 2008:
          Ownit                                                                       Fed introduces                                     rate to 2%.
                                       mortgage                                                                                                                                                 Finance
          Mortgage, a                                                                 Term Auction                                                           Oct. 8, 2008:
                                       broker, files for                                                                                                                                        leaders
          subprime                                                                    Facility.                                                              Fed cuts discount
                                       bankruptcy.                                                                                                                                              endorse G7
          lender, files                                                                                                                                      rate to 1.75%; Fed
                                                                                      Jan. 11, 2008:                                                                                            plan to calm
          for                                                                                                                                                funds rate to 1.5%.
                                       July 31, 2007:       Aug. 16, 2007:            Bank of                                                                                                   markets.
  400     bankruptcy.
                                       Two Bear             Countrywide gets          America agrees
               Feb. 2007:              Stearns hedge        emergency loan of         to buy                          June 9, 2008:
               HSBC sets aside         funds file for       $11 billion from a        Countrywide.                    Lehman announces
                                       bankruptcy.          group of banks.           Jan. 30, 2008: Fed              a $2.8 billion loss.
               $10.6 billion for
                                                                                      cuts discount                                                                                               Oct. 27, 2008:
               bad loans,
                                                                                      rate to 3.5%.                July 11, 2008:                                                                 Down Jones U.S.
               including
  300                                                      Aug. 17, 2007:                                          IndyMac is seized by FDIC.                                                     Financial Index=230
               subprime.
                                                           Fed cuts discount rate     Feb. 13, 2008:               July 30, 2008:
                                                           to 5.75%; Fed introduces   President Bush                                                        Sept. 7, 2008: U.S.                   Oct. 31, 2008:
                                                                                                                   President Bush        Aug. 1, 2008:
                                                           Term Discount Window       introduces tax rebate                                                 seizes Fannie Mae Sept. 14, 2008:     Dow Jones U.S.
                                                                                                                   signs a housing       First Priority
                                                           Program.                   stimulus program of $168                                              and Freddie Mac. Lehman files for     Financial Index=269
                                                                                                                   rescue law.           Bank closes.                           bankruptcy.
                                                                                      billion.
  200
   12/2006 02/2007 04/2007 06/2007 08/2007 10/2007 12/2007 02/2008 04/2008 06/2008 08/2008 10/2008
Sources: BusinessWeek, S&P, Global Insight, Milken Institute.                                                                                                                                                           3
 Federal Government Comes to the Rescue of
          Main Street and Wall Street
Federal Reserve                                       5,365
Congress and White House                              2,436
Federal Deposit Insurance Corporation                 1,465
Treasury, Federal Deposit Insurance Corporation and
Federal Reserve                                        362
Total amount committed (US$ billions)                 9,628

 Upper limit to total funds provided/cost under these
  programs…$9.6 trillion plus ?
                                                              4
Conservatorship of Fannie Mae and Freddie
                 Mac…




                                            5
Bailing Out AIG…




                   6
Capital Purchase Program under the TARP…




                                           7
Automotive Industry Financing Program…




                                         8
Targeted Investment Program and Asset
          Guaranty Program…




                                        9
And Still……




              10
                   Home mortgages: Who borrows, how much
                   has been borrowed, and who funds them?
                                             Total of housing stock = $19.3 trillion
                                      Total valuevalue of housing stock =$19.3 trillion

                                    Subprime
                                    8.4%                                       Securitized
                                                                                                        Government-
          Mortgage debt                                                           58%
                                                                                                         controlled
          $10.6 trillion                                                                                   46%
                                     Prime
                                     91.6%
                                                                                      Non-securitized    Private
                                                                                           42%           sector-
                                                                                                        controlled
                                                                                                          54%
            Equity in housing stock
            $8.7 trillion



      Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion
Sources: Federal Reserve, Milken Institute.                                                                           11
Low Interest and Lending Boom




                                12
             Low interest rates                                                      Home price bubble
              and credit boom                                                         and credit boom
    US$ trillions                                           Percent            US$ trillions                   Index, January 2000 = 100
    4.0                                                           6.0          4.0                                                 250

    3.5                                                                        3.5
                                                                  5.5                                                              200
    3.0                                                                        3.0
                                                                  5.0
    2.5                                                                        2.5                                                 150
    2.0                                                           4.5          2.0

                                                                               1.5                                                 100
    1.5                                                                                S&P/Case-Shiller
                                                                  4.0                                                  Home
                                           Home                                1.0      National Home
    1.0
             1-Year ARM
                                                                                                                     mortgage
                                         mortgage                                        Price Index                               50
            mortgage rate                                         3.5                                               originations
    0.5                                 originations                           0.5       (right axis)
             (right axis)                                                                                            (left axis)
                                         (left axis)
    0.0                                                           3.0          0.0                                                 0
          2001            2004           2007          Q3 2008                       2001           2004            2007     Q3 2008
 Note: Data for Q1-Q3 2008 are annualized.
Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.                   13
    Subprime mortgages increase rapidly before big decline
 US$ billions
                              Originations                                US$ billions      Outstandings
                                                                          1,400    Average annual growth rates
700
                                           625                                     1995–2006: 14%                 1,240
                                                                                                            1,200
                                                      600                 1,200    2006–Q1 2008: -23%
600
                                   540
                                                                                                     973                  940
500                                                                       1,000                                                 895

400                                                                        800                 699
                          310                                                            574
300                                                                        600
                                                                                  479
                  200                                       191
200      160                                                               400

100                                                                        200
                                                                   14
   0                                                                          0
        2001 2002 2003 2004 2005 2006 2007                         Q2
                                                                    H2            2001 2002 2003 2004 2005 2006 2007 Q1
                                                                   2008
                                                                  2008                                               2008
Sources: Inside Mortgage Finance, Milken Institute.                                                                               14
    Financial products:
Complexity is not innovation;
   Leverage is not credit



                                15
               The mortgage model switches from
            originate-to-hold to originate-to-distribute
                           1980, total = $958 billion                             Q2 2008, total = $11.3 trillion
          Residential mortgage loans                                 Residential mortgage loans
           1980: Total = $958 billion                                Q3 2008: Total = $11.3 trillion

    Securitized
      15.6%
       11%
                                                                                                                     Held in
                                                                                                                    portfolio
                                                                                                                      41%



                                                         Held in    Securitized
                                                        portfolio      59%
                                                         84.4%
                                                          89%

Sources: Federal Reserve, Milken Institute.                                                                                 16
                    Securitization becomes the dominant
                  funding source for subprime mortgages
    Percent of all subprime mortgages securitized since 1994
    80
                                                                                                    68    68    68
    70                                                                                         65
                                                                                         62
    60                                                                            57
                                                                            50
    50                                                                47
                                                45    43        45
                                                           42
                                       40
    40                         33
             31       29
    30

    20

    10

      0
            1994 1995 1996 1997 1998 1999 2000                  2001 2002   200   2004   2005 2006 2007    Q1   Q2
                                                                             3                            2008 2008

Sources: Inside Mortgage Finance, Milken Institute.                                                                   17
             Mortgage-backed securities issued by issuer
 US$ billions
 3,000
                              Private label
  2,500
                              Ginnie Mae
  2,000                       Freddie Mac

  1,500                       Fannie Mae


  1,000

     500

         0
             1985       1987        1989        1991   1993   1995   1997   1999   2001   2003   2005   2007
Sources: Inside Mortgage Finance, Milken Institute.
Note: 2008 data are annualized.                                                                                18
             56 percent of MBS issued from 2005 to 2007
                    were eventually downgraded
                                                                                                Downgraded as
        S&P                               Total              Downgraded
                                                                                             a percentage of total
        AAA                                  1,032                       156                        15.1%
        AA(+/-)                              3,495                     1,330                        38.1%
        A(+/-)                               2,983                     1,886                        63.2%
        BBB(+/-)                             2,954                     2,248                        76.1%
        BB(+/-)                               789                        683                        86.6%
        B(+/-)                                   8                         7                        87.5%
        Total                               11,261                     6,310                        56.0%

Sources: Inside Mortgage Finance, Milken Institute.
Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P.                           19
   Subprime mortgage-backed                                              Investment grade S&P 500
     securities downgrades                                              companies’ credit ratings and
           2005–2007 issuance                                              associated CDS spreads
   Percent downgraded
                                                                      S&P       Number of         CDS spread
   100                                                        94     Rating     companies Highest Lowest     Average
                 S&P                           87
    90                                                   84
                 Moody’s                                              AAA             3             56     15   41
    80                                              76
                 Fitch                    71
                                66                                    AA+             1             95     95   95
    70                               63
                                                                       AA             5             86     49   74
    60                                                                AA-             9            265     54   118
                           50
    50                                                                 A+            17            2,999   12   346
                      38                                                A            36            1,040   38   151
    40
                                                                       A-            34            2,557   51   427
    30           24
                                                                     BBB+            43            1,114   38   222
    20   15 17
                                                                      BBB            41            1,210   61   271
    10
                                                                      BBB-           17            1,235   89   359
     0
          AAA        AA(+/-) A(+/-) BBB(+/-)                       Note: As of October 17, 2008.
Sources: S&P, Datastream, Milken Institute.                                                                            20
                                 When is a AAA not a AAA?
                                    Multilayered mortgage products
                          Origination of
                         mortgage loans                   High-grade CDO

                                                            Senior AAA     88%
                                                            Junior AAA     5%
                        Pool of mortgage                        AA         3%
                    loans: prime or subprime                     A         2%
                                                               BBB         1%
                                                             Unrated       1%

                         Mortgage bonds

                               AAA                 80%
                                AA                 11%
                                A                  4%     Mezzanine CDO
                               BBB                 3%                            CDO-squared
                            BB-unrated             2%       Senior AAA     62%
                                                            Junior AAA     14%   Senior AAA    60%
                                                                AA         8%    Junior AAA    27%
                                                                 A         6%        AA        4%    CDO-cubed…
                                                               BBB         6%         A        3%
                                                             Unrated       4%       BBB        3%
                                                                                   Unrated     2%
Sources: International Monetary Fund, Milken Institute.                                                           21
                                                                                          Dollar losses in reported
        Mortgage loan fraud surges                                                        cases of mortgage fraud
 Number of cases reported, thousands
                                                                            US$ millions
 60                                                                             1,200
                                                                         52.9                                     1,014
 50                                                                             1,000                                     946
                                                                                                                                 813
 40                                                               37.3           800

 30                                                        26.0                  600
                                                                                                           429
 20                                                 18.4                         400        293
                                                                                                    225
                                              9.5
 10                                                                              200
                          4.7 5.4
       1.     2.3 2.9 3.5
  0    7                                                                            0
       1997        1999         2001         2003          2005          2007              2002     2003   2004   2005    2006   2007


Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute.                                       22
                              Drivers of foreclosures:
                      Strong appreciation or weak economies?
  Foreclosures per 1,000 homes
25
             Weak economies                                                                      Housing bubbles
                                                                              Stockton
20
            Detroit
                                                                                                     Las Vegas
                                                                                                                         Riverside
15
                   Cleveland           Toledo                   Sacramento
                                                                                                 Fort Lauderdale            Bakersfield
                                         Dayton
10                    Akron               Denver                                                                                 Miami
                                           Atlanta                                               Phoenix
                                                              Oakland                                              Fresno
            Warren                       Memphis                                         Tampa
 5                                                                                                         Orlando
                                                                         San Diego
                                       Columbus
                                    Indianapolis                                                     Palm Beach
           National average
 0
     -20               0                 20                40                 60                80                 100          120       140
                                                Five-year price gain, Q3 2002–Q3 2007 (percent)

Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.                           23
Affordability




                24
     Ratio of home                                Debt-to-income ratio                           Home mortgage share of
  price to household                               of households has                             household debts reaches
    income surges                                   increased rapidly                               a new high in 2007

Median home price/                               Home mortgage debt/disposable                    Percent
                                                                                                                     Q2 2007: 73.7%
median household income                          personal income                                  75
                                                 Percent
                                                 150                 Q4 2007: 139.5%
5.0                      2005: 4.69

4.5
                                                                                                  70
                                                 125
                                                                                                                         Q2 2008: 73.4%
4.0

3.5                               2007: 4.29
                                                                     Average, 1957–2007: 79.7%    65
                                                 100
3.0                                                                                                    Average, 1952–2008: 64.2%
      Average, 1967–2007: 3.38
2.5                                             75                                                60
      1998        2001        2004         2007   1998           2001         2004        2007     1998      2001      2004        2007


Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute.                                           25
What went wrong?




                   26
          The recent run-up of home prices was extraordinary
 Index, 2000 = 100
  250
         Annualized growth rate of nominal home index, 1890–June 2008: 3.3%                            Current
                                                                                                        boom
  200                                                 Great
                                                    Depression
                                 World
                                                           World                    1970’s   1980’s
  150                            War I
                                                           War II                   boom     boom


  100



    50          Long-term trend line


     0
     1890         1900         1910          1920   1930   1940     1950   1960   1970   1980   1990   2000   2010
Sources: Robert Shiller, Milken Institute.                                                                       27
                                    2005: The collapse begins
 Home price indices, percent change on a year earlier
 25
                        S&P/Case-Shiller 10-city
 20
                   S&P/Case-Shiller national
 15

  10                            OFHEO

    5

    0

   -5

 -10

 -15

 -20
     1988                      1992                      1996              2000   2004   2008
Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.                        28
   Rising risk: The credit default swap market nearly
doubled each year from June 2001 through October 2008
 Notional amount of credit default swaps outstanding, US$ trillions
 70
                                                                                                                       62.2
       Annualized growth rate
 60                                                                                                                           54.6
       H1 2001–H2 2007: 102%
 50    H1 2001–H1 2008: 89%                                                                                     45.5                 47.0

 40                                                                                                      34.4
 30                                                                                               26.0

 20                                                                                        17.1
                                                                                    12.4
                                                                              8.4
 10                                                     3.8      5.4
          0.6       0.9      1.6      2.2      2.7
   0
         June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. June Oct.
         2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008
Sources: International Swaps and Derivatives Association, Milken Institute.                                                                 29
  The importance of Fannie Mae and Freddie Mac
US$ billions
3,000
                                         2,443
2,500
                                                                                              2,067
2,000
                                                                               1,410
1,500
                    886                                         879                                           944
1,000

   500

       0
             Fannie Mae:            Fannie Mae:             Freddie Mac:    Freddie Mac: Commercial         Savings
             total assets            total MBS               total assets     total MBS   banks: total    institutions:
                                    outstanding                             outstanding residential real      total
                                                                                         estate assets residential real
                                                                                                         estate assets

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.                                                                 30
                          Leverage ratios of different types
                            of financial firms (June 2008)
           Leverage ratio, total assets/common equtity

                            Freddie Mac                                                                                                 67.9

                             Fannie Mae                                       21.5

       Federal Home Loan Banks                                                   23.7

              Brokers/hedge funds                                                           31.6

                Savings institutions                          9.4

                  Commercial banks                            9.8

                          Credit unions                      9.1

Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration,
Bloomberg, Google Finance, Milken Institute.                                                                                                   31
                            Too much dependence on debt?
                             Leverage ratios at biggest investment banks
 Total assets/total shareholder equity
 40                                                                           2000        2005       2007      Sept. 2008

  35                   34                                           33
                                                32
                                                               31                              31
  30         28                                                          28
                  27                                                                 26
                                                                                          24        24
  25                                                 23                                                           23 22 22
                                                          22
                                        19 19
  20                                                                                                         18

  15
                                                                                                 June
  10                                                                                             2008

    5
                            n.a
    0
             Bear Stearns               Merrill Lynch     Morgan Stanley         Lehman Brothers            Goldman Sachs

Sources: Bloomberg, Milken Institute.                                                                                        32
                                             Debt dependence
                         Leverage ratios at bank holding companies
 Total assets/total shareholder equity
 25
                                                                     2000   2005    2007     Sept. 2008

  20                               19
                                        16                                  17
                                                                                               15
  15                      13                     13
                 13                                   13                                13
                                                           12   11                 11
  10


    5


    0
                          Citigroup               Bank of America            JP Morgan Chase
Sources: Bloomberg, Milken Institute.                                                                 33
Damages scorecard




                    34
                           What is the cumulative damage?
                               Cumulative losses/write-downs, capital raised, and
                               jobs cut by financial institutions worldwide
    US$ billions                                                                               Number of jobs cut
    1,200                     Jobs cut (right axis)                                                        300,000
                              February 4, 2009: 269.1 thousand
    1,000                                                                                                  250,000

       800     Capital raised (left axis)                                                                  200,000
               February 4, 2009: $969.2 billion
       600                                                                                                 150,000
           Losses/write-downs (left axis)
       400 February 4, 2009: $1068.4 billion                                                               100,000

       200                                                                                                 50,000

          0                                                                                                0
                 Prior          Q3 2007   Q4 2007   Q1 2008      Q2 2008   Q3 2008   Q4 2008    Through
                quarters                                                                         Feb. 4,
Sources: Bloomberg, Milken Institute.                                                             2009          35
                Recent losses/write-downs and capital raised
                     by selected financial institutions
       US$ billions, through February 4, 2009   Losses /write-downs     Capital raised
     Wachovia, United States                                     97.9                      11
     Citigroup, United States                                    85.4                    109.3
     AIG, United States                                          60.9                     65.7
     Freddie Mac, United States                                  58.4                     20.8
     Fannie Mae, United States                                   56.0                     15.6
     Merrill Lynch, United States                                55.9                     29.9
     UBS, Switzerland                                            48.6                     32.0
     Washington Mutual, United States                            45.6                     12.1
     Bank of America, United States                              40.2                     78.5
     HSBC, United Kingdom                                        33.1                      4.9
     Others                                                    486.4                     589.4
     Grand total (US$ billions)                              1,068.40                    969.2
Sources: Bloomberg, Milken Institute.                                                            36
Credit Crunch and Liquidity
          Freeze




                              37
              Tightened standards for real estate loans
  Net percentage of domestic respondents tightening standards for commercial real estate loans
100
          The end of S&L crisis                        LTCM      Dotcom                 Subprime
  80

  60

  40

  20

    0

 -20

 -40
     1990            1992           1994      1996   1998     2000    2002   2004   2006         2008

Sources: Federal Reserve, Milken Institute.                                                             38
                              Widening spreads between
                         mortgage-backed and high-yield bonds
    Basis points, spread over 10-year Treasury bond
    5,000
                                            Maximum spread: 01/30/2009: 3,647 bps
    4,500
    4,000
                                   MerrillMerrill Lynch Mortgage-Backed Securities Index
                                          Lynch BBB-
    3,500                                   Average, 2004–Januray 30, 2009: 503 bps
    3,000
    2,500                   Merrill Lynch High-Yield Bond Index
                            Average, 2004–Januray 30, 2009: 426 bps
    2,000
    1,500
    1,000
      500
         0
        01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008 01/2009

Sources: Merrill Lynch, Bloomberg, Milken Institute.                                              39
                                        Liquidity freeze
          Spread between 3-month LIBOR            Spread between 3-month LIBOR and
                  and T-bill rate                      overnight index swap rate
    Basis points                                  Basis points
    500                                            400
    450     October 10, 2008: 463.6 bps
                                                   350 October 10, 2008: 364 bps
     400
              August 20, 2007: 240 bps            300
     350                                                     Average since
     300 Average since                            250        August 2007: 97 bps
          August 2007:
     250                                          200
          150 bps
     200                                          150   Average since
          Average since                                 December 2001: 29 bps
     150
          1985: 92 bps                            100
     100
      50                                           50
       0                                            0
       2006        2007      2008          2009     2006       2007      2008      2009
Sources: Bloomberg, Milken Institute.                                                     40
                                    Counterparty risk increases
   Average CDS spread, basis points
   700                                                                                    October 10, 2008: 607 bps

                                                   Citigroup agreed to buy Wachovia
   600
                                                            AIG rescued
                                                                                                                                 January 30, 2009:
   500                                 Lehman Brother files for bankruptcy                                                       422 bps
                                           and Merrill Lynch acquired
   400             Government announces support for
                      Fannie Mae and Freddie Mac
   300

   200                 Bear Stearns acquired

   100

       0
     07/2007        09/2007 11/2007               01/2008 03/2008 05/2008                     07/2008        09/2008        11/2008 01/2009
Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN
Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers,
JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia.
Sources: Datastream, Milken Institute.                                                                                                                   41
                        Commercial paper issuance dries up
  Quarterly change in outstanding amount, US$ billions
  150

   100

     50

      0

    -50

  -100
                      Issuers of asset-backed securities
  -150
                      Other issuers
  -200
            Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008

Sources: Federal Reserve, Milken Institute.                                                   42
       Federal Reserve responds by cutting Fed funds rate,
             but mortgage rates remain relatively flat
   Percent                                                                                                              Percent
 10                                                                                                                           6

               30-year FRM rate (left axis)                                                                                  5
   8

                                                                                                                             4
   6
                                                                                                                             3
   4                                                                                Spread (right axis)
          Federal funds rate (left axis)                                                                                     2

   2
                                                                                                                             1

   0                                                                                                                          0
  01/2007        03/2007        06/2007        09/2007        12/2007           02/2008   05/2008   08/2008   11/2008   01/2009

Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.                                                     43
   Increasing spreads between corporate bonds,
  mortgage securities, and target federal funds rate
  Percent
  24
                                                                   High yield corporate bonds yield
  20

  16

  12
                                                                                     Freddie Mac 30-year fixed mortgage rate
    8

    4
              Federal intented funds rate
                                                        AAA corporate bonds yield
   0
  01/2007          04/2007          07/2007           10/2007          01/2008         04/2008    07/2008    10/2008    01/2009
Sources: Federal Reserve, Freddie Mac, Merrill Lynch, Bloomberg, Milken Institute.                                                44
                         Federal Reserve assets increased
                           but asset quality deteriorated
     US$ billions
     2,400
                         Total assets of Federal Reserve banks      11/12/2008: $2.21 trillion
     2,000
                         U.S. Treasury securities held outright
                                                                    12/17/2008: $2.31 trillion
     1,600
                                                                     1/28/2009: $1.93 trillion
     1,200

        800

        400
                                                                  1/28/2009: $475 billion
           0
           2000            2001           2002   2003    2004     2005     2006       2007       2008   2009

Sources: Federal Reserve, Milken Institute.                                                                    45
           Federal Reserve has little maneuvering room
      Percent
      3
                    Effective federal funds rate                              Target federal funds rate
                                                                              Apr. 30, 2008: 2%
                                                                              Oct. 8, 2008: 1.5%
                                                                              Oct. 29, 2008: 1%
      2
                                                                              Dec. 16, 2008: 0-0.25%



      1




     0
    06/01/08         07/01/08          07/31/08   08/30/08   09/29/08   10/29/08   11/28/08   12/28/08    01/27/09

Sources: Federal Reserve, Milken Institute.                                                                      46
                                        Leverage vs. issuer rating
  Fitch long term issuer default rating
    24
   AAA
                                                         Merrill Lynch           ● 2000 ● 2005 ● 2007
    23
   AA+
                                        Citigroup                                   Morgan Stanley
                                                                Morgan Stanley
    22
   AA
             Bank of America
                                                    Merrill Lynch
   AA-
    21
                                                                                                  Merrill Lynch
   A+
    20
                JP Morgan                       Goldman Sachs
   A 19
                                                                                                 Bear Stearns
   A-                                                                     Lehman Brothers
    18
           10                           15               20                 25              30                  35
                                             Total assets/total equity capital
Sources: Bloomberg, Milken Institute.                                                                             47
                              CDS premiums vs. issuer rating
  Fitch long term issuer default rating
AAA
                                                                                                 ● 2004 ● 2005 ● 2007
AA+
                                         Citigroup         Morgan Stanley
AA
           Bank of America                                     Merrill Lynch                   Lehman Brothers
AA-
                    JPMorgan
                                                        Goldman Sachs
A+                                                                             Merrill Lynch

A                                               Bear Stearns
                   Lehman Brothers
A-
          0              10                20         30        40        50            60           70          80      90
                                                Average CDS premium, basis points
Sources: Datastream, Milken Institute.                                                                                  48
                                  Leverage vs. CDS premiums
 Average CDS premium, basis points
    100
                                                                                   ● 2004 ● 2005 ● 2007
                                                                                                 Bear Stearns
      80
                                                                                     Lehman Brothers
                                                                                                  Merrill Lynch
      60                                                      Goldman Sachs
                                     JP Morgan                               Morgan Stanley
      40
                                                                                                   Morgan Stanley

      20
                                                    Merrill Lynch            Bear Stearns
             Bank of America                Citigroup        Lehman Brothers
        0
            10                         15                  20                25               30               35
                                               Total assets/total equity capital
Sources: Datastream, Bloomberg, Milken Institute.                                                               49
     Credit ratings of selected S&P 500 companies and
      associated CDS spreads as of October 17, 2008
                      Investment grade                                                        Speculative grade
                Number of CDS spreads (basis points)                                       Number of CDS spreads (basis points)
    S&P's                                                                      S&P's
                companies Highest Lowest Average                                           companies Highest Lowest Average
     AAA               3              56            15            41            BB+              12             795          130            419
     AA+               1              95            95            95             BB              14             938          168            522
      AA               5              86            49            74             BB-              8            1,352         337            713
     AA-               9              265           54            118            B+               4            3,925         418           1,612
      A+              17            2,999           12            346             B               3            2,686         894           1,523
       A              36            1,040           38            151             B-              2            4,718        3,701          4,209
      A-              34            2,557           51            427
    BBB+              43            1,114           38            222
     BBB              41            1,210           61            271
    BBB-              17            1,235           89            359

Sources: S&P, Bloomberg, Datastream, Milken Institute.
Note: Credit ratings of S&P 500 companies and the associated CDS spreads for those firms for which both ratings and CDS spreads are available.     50
                                    Balance sheet information
 Percent
                                   on FDIC-insured institutions                                                Percent
  20                                                                                                               90
                                                                                Borrowed funds-to-
   18                                                                               asset ratio                      80
   16                                                                                (left axis)
                                                                                                                     70
   14
                                                                                                                     60
                                            Deposits-to-asset                            Insured deposits-to-
   12
                                             ratio (right axis)                         asset ratio (right axis)     50
   10
                                                                                                                     40
     8
                                                                                                                     30
     6
            Equity capital-to-
     4        asset ratio                          Cash-to-asset ratio                                               20
              (right axis)                             (left axis)
     2                                                                                                               10

     0                                                                                                               0
         1992             1994       1996   1998         2000            2002    2004          2006        Q3 2008

Sources: FDIC, Milken Institute.                                                                                          51
                U.S. regulatory capital requirements and
                  prompt corrective action categories
                             Tier 1             Tier 1 risk-
                                                                    Total risk-based
                             leverage           based
    Well capitalized         >= 5% and          >= 6% and           >= 10%

    Adequately capitalized   >= 4% and          >= 4% and           >= 8%

    Undercapitalized         < 4% or            < 4% or             < 8%
    Significantly
                             < 3% or            < 3% or             < 6%
    undercapitalized
    Critically
                             Tangible equity capital ratio that is <= 2%
    undercapitalized

Source: FDIC.                                                                          52
  Equity capital-asset ratio for U.S. commercial banks
Equity capital/asset ratio, percent
30
       1896: 28.1%
25

20
                                                  1932: 16.2%                                               Q3 2008: 9.7%
15
                                                                                  Average, 1896 - Q3 2008: 10.9%
10

  5
                                                                1945: 5.5%                          1979: 5.8%
  0
   1896         1905        1914         1923        1932        1941          1950   1959   1968   1977   1986    1995     2004
Sources: Historical Statistics of the United States, FDIC, Milken Institute.
                                                                                                                                   53
                 Leverage ratio for U.S. commercial banks
    Asset/equity capital ratio
    20
                                                                           1945: 18.2x              1979: 17.4x
    18
    16
    14
    12
    10
                                                                                  Average, 1896 - Q3 2008: 11.0x
     8
     6                                                                                                       Q3 2008: 10.3x
                                                  1932: 6.2x
     4
     2
                 1896: 3.6x
     0
      1896         1905       1914        1923        1932       1941          1950   1959   1968   1977   1986    1995   2004

Sources: Historical Statistics of the United States, FDIC, Milken Institute.
Note: The leverage ratio is the reciprocal of the capital-asset ratio.                                                           54
 Loan loss allowance ratio for U.S. commercial banks
   Percent of total assets
    2
       Shaded columns denote periods of recession                                     1987: 1.66%
  1.6
          Average, 1948 - Q3 2008: 0.91%                                                            Q3 2008: 1.14%
                                                               1969: 1.12%
  1.2


  0.8

                                                                                                       2006: 0.68%
  0.4                                                                   1977: 0.50%
            1948: 0.27%
     0
         1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004                                   Q3
                                                                                                                     2008
Sources: Historical Statistics of the United States, FDIC, Milken Institute.
                                                                                                                       55
 Loan loss allowance ratio for U.S. commercial banks
   Percent of total assets
  5
        Shaded columns denote periods of recession                                                  Wachovia
  4
                                                                                                    IndyMac Bank

  3                                                                                                 Washington Mutual

                                                                                                    All commercial banks
  2


  1


  0
       1992            1994            1996            1998             2000            2002            2004       2006     Q3
                                                                                                                           2008
Sources: Historical Statistics of the United States, FDIC, Milken Institute.
Note: IndyMac Bank became IndyMac Federal Bank in July 2007. Latest data for Washington Mutual is Q2 2008.                        56
 Loan loss allowance ratio for U.S. commercial banks
  Percent of total assets
5
        Shaded columns denote periods of recession                                           JPMorgan
4                                                                                            Citibank
                                                                                             Bank of America
3
                                                                                             All commercial banks

2


1


0
      1992               1994              1996               1998             2000   2002    2004       2006        Q3
                                                                                                                    2008
Sources: Historical Statistics of the United States, FDIC, Milken Institute.
                                                                                                                       57
                                        Reserve coverage ratio of
                                       all FDIC-insured institutions
US$ billions                                                                                                        Percent
200                                                                                                                     200
180                                                                                                                        180
                                                                         Coverage ratio (right axis)
160                                                                                                                        160
140         Loan-loss reserves (left axis)                                                                                 140
120                                                                                                                        120
100                                                                                                                        100
  80                                                                                                                       80
  60                                                                                                                       60
  40                                                                                                                       40
  20        Noncurrent loans (left axis)                                                                                   20
    0                                                                                                                      0
        03/2005           09/2005            03/2006           09/2006       03/2007      09/2007      03/2008   09/2008

Sources: Quarterly Banking Profile, FDIC, Milken Institute .                                                                    58
               The U.S. regulatory regime: In need of reform?
                                                         Financial, bank and thrift       Fannie Mae, Freddie Mac, and                         Federal courts
                        Justice Department
                     • Assesses effects of                  holding companies              Federal Home Loan Banks                       • Ultimate decider of
                                                                                                                                         banking, securities, and
                     mergers and acquisitions on         • Fed                              • Federal Housing Finance
                                                                                                                                         insurance products
                     competition                         • OTS                              Agency


                                                                       Fed is the umbrella or consolidated regulator

                             National banks          State commercial Federal savings Insurance                    Securities            Other financial companies,
                                                    and savings banks     banks       companies                 brokers/dealers             including mortgage
                                                                                                                                          companies and brokers
                    Primary/       • OCC         • State bank          • OTS      • 50 State insurance           • FINRA                     • Fed
                    secondary      • FDIC          regulators          • FDIC       regulators plus              • SEC                       • State licensing
                    functional                   • FDIC                             District of Columbia         • CFTC                        (if needed)
                    regulator                    • Fed--state member                and Puerto Rico              • State securities          • U.S. Treasury
                                                   commercial banks
                                                   commerical banks                                                regulators                   for some products
                                                                                         Notes:
                                                                                         Justice Department: Assesses effects of mergers and acquisitions on competition
                                    Federal              Foreign       Limited foreign   Federal Courts: Ultimate decider of banking, securities, and insurance products
                                    branch                branch           branch        CFTC: Commodity Futures Trading Commission
                                                                                         FDIC: Federal Deposit Insurance Corporation
                                 • OCC               • Fed             • OTS             Fed: Federal Reserve
                                 • Host county       • Host county     • Host county     FINRA: Financial Industry Regulatory Authority
                                   regulator           regulator         regulator       GSEs: Government Sponsored Enterprises
                                                                                         OCC: Comptroller of the Currency
                                                                                         OTS: Office of Thrift Supervision
                                                                                         SEC: Securities and Exchange Commission




Sources: Financial Services Roundtable (2007), Milken Institute.                                                                                                           59
When will we hit bottom?




                           60
                                Looking for a bottom?
                     Economists say the economy isn’t at its low point yet,
                     and house prices likely won’t get there until 2009
           Does this feel like the bottom           When will home prices hit bottom?
                 to a downturn?
                                    Yes        1st half
                                                              6%
                                    27%         2010
                                               2nd half
                                                                                  29%
                                                2009
                                               1st half
                                                                                        38%
                                                2009
                                               2nd half
                                                                       17%
           No                                   2008
           73%                                 1st half
                                                            4%
                                                2008
Source: Wall Street Journal.                                                              61
                     How far do home prices have to fall?
   Annual rents as percent of home prices
   6.5      Q2 1971: 6.08%
    6.0

    5.5

    5.0

    4.5                                                                                              Q1 2008:
                                                                                                      3.93%
               Average, 1960–Q1 2008: 5.04%
    4.0
                                                               Average, 2000–Q1 2008: 4.06%
    3.5
                                                                                          Q4 2006: 3.48%
    3.0
      1960            1965          1970           1975       1980   1985   1990   1995       2000   2005   2010

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.                                                     62
     Declines in home prices and the time it takes to get the
              rent-to-price ratio to a targeted value
                                              (5.04 is the longer-run average ratio)
                                                              Annual home price decline required
                                                                 Annual home price decline
                                                       -2.0%          -5.0%     -10.0%    -15.0%   -20.0%

                                            3.80%     2010 Q3        2008 Q4   2008 Q2   2008 Q2   2008 Q2
                      Rent-to-price ratio




                                            4.00%     2013 Q1        2009 Q4   2008 Q3   2008 Q2   2008 Q2

                                            5.00%     2024 Q1        2014 Q1   2010 Q4   2009 Q3   2009 Q1
                                             5.04%
                                                      2024 Q3        2014 Q2   2010 Q4   2009 Q3   2009 Q1
                                            average
                                            6.00%     2026 Q4        2017 Q3   2012 Q3   2010 Q4   2009 Q4


Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.                                                  63

				
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