Transcript A Theory of Bank Resolution: Political Economics and
The Root Causes of the Crisis: What have We Learned?
Bob DeYoung
Capitol Federal Professor University of Kansas School of Business Summer Teacher Institute University of Chicago June 2009 1
100 50 0
Case-Shiller Home Price Index
250 200 From 1997 to 2006, home prices increased at a 9.1% annual rate.
150 Home prices have declined more than 25% since 2006.
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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% of Jobs Lost in Past Recessions 0 -1 -2 -3 -4 -5 2 1 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 months 1960 1969 1973 1981 1990 2001 2007
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My talk today
All recessions are different. This recession was caused by a collapse in residential real estate values.
Real economy:
Home prices fell collapsed Housing sector Aggregate spending declined.
• This is a demand-side story.
• Reduced spending on houses and related items.
Financial sector:
Mortgage defaults mortgage-backed securities Big losses on Investor uncertainty.
• This is a supply-side story.
• Less credit available for businesses and households.
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My talk today
1. Root causes of the recession:
– A bubble in the housing market.
– A new lending model (which performed poorly).
– A history of short-sighted economic, financial, and social policies. – Bad financial behavior by households.
2. What have we learned?
– Have the responses of policymakers been appropriate? – Have households changed behavior?
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Root Causes of the Crisis:
•
Housing bubble.
•
A new banking model.
•
Poor historical public policy.
•
Poor household finance.
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75% 70% 65% 60% 55% 50% 45% 40% 35% Rate of Homeownership in U.S.
• GI Bill • Automobile/Suburbs • High income tax rates.
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75% 70% 65% 60% 55% 50% 45% 40% 35% Rate of Homeownership in U.S.
• Affordable home policies.
• Easier access to mortgage credit.
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100 50 0
Case-Shiller Home Price Index
250 200 From 1997 to 2006, home prices increased at a 9.1% annual rate.
150 15
Home Price Home Sales
Increased House Demand
• Easy Federal Reserve monetary policy.
• Mortgage interest tax deduction.
• Policies to provide "affordable housing." • Ownership Society.
• Originate-to-Securitize banking model.
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Distribution of Assets held at Financial Intermediaries in the U.S.
1970
Depository Institutions (
banks
, thrifts, credit unions) Insurance Companies (life, property & casualty) Pension Funds (public, private) Mortgage and Consumer Finance (GSEs, finance companies, REITs, securitized asset pools) Mutual Funds (stock, bond, money market) Securities Firms (brokers, dealers, funding corps.) 54.4% 17.4
14.6
8.8
3.7
1.2
2007 Banks were the center for:
• Personal savings • Business credit • Payments 17
Distribution of Assets held at Financial Intermediaries in the U.S.
1970 2007
Depository Institutions (
banks
, thrifts, credit unions) Insurance Companies (life, property & casualty) Pension Funds (public, private) Mortgage and Consumer Finance (GSEs, finance companies, REITs, securitized asset pools) Mutual Funds (stock, bond, money market) Securities Firms (brokers, dealers, funding corps.) 54.4% 17.4
14.6
8.8
3.7
1.2
22.8% 10.5
16.9
23.3
18.5
7.9
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1.5% 1.0% 0.5% Bank profits as % of GDP 0.0% 1970 1980 1990 2000 Asset share of banks, thrifts, credit unions 60% 50% 40% 30% 20% 10% 2007 0% 19
Bank asset shares plunged, but bank profits soared. Why?
• A new business model for large banks emerged.
• The new model exploits post-1980s information technologies, financial products, and regulations.
– Much activity at banks moved off the balance sheet.
– Much income at banks now comes from fees, not from interest.
• This new model is highly efficient, highly profitable, but
riskier than most of us thought
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Traditional Mortgage Finance
Agents that need funds
Home Buyers
Agents with excess funds
Depositors
$ funds $ Bank or Thrift mortgages deposits $ funds $ Bank earns profits from interest margins.
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Innovation: technology and deregulation
• • •
Geographic deregulation (Riegle-Neal Act 1994)
– Permitted inter-state branching.
– Banks could exploit scale economies.
Product deregulation (Gramm-Leach-Bliley Act 1999)
– Permitted commercial banks to engage in investment banking, securities brokerage, and insurance sales.
– Largely fee-based, off-balance sheet activities.
New technologies
– Credit bureaus and credit scores.
– Automated loan underwriting.
– Loan securitization. – Deeper capital markets.
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Traditional Mortgage Finance
Agents that need funds
Home Buyers
Agents with excess funds
Depositors
$ funds $ Bank or Thrift mortgages deposits $ funds $ Bank earns profits from interest margins.
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Traditional Mortgage Finance
Agents that need funds
Home Buyers
Agents with excess funds
Depositors
$ funds $ Bank or Thrift mortgages deposits $ funds $ 24
Bank or Thrift mortgages deposits
Mortgage Securitization
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Bank or Thrift
Mortgage Securitization
mortgages $$$ Mortgage Pool (off-Balance Sheet) mortgages 26
Bank or Thrift
Mortgage Securitization
Institutional Investors mortgages $$$ $$$ Mortgage Pool (off-Balance Sheet) mortgage-backed securities (MBS) MBS 27
Bank or Thrift
Mortgage Securitization
Institutional Investors Mortgage payments from Households Loan servicer (often the bank or the securitizer) withholds a small fee from each mortgage payment.
Mortgage Pool (off-Balance Sheet) securities (MBS) Payments go to investors based on terms of the MBS contract.
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Bank or Thrift
Mortgage Securitization
Bank earns profits from origination fees, securitization fees, servicing fees.
Institutional Investors mortgages $$$ Credit scoring allows a bank to make more loans faster.
Investors get the principal & interest payments.
$$$ Mortgage Pool (off-Balance Sheet) mortgage-backed securities (MBS) MBS MBS rated by Moody's, S&P or Fitch.
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• • •
This model increased risk at large banks.
Increasing reliance on fee income.
– Fee income is often
more volatile
than interest income.
– Fee-based activities require
higher operating leverage.
– Fee-based activities are off-balance sheet, allowing banks to use
more financial leverage.
– Fee income
has not yielded expected diversification benefits.
Increasing reliance on third-party information.
– All lenders have same information (credit bureaus).
– Investors (firms and funds that own the MBS) rely on bond raters.
Fundamentally poor financial management.
– A lack of diversification.
– Excess reliance on financial leverage for earnings.
– Too much interest rate risk.
– Modeling risk without adequate historical data. – Why? Did large banks know they were Too-Big-To-Fail?
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Model gives banks incentives to make riskier loans…that others will hold!
•
Credit underwriting separated from risk-bearing.
– Incentives for lenders to make riskier loans. •
Securitization separated from risk-bearing.
– Incentives for investment banks to engineer riskier MBS. •
Loan monitoring separated from risk-bearing.
– Investors must rely on opinions of rating firms…and the rating firms get paid by the securitizing banks. •
Control rights separated from risk-bearing.
– Fractured ownership of mortgages impedes the modification of nonperforming mortgage loans. 31
Bad banking model? Or bad policy?
•
Regulation did not evolve with banking practices.
– Bank moved activity off of their balance sheets.
– This circumvented capital rules; increased leverage.
•
SEC reduced capital requirements for largest five investment banks in 2004.
•
Regulators did nothing to rein in "Too-Big-To-Fail."
•
SEC limits competition in securities rating business.
– Only three main NRSROs (Moodys, S&P, Fitch) have been licensed to rate these securities.
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Bad banking model? Or bad policy?
•
Congress made sure that OFHEO was a weak regulator of Fannie Mae and Freddie Mac.
– Congress wanted more "affordable mortgages." – Pressured Fannie and Freddie into providing funds for subprime mortgage securitizations.
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Many households also at fault.
•
Too much mortgage debt.
– Bigger houses – Small down payments – Home equity loans 34
35% 30% 25% 20% 15% 10% 5% 0%
Household Financial Obligations (% of Disposable Income)
Renters All households Homeowners Mortgage Debt 35
Subprime mortgage lending
• • •
A typical subprime mortgage scenario in mid-2000s:
– Borrower cannot qualify for a conforming mortgage.
– Gets a 3-year ARM: 0% down and a teaser rate.
– Borrower can just afford the payments in years 1-3.
– Borrower cannot afford the payments after year 3.
Deal works out only if home prices keep increasing.
– As prices rise, borrower builds up equity in home.
– Borrower builds credit rating with a good payment record during first 3 years.
– At year 3, borrower refinances with a conforming loan at a low fixed rate.
But what if prices stop going up?
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Case-Shiller Home Price Index
250 200 150 100 Home prices have declined more than 25% since 2006.
A profound effect on the economy.
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Home Price Excess Supply Home Sales
Reduced House Demand
• Prices stop rising… • Levered homeowners stop building equity.
• Refinancing is no longer possible.
• As these homeowners default on mortgages… • Investors wary and stop financing MBS.
• Mortgage loans become scarce.
• As prices fall, buyers wait for a good deal.
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Single-family Housing Starts (thousands per quarter)
600 500 400 300 home generates about 3.5 jobs.
100 Rough calculation: The annual decline in starts since 2006 implies 4.2 million fewer jobs…an approximate 3% reduction in jobs. 2007 2008 39
% Change in Aggregate Spending (Annualized change from previous quarter, seasonally adjusted) 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 2006 2007 2008 Consumption Spending Nonresidential Investment Residential Investment
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% Change in Aggregate Spending (Annualized change from previous quarter, seasonally adjusted) 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 2006 2007 2008 Consumption Spending Nonresidential Investment Residential Investment
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% Change in Aggregate Spending (Annualized change from previous quarter, seasonally adjusted) 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 2006 2007 2008 Consumption Spending Nonresidential Investment Residential Investment
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Impact on the Financial Sector
•
Large capital losses at banks.
– U.S. banks will suffer at least $2 trillion from MBS losses.
– About $1 trillion of these losses remain to be taken.
–
Based on estimates from IMF; Goldman Sachs; Nouriel Roubini
.
– Largest U.S. banks propped up by the tax payers.
•
Massive operating losses at mono-line mortgage firms.
– Novastar, Countrywide, American Century, WAMU, IndyMac, and others have failed.
•
Lender losses created uncertainty in financial markets.
– No new private mortgage securitizations in over a year.
– BX 2007 AAA-rated subprime trading at 24¢.
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14% 12% 10% 8% 6% 4% 2% 0%
% Delinquencies at U.S. Commercial Banks
Credit cards Business Loans Single-family mortgages Commercial mortgages 44
Subprime Mortgage Delinquencies
NOTE: Most subprime mortgages written by non-banks.
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Lending at U.S. Banks ($ billions)
$1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Commercial Loans Interbank Loans 46
7% 6% 5% 4% 3% 2% 1% 0%
Rates on 3-month financial securities
Financial CP Non-Financial CP Treasury Bills 47
400 350 300 250 200 150 100 50 0
Daily New Issues of Financial Commercial Paper, 2006-2009
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What Have We Learned?
•
Have the policy responses been appropriate?
•
Have households responded appropriately?
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Congress
• • • •
Silly populist legislation:
– Tax AIG bonuses (ex post).
– Limit executive pay (ex post).
– Tank the corporate jet market.
Efforts to modify mortgages.
– Gives households moral hazard incentives.
– OCC study: High recidivism rate.
"TARP-plus" funding.
– A $115 billion ransom payment to get bill passed.
Hair of the dog:
– $8,000 tax credit for first-time home buyers. – 3% down payments for VA, FHA and FMHA loans.
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SEC
•
Largely a bystander in the post-crisis policy response.
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FDIC
• • • •
New FDIC guarantees:
– Deposits up to $250,000 – Pre-existing MMMF accounts – Newly issued corporate debt
Failed bank resolutions:
– Allowed historically large bank failures. – An hour away from arranging a subsidized purchase of Wachovia by CitiGroup.
Financing the insurance fund:
– Increased deposit insurance premiums paid by banks.
– $500 billion line of credit from Treasury.
Leading the charge on modifying mortgages.
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Federal Reserve
•
New lending facilities:
– Term Auction Facility – Commercial Paper Funding Facility – Term Securities Lending Facility – Primary Dealer Credit Facility •
Aggressive monetary policy response
– Fed funds target rate is near 0%.
– M1 and M2 have exploded. •
Co-conspirator with Treasury on "bailouts"
– Fannie and Freddie (discount window loans) – AIG ($152 billion credit facility) – Bear Stearns ($29 billion loan to J.P.Morgan Chase) 53
Treasury
•
Bailouts
– Fannie and Freddie; AIG; Bear Stearns…not Lehman?
•
TARP (Troubled Asset Relief Program)
– Still hasn't bought a single $1 of troubled assets…but it is keeping Citi and BofA afloat.
•
The Hotel Geithner
•
Son of TARP
1. Public-Private investment partnerships to purchase troubled assets.
2. Inject more capital (as previous TARP is paid off).
3. Loan modifications 4. Provide funding in ABS markets (w/ FDIC and Fed) 54
The New Administration Proposal
• • •
Announced on Wednesday, June 17. Five point plan:
– Federal Reserve becomes the regulator of all large or systemically important financial firms.
– Requires reforms in securities markets (ratings firms, securitized loans, derivatives).
– Creates the Consumer Financial Protection Agency (CFPA).
– Established procedures for federal government to takeover and "unwind" large failing financial firms.
– Encourages other countries to do this, too.
Details to come…
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First National Too-Big-To-Fail Bank 1. FNB marks MBS to market: Equity = -$75. Bank fails.
FDIC takes a $75 loss.
2. Treasury buys MBS for $100: Equity = $0 and Cash = $100.
Treasury takes a $75 loss when it sells MBS.
3. Treasury injects $75 of equity: Bank sells MBS and loses $75. Equity = $0 and Cash = $100.
Treasury takes a loss of $75 on equity investment.
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Household Behavior
A 14-year high level of household savings.
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The Root Causes of the Crisis: What have We Learned?
Bob DeYoung
Capitol Federal Professor University of Kansas School of Business Summer Teacher Institute University of Chicago June 2009 58