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1 The Financial Crisis: Causes and Consequences Michael S. Pagano, Ph.D., CFA June 14-16, 2009 1.

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Presentation on theme: "1 The Financial Crisis: Causes and Consequences Michael S. Pagano, Ph.D., CFA June 14-16, 2009 1."— Presentation transcript:

1 1 The Financial Crisis: Causes and Consequences Michael S. Pagano, Ph.D., CFA June 14-16,

2 2 Course Overview Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

3 3 Financial Institutions: The “Heart” of an Economy Borrowers Corporations Households Savers Households Corporations Financial Institutions Commercial Banks Securities Firms Insurance Companies Investment Managers Cash Bank Assets Bank Liabilities Loan, Bond & Equity Contracts Deposits, Insurance Policies, ST Debt, Bonds & Equity

4 4 The Negative Effects of Bad Loans on a Bank’s Balance Sheet Cash Securities Loans Net Fixed Assets Total Assets Deposits Short-term Debt Long-term Bonds Preferred Stock Common Equity Total Liabilities & Shareholders Equity Bank’s Key Asset is the TRUST of its Investors

5 5 Quick Quiz: What is the Effect of a $10 Increase in Loan Loss Reserves? Cash 5 Securities20 Net Loans65 Net F.A.10 Tot. Assets 100 Deposits82 Short-term Debt10 Preferred Stock 0 Common Equity 8 Tot. Liab. & S.E

6 6 From Bank Run to Bank Panic: Asset Write-Downs can spread Cash Securities Loans Net F.A. Total Assets Deposits S.T. Debt Common Equity Tot. Liab. & S.E. BANK AAABANK BBB Cash Securities Loans Net F.A. Total Assets Deposits S.T. Debt Common Equity Tot. Liab. & S.E.

7 7 Course Overview Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

8 8 Originate & Distribute vs. Make & Hold: “Elongated” Financial Intermediation Traditional “Old-School” Make & Hold Business Model: BorrowersSavers Commercial Banks Cash MortgagesBank Deposits “Elongated” or “New-School” Originate & Distribute Model: B or ro w er s SaversSavers Investment Banks Cash Fixed Income Funds (NAV) Cash Mort- gages CB’s Money Manag- ers Cash Pools of Mortgages SIVs & CDOs

9 9 A Basic Balance Sheet with Leverage Assets Debt Equity Profit / Loss on Asset Priority of Re-Payment Leverage Factor = Assets / Equity

10 10 Mortgage Gives Homeowners 5x’s Leveraged Returns Return on Equity = 25% [(Return on Assets - Interest Expense) / Equity] = 25% [($ $4.00) / $20] = 25% House $100 Gain on House = 9% Mortgage Debt $80 Interest Rate = 5% Equity $20

11 11 Mortgage Securitization Creates “MBS” and Leverage Pool of Mortgage Debts Equity D D D D D D D D D D D Super Senior AAA MBS BB MBS B MBS BBB MBS AA MBS A MBS Loss Position Credit Risk Yield First Loss High Risk High Yield Last Loss Low Risk Low Yield HOME OWNERSHOME OWNERS AAA MBS

12 12 Collateralized Debt Obligation (“CDO”)– More Leverage Pool of AA, A, BBB MBS Equity MBS Super-Senior AAA CDO B CDO Loss Position Credit Risk Yield First Loss High Risk High Yield Last Loss Low Risk Low Yield WALL ST BANKSWALL ST BANKS MBS

13 13 Credit Default Swaps – Infinite Leverage  Does not usually own reference asset  Going “long”  Benefits when reference asset price INCREASES, max at Par  Tends to own reference asset  Hedging or going “short”  Benefits when reference asset price DECREASES Protection SellerProtection Buyer Payment upon Default of Reference Asset Premium Payments Reference Asset can be a MBS, CDO, Bond, or Loan Like an insurance contract that pays in the event of default. FASB requires mark-to-market valuation. Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value.

14 14 House $100 Mortgage Debt $95 Equity $5 Homeowner 20X’s Increasing Leverage Sub-prime Mortgage 20X’s Leverage

15 15 House $100 Mortgage Debt $95 Equity $5 Mortgage Debt $95 MBS $91.8 Equity $3.2 Homeowner 20X’s Increasing Leverage Mort. Securitiz 30X’s Pooled into MBS – 30X’s Leverage

16 16 House $100 Mortgage Debt $95 Equity $5 MBS $91.8 CDO $90.0 Equity $1.8 Mortgage Debt $95 MBS $91.8 Equity $3.2 Homeowner 20X’s Increasing Leverage Mort. Securitiz 30X’s CDO Structure 50X’s Pooled into CDO – 50X’s Leverage

17 17 House $100 Mortgage Debt $95 Equity $5 MBS $91.8 CDO $90.0 Equity $1.8 CDO $90.0 CDS on CDO $90.0 Equity $0 Mortgage Debt $95 MBS $91.8 Equity $3.2 Homeowner 20X’s Increasing Leverage Mort. Securitiz 30X’s CDO Structure 50X’s Credit Default Swap ∞ CDS on CDO – Infinite Leverage

18 18 In-Class Exercise: Compare and Contrast the Make & Hold and Originate & Distribute Models You can consider the two types of FI models and their impact on the: Speed / velocity of lending Availability of credit in the economy Bank’s credit culture Executive compensation Role of regulators Profitability, Riskiness, & Growth of FIs Future of commercial banking Discuss these issues in small groups and report back to the class.

19 19 Course Overview Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

20 Subprime Mortgage Mess in brief Unintended Consequences: in 1990s, Clinton administration pushed for greater credit access for lower income borrowers. Regulatory Loopholes: in 1999, Citigroup and others agreed to underwrite more risky mortgages if they could be kept off- balance sheet. Perfect Storm hits: low interest rates and recovery loosens credit standards further and investors “stretch” for higher yields. Incentives Misaligned: lenders/brokers, investment bankers, rating agencies, fixed income investors, hedge funds, politicians all have incentive to “turn a good idea into a bad one!”

21 21 Sub-prime Loan Delinquencies Increase Greatly Failures in the origination process come home to roost. Rating agencies, mono-line insurance companies, Investment Banks, and investors did not anticipate this level of loss.

22 22 Foreclosures Push Home Prices Down Further …and delinquent sub-prime homeowners are forced into foreclosure.

23 23 Money Market Investors Go on Strike The difference between overnight rates and 3 month rates sky-rockets to 3.50% (normally 0.15%). Fed Funds vs. LIBOR. No borrowing / lending in the short term markets– Liquidity vanishes! This is precisely what Sectretary of Treasury was reacting to with bail-out.

24 24 Bond Investors Go on Strike Too Corporations could not borrow in the long term institutional bond markets. Hedge funds that bought bonds on leverage are forced to unwind

25 25 U.S. Bank Lending Standards to Large Firms Banks significantly restrict lending to Corporations. Corporations begin to draw on revolving credit facilities that were arranged pre-crisis. Massive cutbacks and lay-offs follow swiftly.

26 26 Bank Lending Standards for Residential Mortgages A Bail Out for Main Street !? Sub-prime and Mid-prime borrowers find it harder to get credit.

27 27 Course Overview Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

28 28 FNMA Guarantees Mortgages behind MBS Pool of Mortgage Debts Equity D D D D D D D D D D D Super Senior Aaa / AAA Ba2 / BB B2 / B Baa2 / BBB Aa2 / AA A2 / A HOME OWNERSHOME OWNERS Aaa / AAA FNMA Guarantees Principal and Interest Payments

29 29 FNMA’s Total Leverage is 85.7X’s Assets = $883bn Equity = $44bn “Book” Leverage = 20.1X’s Guarantees = $2.9tn Total Leverage = 85.7X’s Write-downs in 2007 Inability to raise capital Fed injects $100bn Stock falls to near $0 CDS volatile as mkt not sure about Government guarantee

30 30 AIG Sells Default Protection on Super Senior CDO Pool of AA, A, BBB MBS Equity MBS Super-Senior AAA CDO BB CDO B CDO BBB CDO AA CDO A CDO WALL ST BANKSWALL ST BANKS MBS AAA CDO AIG Sells Protection Reference d to Super Senior CDO

31 31 AIG Sells Default Protection on Super Senior of CDO (cont.) AIG Banks Holding Super Senior CDO Protection SellerProtection Buyer Payment upon Default of Reference Asset Premium Payments Reference Asset is Super Senior CDO AIG gets annual premium of 0.15% on $527 billion (or $790 mil per year). As mortgage losses mount and as investors stop buying MBS and CDO… Mark-to-market of Super Senior CDO goes down AIG is forced to post additional Collateral.

32 32 AIG’s Total Leverage is 16.6X’s Assets = $1.06tn Equity = $95.8bn “Book” Leverage = 11.1X’s CDS on Super Senior = $527bn Total Leverage = 16.6X’s Write-downs of $12bn in 2007 MTM and Collateral Calls Fed Loan of $85bn, now higher. Stock falls to near $0 CDS skyrockets to 25%

33 33 Major FI’s Dupont Ratios: ROE = ROA x Leverage (EM)

34 34 In-Class Exercise: What is Citi’s Leverage Ratio and Dupont Ratio (ROE = ROA x EM)? 2008 OBS Arrangements: LC’s, Lines, LN Comm. 1,460,000 CDOs, CLOs, ABCPCs 97,300 Municipal Sec. TOBs 30,100 Total OBS: 1,587,400

35 35 Course Overview Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc.

36 36 Remedies for the Crisis Fed Liquidity for Fin. Institutions (FIs) beyond traditional Commercial Banks Too-Big-To-Fail (TBTF) Bailouts (Fannie, Freddie, AIG, Citi) Increased Deposit Insurance ($250K / account) $700 Bil. Troubled Asset Relief Program ( TARP ) Federal Guarantees: Commercial Paper, FI Debt, Money Market Funds Major Investment Banks (GS, MS) become BHCs Public-Private Joint Ventures: TALF and PPIP

37 37 U.S. Government Programs – source: Goldman Sachs 2009 report $6 trillion so far (with total commitments up to $13 trillion) The Federal Reserve Bank = $1.877 trillion –Term Auction Facility (TAF): loanable funds to depository FIs –FX Swaps –Commercial Paper Funding Facility (CPFF): buys CP directly from issuers –Term Sec. Lending Facility (TSLF): funds to primary dealers / sec. firms FDIC = $968 billion –Deposit Insurance & Money Market Fund Guarantees –Temporary Liquidity Guarantee Program (TLGP): g’ty for unsec. FI debt U.S. Treasury = $3.310 trillion –CPP (Commercial Paper financing for Bank Conduits) –AIFP (Autos) –TARP and others (Bank preferred, AIG, TALF and PPIP)

38 38 TALF – Term Asset-Backed Securities Loan Facility Asset-backed securities (ABS) are a key source of funding for consumer credit and small business loans ( “shadow banking system” ). ABS issuance has almost completely stopped as investors back away. The Federal Reserve announced the creation of TALF with a $200 bil. facility to support investors purchasing securities backed by pools of: –Student loans –Auto loans –Credit card loans –Small business administration guaranteed loans

39 39 TALF – Term Asset-Backed Securities Loan Facility (cont.) Pool of AAA ABS backed by consumer or small business loans ABS Loan from Federal Reserve Bank Private Investors Loss Position Credit Risk Yield First Loss High Risk High Yield Last Loss Low Risk Low Yield WALL ST BANKSWALL ST BANKS ABS

40 40 PPIP – Public Private Investment Program Goal: Potential to relieve financial institutions from troubled asset classes, create private market pricing transparency and increase asset prices. Legacy Loan Program –Intention is to remove “toxic” loans from bank balance sheets –Joint equity investment by U.S. Treasury and private investors –FDIC provides guarantee for up to 6:1 leverage on debt issued by PPIP vehicle Legacy Securities Program –Expansion of TALF into securities issued before 2009 –Applies to MBS originally rated AAA –Potential to enhance TALF leverage through U.S. Treasury loan

41 41 PPIP – Public Private Investment Program Pool of Bank Loans Loan FDIC Guaranteed Debt (up to 6:1 leverage) Private Investors Loss Position Credit Risk Yield First Loss High Risk High Yield Last Loss Low Risk Low Yield BANKSBANKS Loan U.S. Treasury

42 42 In-Class Exercise: What Consequences (and Opportunities) are related to the Crisis and these Remedies? You can consider the effects on the following areas: U.S. Economy (e.g., growth, inflation, employment) Global Economy (Americas, Europe, Asia) Financial Markets (U.S. and International) Regulation of Financial Institutions Profitability, Riskiness, & Growth of FIs New Business models? Discuss these issues in small groups and report back to the class.

43 43 Some Possible Consequences Reduced Appetite for Risk by FIs Lower Financial Leverage ( De-Leveraging ) Less Profitability (ROE = ROA * Leverage) Tighter Regulation of Financial Institutions Limits on Executive Pay Above Factors suggest Slower Growth and Less Innovation in the long-run Government Stimulus might be inflationary

44 44 Conclusion – Crisis can lead to Opportunities! Part 1 – Foundations of Financial Intermediation Part 2 – Securitization and Financial Leverage Part 3 – The Credit Crisis Part 4 – Case Studies: FNMA, AIG, Citi, etc. Part 5 – Proposed Remedies: TARP, TALF, PPIP, etc. “When it’s raining porridge, you’ll find John’s dish right side up!” ---Lucy Rockefeller. On her brother, John D. Rockefeller.


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