12: Regulating Capital 1 December 3, 2014

2 An Idea from Last Time A fringe benefit increases surplus if its cost to the employer is less than its benefit to the worker.

Coordination Externalities Runs on a single bank are problem. “Systemic Risk”: chain reaction between banks. This is a different problem. NOT the same as “systematic risk”, which is the part of a stock’s riskiness that is correlated with the entire market’s riskiness and so cannot be escaped by diversification. 3

A Bank Run 4

Bank Runs 5 Is this a Prisoner’s Dilemma?

Citizens Bank fails, will reopen as Heartland Bank (2012) PRINCETON – Federal banking regulators designated Citizens First National Bank as a failed bank Friday afternoon, ending its business and selling its assets. Citizens Bank customers can access their money by writing checks or using ATM or debit cards. All checks drawn on the bank will be honored, the Federal Deposit Insurance Corp. said, and all loan customers should continue to make their payments as usual. … The bank branches will reopen today as branches of Heartland Bank and Trust Company of Bloomington, which has agreed to assume Citizens Bank’s assets, including about $870 million in total deposits, the FDIC said in a news release Friday evening. Customers of Citizens Bank are now customers of Heartland Bank. 6

Three Government Tools 1. Deposit insurance. 2. The Fed’s discount window--- serving as lender of last resort. 3. Bailouts, even if not authorized by law. These solve the coordination externality problem. All of these necessitate supervision of banks because they create moral hazard. 7

The Problem with Dep.Insurance Moral Hazard 8 Moral hazard in insurance: The driver drives carelessly, knowing that the insurance company will pay if he dents his car. Moral hazard in the principal-agent model: The worker will choose to slack off if he is paid an annual salary and his boss can’t observe how hard he is working. Moral hazard in banking: The bank make srisky investments because it knows someone will rescue them if the investments fail. The FDIC is the principal; the bank is the agent.

LEVERAGE RAISES PROFITS: Riskless Arbitrage 9

Risky Arbitrage— paying back the loan 10 Average return in Plan 3: 0.8(610) +.2 (-400) = 210%

Risky Arbitrage (corrected for bankruptcy) 11 Plan 3 Return:.8(610%) +.2 (-100%) = 488%- 20%= 468%.

Risk Regulation 1. Capital requirements. There is no one set ratio required; it depends on the riskiness of the bank’s assets. Basel I, II, III are international standards for capitalization ratios– nonbinding advice to each country’s regulators. 2. Restrictions on risky investments. No common stock, limits on options trading, loans to a single borrower can’t be too big, etc. 12

13 If Apple wants to park $20 million dollars somewhere and be able to get it back quickly, what can it do? Apple could buy a repo, a repurchase agreement, from the Apex Hedge Fund. Apple pays Apex $20 million in cash. Apex gives Apple $20 million in securities and agrees to buy them back tomorrow for $ million in cash (about a 2% annual interest rate, $1,000 for the day). Then, Apex lends the money to someone else for.002 million in interest. In effect, Apple deposits $20 million with Apex. Apex is a shadow bank, paying interest on Apple’s deposits and using those deposits to make loans. An odd feature of this is that if the security income happens to arrive overnight, Apex gets it, not Apple. Shadow Banks

Runs on Shadow Banks Apex doesn’t have deposit insurance, but Apple holds the $20 million in securities as collateral. But what if Apple thinks the Apex collateral securities are really worth only $16 million? Suppose one day Apple refuses to renew unless Apex gives it “face value” of $25 million in securities instead. Apex has to return the $20 million or come up with an extra $5 million in securities. Suppose Apex spent the $20 million on other securities, believing Apple would keep renewing the repo. Apex doesn’t have the $20 million cash on hand. If Apex can borrow, fine. But if Apex sells its securities to get cash, securities prices fall. And that reduces the value of securities as collateral. Chain reaction! 14

Systemic Risk 15 Systemic Risk: The risk of collapse of an entire financial system because of the troubles of a few firms. Essentially, the bank run problem. Bank A can’t pay Bank B. Can Bank B pay Bank C? If B can’t, will C be able to pay? “Too big to fail”: A company with debts to so many other companies that if it collapses it creates systemic risk, e.g., AIG. Again: NOT the same as systemATic risk in the CAPM model.

Securitization Securitization means the bundling together of diverse cash flows into a single asset, pieces of which are then sold. Someone could approach various banks around the country and buy the rights to the cash flows from 500 mortgages. Then he could sell shares in that to,1000 other investors. That way, the risk from the mortgages is pooled, the bank gets cash instead of having to hold loans, and investors get to buy an asset with a high interest rate. Securitization has a direct effect of reducing risk and making banks safer. 16

Tranching: Creating Safe Assets Out Of Risky Ones 17 I made up the market prices; they can't be derived from the other information. The prices depend on supply and demand for bonds of different riskiness.

The Bond Rating Companies 18 The bond rating companies such as Moody’s grossly overrated the safety of mortgage-backed securities. Why? 1. Conflict of interest in getting rating fees? 2. The same reason as the banks and investment companies— inexperience and folly? 3. Lack of incentive to maintain their reputations? Would a government agency have rated them more accurately?

The 2008 Banking Crisis We’ll look at this as an example of what happens with regulation in good times and in bad times. 19

The Events of Already, in 2007, some mortgage lenders were failing and the subprime mortgage market was in trouble. In 2008, the Bear Stearns brokerage firm failed. Fannie Mae and Freddie Mac were taken over by the Treasury because of insolvency. The Lehmann Brothers investment bank failed. The Fed bailed out AIG. Treasury asked Congress for the TARP program and got it. Things calmed down again--- but a recession started.

What Caused the Crisis? We’ll look at the housing market, securitization, and the regulatory response. 21

Housing Prices

Housing Prices spusa-cashpidff--p-us

How Down Payments Restrict Leverage 24 Suppose you buy a $100,000 house by paying $20,000 in cash and taking out a mortgage for $80,000. You are highly leveraged. If the price of the house goes down to $90,000, you still have some capital (equity) left, because you only have to pay off $80,000 to keep it. If the house price falls to $60,000, you would do better to let the bank foreclose (though it would hurt your credit rating).

Loan/House-Value 25

Subprime and Other Loans 26

Negative-Equity Nonprime Loans 27

Percentage of Defaults over Time 28

Foreclosures 29

Free Rent---Defaulters 30

Borrowing and Foreclosure 31 What happens when Smith loses ownership of a house? --Somebody else gets to live there. There is an opportunity cost to having Smith live in the house at 2810 Linden Court: Jones can’t live there. If Smith would only pay $1,500 per month to live there and Jones would pay $2,500, value is maximized by having Jones live there instead.

2011 Foreclosure Rates 32 See

Prices of Credit Default Swaps 33

The TED Spread 34

Reserves in Banks 35

Policies for Crises The insolvent banks are liquidated, their assets sold o to new owners. 2. The government nationalizes the insolvent banks, possibly reselling them later. 3. The Fed lends money to banks as lender of last resort. 4. The Treasury or Fed buys preferred stock in banks or in some other way injects capital that is to be repaid. 5. The Treasury or Fed buys toxic assets ---the assets of the bank whose prices have collapsed.

2008 Policy Responses The Fed served as lender of last resort. It also bought dubious assets ($600 billion+) and commercial paper ($350 billion). 2. TARP. The Treasury made loans and bought stock in banks and nonbanks. (Cost: $435 billion disbursed, $279 returned) 3. AIG insurance company bailout. The Fed and TARP helped it out to address the CDS problem. 4. Treasury took over Fannie Mae and Freddie Mac, paying their debts (cost: $145 billion so far, $3.7 trillion in liability exposure!)

Why the Lax Regulation of 2005? 38 Barney Frank, the Chairman of the House Banking Committee, in 2003: “I do think I do not want the same kind of focus on safety and soundness that we have in OCC and OTS. I want to roll the dice a little bit more in this situation towards subsidized housing.”

Republic Windows and Doors: Systemic Risk? ::39 In 2008, Bank of America cut off the line of credit of Chicago’s Republic Windows and Doors. Republic laid off its workers. Under state law the company was supposed to give two months notice, with continued pay and benefits. Politicians jumped in. Bank of America surrendered and gave Republic $1.35 million in the form of a “loan”.

The GM and Chrysler Bailouts: Systemic Risk? In 2009 the government and union medical fund bought a majority interest in Chrysler and in General Motors. Why was this more controversial than buying stock in AIG or Citigroup?