Losses, Leverage, and Liquidity The Road Ahead for Risk Management Carl Tannenbaum Vice President, Risk Specialist Division Federal Reserve Bank of Chicago

Risk Conference, April 2009 Page 2 Presentation Outline Risk and Reinforcement: When Moods Add to Models

Risk Conference, April 2009 Page 3 Key Risk Metrics

Risk Conference, April 2009 Page 4 Spiraling Upward Gains Capital ConfidenceAggression Absence of Caution

Risk Conference, April 2009 Page 5 Spiraling Downward Losses Capital ConfidenceApprehension Abundance of Caution

Risk Conference, April 2009 Page 6 Models: Natural Accelerants Roll rates VaR Economic Capital  Once bad things start to happen, models close down fast Losses

Risk Conference, April 2009 Page 7 Lessons Learned: 1 Past is not always prologue; models should not assume that it is Life events are not normally distributed; why do models assume that they are? How do we avoid extreme overreactions?  Follow-up: models and their applications need to be recalibrated

Risk Conference, April 2009 Page 8 Source: Bloomberg, ICI Statistics & Research Still in the Mattress Volumes in Money Market Funds

Risk Conference, April 2009 Page 9 Assets of Commercial Banks Ratio of Loans & Leases to Total Assets ( All Commercial Banks, SA) Ratio of Cash to Total Assets (All Commercial Banks, SA) Week of Feb. 25 9

Risk Conference, April 2009 Page 10 Source: Federal Reserve Still in the Vault Excess Reserves Held by Commercial Banks

Risk Conference, April 2009 Page 11

Risk Conference, April 2009 Page 12 A Thought: We’ve gone from disintermediation right past re- intermediation to non- intermediation

Risk Conference, April 2009 Page 13 Presentation Outline Risk and Reinforcement: When Moods Add to Models Learnings Gained the Hard Way

Risk Conference, April 2009 Page 14 Spiraling Downward Losses Downgrades Collateral Calls Reduced Liquidity Distressed Asset Sales

Risk Conference, April 2009 Page 15 Liquidity Issues to Think About Mismatches matter –Think about liquidity transfer pricing Look beyond the boundaries of the balance sheet –Commitments, SPVs, sponsored funds Value collateral conservatively –Don’t assume availability, even with FHLB –Know when you might be asked for more When will investors return to buy assets in the seconday market? –Structures go back to basics

Risk Conference, April 2009 Page 16 Loss Estimates Escalate Contagion increases losses Initial capital raising proves inadequate Investors become hesitant to absorb new issues Source: IMF Projected Credit Losses, $$ Billions

Risk Conference, April 2009 Page 17 Lessons Learned: 2 Declines in asset prices can be a cross product of loss and liquidity –Note: A pool with a 50% PD and 50% LGD still has an intrinsic value of 75 cents on the dollar Credit and liquidity risk are closely related, for both markets and institutions Know where you stand in the capital hierarchy  Follow-up: linking events in stress testing for liquidity and market risk

Risk Conference, April 2009 Page 18 Presentation Outline Risk and Reinforcement: When Moods Add to Models Learnings Gained the Hard Way Where We Stand in the Journey Back to Normalcy

Risk Conference, April 2009 Page 19 Rebuilding the Base Public capital predominates More losses ahead Concerns over the “quality of capital” How to make capital levels countercyclical?

Risk Conference, April 2009 Page 20 Where We Stand: Credit Risk Loss Recognition Risk Recognition Residential RE Commercial RE Consumer Credit C&I Lending Issues Recession Scenario Guarantors Models: High-end, low-end Inexperience Ag Lending

Risk Conference, April 2009 Page 21 Foreclosure Filings 2008 Foreclosure Rate United States: 1.8% 1.Nevada: 7.3% 2.Florida: 4.5% 3.Arizona: 4.5% 4.California: 4.0% 5.Colorado: 2.4% 6.Michigan: 2.4% 7.Ohio: 2.3% 8.Georgia: 2.2% 9.Illinois 1.9% 10.New Jersey: 1.8%

Risk Conference, April 2009 Page 22 Credit Spreads: Still Wide

Risk Conference, April 2009 Page 23 Policy Steps $800 billion in fiscal stimulus TALF, PPIFF for banks Foreclosure mitigation Bigger line for the FDIC Review of Mark to Market Accounting Regulatory Restructuring

Risk Conference, April 2009 Page 25 Conclusions The American financial landscape has changed historically in just the past six months; maybe more ahead? The Treasury and the Fed have been exceptionally active We’ll be learning from and debating recent events for years to come

Losses, Leverage, and Liquidity The Road Ahead for Risk Management Carl Tannenbaum Vice President, Risk Specialist Division Federal Reserve Bank of Chicago