the banking crisis: what’s happening and what’s it going to cost? patrick honohan trinity...
TRANSCRIPT
The Banking Crisis:What’s Happening and What’s It
Going to Cost?
Patrick Honohan
Trinity College Dublin (Institute for International Integration Studies and Department
of Economics)
1st October 2008
14th Sep 2007
Northern Rock
24th Sep 2008
Bank of East Asia
Outline
1. What went wrong?
2. Survivors and failures
3. Government rescues
What went wrong?
• Perennial sources of bank fragility
• This time it’s different? And so it is…but not in a good way
• The distinctive feature this time: new formal risk management models and procedures (within banks, rating agencies and regulators) generated over-confidence
• Followed by revulsion when they proved inadequate
The usual suspects
• Over-optimism (inexpensive risk-pricing) especially in the housing market (US, UK, Ireland, etc.)
• This was encouraged by and embodied in financial innovation
• Maturity transformation (though this almost a definition of banking.
• The crisis was preceded by rapid credit growth – a classic danger sign both at the level of individual banks and at the level of the system as a whole.
• Principal-agent problems have emerged as they always do when innovation is intense.
• Regulatory arbitrage has been to the fore, as in the past
• Depositor runs (wholesale and retail) have precipitated dramatic reactions from the authorities.
Role of dishonest and predatory lending
• A mixture of horror stories from parts of the US, mostly by nonbank mortgage originators. There are laws against this sort of thing, but enforcement/conviction is hard.
• Subprime should have been a boon to those excluded from mortgage lending…instead it turned into a nightmare for too many
• “Originate to distribute” model is not really new, nor is predatory lending
• The ramped-up securitization model, using rating agencies as a seal of approval to enable US mortgages to be funded by lenders all over the world was a key to the rapid growth in subprime (honest and dishonest)
Overconfidence in ratings and models
• Elaborate risk management models were poorly understood by users, but widely used to justify lending where traditional protections were absent.
• Securitization practices built around packaging and repackaging bundles of mortgages in such a way as to get AAA ratings on the maximum volume of funding.
• Rating agencies worked with issuers to design the packages that would do the trick – so many of the AAA packages were close to the edge. (Agency/conflict of interest).
• Also, the agencies used optimistic assumptions on average defaults, and on the correlation between defaults in different regions. There was insufficient relevant historic data to validate these assumptions.
• Even modest house price declines drastically lowered the likely repayments on these AAA tranches.
The mortgage-backed securities story illustrates the fact that…
…big losses in this crisis are due to long-standing issues (especially incentive effects, moral hazard)
but activated by (banker and regulator) overconfidence in the new formal risk management techniques
Now there’s revulsion:
no confidence in anyone’s risk models; little interbank lending and trading in complex securities
Interbank and riskfree rates (3-month) (LIBOR-OIS)
October 2005-September 2008
“Policy rate” (OIS) (1.73)
Interbank rate (4.05)
Source: Bloomberg
2. Survivors and failures
• Previous banking crises around the world generated huge fiscal (taxpayer) costs
• In the early stages of this crisis (i.e. until about mid-September), despite big reported bank losses, the taxpayer had not been implicated in a big way.
• To see why, we look at the different categories of bank that suffered losses.
Systemic Crises 1970-2008: Fiscal costs and GDP per head
0
10
20
30
40
50
60
0 5 10 15 20 25 30
GDP per head $000 PPP (1997)
Fis
cal c
osts
% G
DP
Honohan (2008)
Reported credit losses at big banks, 2007-8(US$ billion)
Banks hit by losses fall into four failure categories
1. Diversified survivors
2. Gambled and lost
3. Too opaque to survive
4. Over-leveraged mortgage lenders
Banks hit by losses fall into four failure categories
1. Diversified survivors UBS, Citigroup, Barclays….
2. Gambled and lost Sachsen, IKB, IndyMac
3. Too opaque to survive in the market Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis
4. Over-leveraged mortgage lenders Fannie and Freddie, HBOS, Northern Rock (?), Bradford&Bingley
Banks hit by losses fall into four failure categories
1. Diversified survivors UBS, Citigroup, Barclays….
2. Gambled and lost Sachsen, IKB, IndyMac
3. Too opaque to survive in the market Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis
4. Over-leveraged mortgage lenders Fannie and Freddie, HBOS, Northern Rock (?), Bradford&Bingley
Four cases:1. UBS
– 2nd Largest Bank in the World by Total assets, end-2006– Winner of Euromoney magazine’s “Global Best Risk
Management House” award for excellence in 2005.
2. Sachsen– Newest of the German regional banks– With a wholesale operation in Dublin’s offshore financial
centre
3. Northern Rock– Winner of International Financing Review’s prestigious
“Financial Institution Group Borrower of the Year” award for 2006
4. GSEs (Fannie Mae and Freddie Mac)– Combined liabilities greater than ⅓ of US GDP in 2007.
Four cases:1. UBS
– Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance
– Despite huge losses, no government bailout needed (just) and it was able to replenish capital
2. Sachsen– Business model unknowingly based on large under-priced
guarantee of bought-in AAA tranches of US MBS (rogue sub)– Removal in 2005 of explicit government guarantee mattered
3. Northern Rock– Had funded (over-rapid) growth with wholesale financing:
dependent on continued funding at assumed spreads– Lending originated by NR itself – liked by borrowers
4. GSEs– Mesmerized by the complexities of trying to hedge
prepayment risk, they ignored the basics of credit risk / housing bubble
– Lenient capital regulation meant they had little cushion
Four cases:1. UBS
– Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance
– Despite huge losses, no government bailout needed (just) and it was able to replenish capital
2. Sachsen– Business model unknowingly based on large under-priced
guarantee of bought-in AAA tranches of US MBS (rogue sub)– Removal in 2005 of explicit government guarantee mattered
3. Northern Rock– Had funded (over-rapid) growth with wholesale financing:
dependent on continued funding at assumed spreads– Lending originated by NR itself – liked by borrowers
4. GSEs– Mesmerized by the complexities of trying to hedge
prepayment risk, they ignored the basics of credit risk / housing bubble
– Lenient capital regulation meant they had little cushion
Four cases:1. UBS
– Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance
– Despite huge losses, no government bailout needed (just) and it was able to replenish capital
2. Sachsen– Business model unknowingly based on large under-priced
guarantee of bought-in AAA tranches of US MBS (rogue sub)– Removal in 2005 of explicit government guarantee mattered
3. Northern Rock– Had funded (over-rapid) growth with wholesale financing:
dependent on continued funding at assumed spreads– Lending originated by NR itself – liked by borrowers
4. GSEs– Mesmerized by the complexities of trying to hedge
prepayment risk, they ignored the basics of credit risk / housing bubble
– Lenient capital regulation meant they had little cushion
Four cases:1. UBS
– Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance
– Despite huge losses, no government bailout needed (just) and it was able to replenish capital
2. Sachsen– Business model unknowingly based on large under-priced
guarantee of bought-in AAA tranches of US MBS (rogue sub)– Removal in 2005 of explicit government guarantee mattered
3. Northern Rock– Had funded (over-rapid) growth with wholesale financing:
dependent on continued funding at assumed spreads– Lending originated by NR itself – liked by borrowers
4. GSEs– Mesmerized by the complexities of trying to hedge
prepayment risk, they ignored the basics of credit risk / housing bubble
– Lenient capital regulation meant they had little cushion
Four cases:1. UBS
– Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance
– Despite huge losses, no government bailout needed (just) and it was able to replenish capital
2. Sachsen– Business model unknowingly based on large under-priced
guarantee of bought-in AAA tranches of US MBS (rogue sub)– Removal in 2005 of explicit government guarantee mattered
3. Northern Rock– Had funded (over-rapid) growth with wholesale financing:
dependent on continued funding at assumed spreads– Lending originated by NR itself – liked by borrowers
4. GSEs– Mesmerized by the complexities of trying to hedge
prepayment risk, they ignored the basics of credit risk / housing bubble
– Lenient capital regulation meant they had little cushion
Four cases:1. UBS
– Internal risk models neglected catastrophe tails and were gamed by some operations staff using first-loss insurance
– Despite huge losses, no government bailout needed (just) and it was able to replenish capital
2. Sachsen– Business model unknowingly based on large under-priced
guarantee of bought-in AAA tranches of US MBS (rogue sub)– Removal in 2005 of explicit government guarantee mattered
3. Northern Rock– Had funded (over-rapid) growth with wholesale financing:
dependent on continued funding at assumed spreads– Lending originated by NR itself – liked by borrowers
4. GSEs– Mesmerized by the complexities of trying to hedge
prepayment risk, they ignored the basics of credit risk / housing bubble
– Lenient capital regulation meant they had little cushion
Common features of the cases
Causes
• High leverage (even before the crisis)
• Heavy reliance on market liquidity and/or accuracy and precision of formal internal risk models and external ratings – even minor model errors or higher funding spreads could
generate solvency issues
US$ billionSachsen N Rock UBS GSEs
Gross assets* 110 198 1924 4353Equity** 2 3 41 71 Leverage 58 59 47 61
Reported losses† 2 2 44 16Liquidity supports 23 56 0Solvency supports 4 7 25
Exchange rate conversion for all figures is at end-2006 exchange rates
*including off-balance sheet mortgage book; end-2006 **end-2006
†Reported credit-related losses 2007 and 2008H1 sFrom official sources
Key financials for four cases
To end-September 2008
Why it’s hard to predict ultimate costs of Category 4 failures
US House Prices 1987-2008
Irish House Prices 1997-2008
0
50
100
150
200
250
300
350
400
450
97 98 99 00 01 02 03 04 05 06 07 08
ESRI/Irish Permanent series: all
Based on Dept of Env series: new houses
Irish Real New House Prices 1970-2008
0.5
1
1.5
2
2.5
3
3.5
4
1970 1975 1980 1985 1990 1995 2000 2005
Inde
x, 1
970=
1
3. Government rescues (1)
Before AIG; Sep 22• Rather low government costs
• Some US banks closed with losses to uninsured creditors (Indybank, Lehman, WaMu)
• Shareholders liability enforced – more or less– and management changes in most cases.
• (Limited) deposit insurance not a constructive player– Problem of the partially insured
After AIG• Open bank assistance case-by-case
– US: Wachovia—FDIC takes second-loss exposure (not “least cost principle”)– BEL/NLD/FRA/LUX: Injections of government equity (Fortis, Dexia, Glitnir)
• Nationalization– AIG (shareholders retain 20%)
• Government-guaranteed bank borrowing– Hypo RE bank
• Troubled asset relief program– Buys “toxic” assets at above market prices in the hope that their value will prove
higher– Removes some of the opaqueness/uncertainty, but fails to give government a share
in the upside for shareholders
• Blanket deposit insurance (Ireland)– Needs intensified supervision– And some limitations on abuse of this guarantee to build market share
Government rescues (2)
Identified fiscal costs: Order of magnitudeUS$ bn Basis
(a) Identified institutionsEquity injections Fortis 16 BEL, NLD, LUX govt equity
IKB 11 KfW StatementDexia 8 BEL, FRA, LUX govt equityBradford & Bingley 7 Government equityNorthern Rock 7 Government equitySachsen 4 Total Government shieldRoskilde 1 Danish National Bank equityGlitnir 1 Iceland government equity
Dep Insur payouts Bradford & Bingley 26 IndyMac 9 FDIC15 other FDIC 1 FDIC
Intended fiscal support FNM & FRE 25 CBOHypo RE ?? Govt liquidity guar up to $63 bnIreland 6 banks ?? Blanket guarantee
Central bank collateral Bear Stearns 4 ? Loss on NY Fed $29 bn facilityAIG 15 Special loanOthers ?? Relaxation of collateral standards
(b) Future failing institutions (c) Asset purchases from going concerns ?? US Government plan(d) Distressed borrower assistance Overall total 135++
Examples Protects small depositors
Avoids disruption of bankruptcy
Closure (possible transfer of good business).
Lehman, Indybank, WaMu, Bradford&Bingley
Only if insured No
Assisted merger Wachovia, Bear Stearns
Yes Yes
Equity injection Fortis, Dexia, Glitnir, Roskilde
Yes Yes
Nationalization AIG, Northern Rock, Sweden
Yes Yes
Loan on weak collateral
Bear Stearns/Morgan, Hypo RE
Yes Yes
Blanket guarantee Ireland, Japan, Finland, etc.
Yes Yes
Assistance to borrowers
Chile Yes Yes
Asset purchase US Proposal Yes Yes
Effect on shareholders
Limits future risky behaviour
Protects interest of taxpayer
Closure (possible transfer of good business).
Bad Yes Yes
Assisted merger Bad Yes Maybe Equity injection Depends on price Maybe Maybe Nationalization Usually bad Maybe Maybe Loan on weak collateral
Good No No
Blanket guarantee Good No No Assistance to borrowers
Good No No
Asset purchase Very Good No No
3-month Interbank rate (LIBOR)%
pe
r a
nn
um
Difference between Interbank and US Treasury Bill rate
Irish Life & Permanent
Anglo Irish Bank
AIB
Bank of Ireland