1

The Financial Crisis:Causes and Consequences

Michael S. Pagano, Ph.D., CFA

June 14-16, 2009

1

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

Financial Institutions: The “Heart” of an Economy

Borrowers

Corporations

Households

Savers

Households

Corporations

Financial Institutions

Commercial Banks

Securities Firms

Insurance Companies

Investment Managers

Cash Cash

Bank AssetsBank Liabilities

Loan, Bond & Equity Contracts

Deposits, Insurance Policies, ST Debt, Bonds & Equity

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

Quick Quiz: What is the Effect of a $10 Increase in Loan Loss Reserves?

Cash 5

Securities 20

Net Loans 65

Net F.A. 10

Tot. Assets 100

Deposits 82

Short-term Debt 10

Preferred Stock 0

Common Equity 8

Tot. Liab. & S.E. 100

55

90

8

0

90

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 AAA BANK BBB

Cash

Securities

Loans

Net F.A.

Total Assets

Deposits

S.T. Debt

Common Equity

Tot. Liab. & S.E.

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

Originate & Distribute vs. Make & Hold: “Elongated” Financial Intermediation

Traditional “Old-School” Make & Hold Business Model:

Borrowers SaversCommercial Banks

Cash Cash

Mortgages Bank Deposits

“Elongated” or “New-School” Originate & Distribute Model:Borrowers

Savers

Investment Banks

Cash

Fixed Income Funds (NAV)

Cash

Mort-gages

CB’sMoney Manag-

ers

CashCash

Pools of Mortgages

SIVs & CDOs

9

A Basic Balance Sheet with Leverage

Assets

Debt

Equity

Profit / Loss on A

sset

Priority of R

e-Paym

ent

• Leverage Factor = Assets / Equity

10

Mortgage Gives Homeowners 5x’s Leveraged Returns

• Return on Equity = 25%• [(Return on Assets - Interest Expense) / Equity] = 25%• [($9.00 - $4.00) / $20] = 25%

House

$100

Gain on House =

9%

Mortgage Debt

$80

Interest Rate =

5%

Equity

$20

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

Cre

dit

Ris

k

Yie

ld

FirstLoss

HighRisk

HighYield

LastLoss

LowRisk

LowYield

HOME OWNERS

AAA MBS

12

Collateralized Debt Obligation (“CDO”)– More Leverage

Pool of AA, A, BBB MBS

Equity

MBS

Super-Senior

AAA CDO

AAA CDO

B CDO

Loss Position

Cre

dit

Ris

k

Yie

ld

FirstLoss

HighRisk

HighYield

LastLoss

LowRisk

LowYield

WALL ST BANKS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

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

House

$100

Mortgage Debt

$95

Equity $5

Homeowner 20X’s

Increasing Leverage

Sub-prime Mortgage 20X’s Leverage

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

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

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

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

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

2007-2008 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 2002-07 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

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.Subprime Delinquencies

10

11

12

13

14

15

16

17

18

19

20

Mar

-98

Sep

-98

Mar

-99

Sep

-99

Mar

-00

Sep

-00

Mar

-01

Sep

-01

Mar

-02

Sep

-02

Mar

-03

Sep

-03

Mar

-04

Sep

-04

Mar

-05

Sep

-05

Mar

-06

Sep

-06

Mar

-07

Sep

-07

Mar

-08

% o

f T

ota

l L

oan

s

22

Foreclosures Push Home Prices Down Further

• …and delinquent sub-prime homeowners are forced into foreclosure.

Case Shiller Home Price Index - All Metro Areas

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

YO

Y P

erce

nta

ge

Ch

an

ge

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.

"Fear Factor" - OIS vs. 3M LIBOR

0

0.5

1

1.5

2

2.5

3

3.5

4

10/3

1/20

03

1/31

/200

4

4/30

/200

4

7/31

/200

4

10/3

1/20

04

1/31

/200

5

4/30

/200

5

7/31

/200

5

10/3

1/20

05

1/31

/200

6

4/30

/200

6

7/31

/200

6

10/3

1/20

06

1/31

/200

7

4/30

/200

7

7/31

/200

7

10/3

1/20

07

1/31

/200

8

4/30

/200

8

7/31

/200

8

Per

cen

tag

e

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 unwindBBB Corporate Debt

100

150

200

250

300

350

400

450

500

550

600

Oct

-03

Jan-

04

Apr

-04

Jul-0

4

Oct

-04

Jan-

05

Apr

-05

Jul-0

5

Oct

-05

Jan-

06

Apr

-06

Jul-0

6

Oct

-06

Jan-

07

Apr

-07

Jul-0

7

Oct

-07

Jan-

08

Apr

-08

Jul-0

8

Sp

read

to

Tre

asu

ry

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. Federal Reserve Bank Survey of Senior Loan Officers

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008%

of

Res

po

nse

s T

igh

ten

ing

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.

Federal Reserve Bank Survey of Senior Loan Officers

-20

-10

0

10

20

30

40

50

60

70

80

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2006

2007

2008

2008

% o

f R

esp

on

den

ts T

igh

ten

ing

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

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 OWNERS

Aaa / AAA

FNMA

Guarantees Principal

and Interest Payments

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

FNMA Stock and CDS

0

10

20

30

40

50

60

70

80

10/30/2006 3/13/2007 7/20/2007 11/27/2007 4/8/2008 8/14/2008

Sto

ck P

rice

0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

0.80%

0.90%

1.00%

CD

S A

nn

ual

Pre

miu

m

Stock CDS

FNMA Balance Sheet Leverage

On B/S

Off B/S

$44,011

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

Assets & Liabs Equiity

US

D i

n M

illi

on

s

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 BANKS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

MBS

AAA CDO

AIG Sells Protection Referenced to Super

Senior CDO

31

AIG Sells Default Protection on Super Senior of CDO (cont.)

AIGBanks

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

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%

AIG Stock and CDS

0

10

20

30

40

50

60

70

80

10/30/2006 3/13/2007 7/20/2007 11/27/2007 4/8/2008 8/14/2008

Sto

ck P

rice

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

CD

S A

nn

ual

Pre

miu

m

Stock CDS

AIG Balance Sheet Leverage

On B/S

Off B/S

$95,801

$0

$200,000

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

$1,400,000

$1,600,000

$1,800,000

Assets & Liabs Equiity

US

D i

n M

illi

on

s

33

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

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. 1,460,000CDOs, CLOs, ABCPCs 97,300Municipal Sec. TOBs 30,100

Total OBS: 1,587,400

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

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

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

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

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

Cre

dit

Ris

k

Yie

ld

FirstLoss

HighRisk

HighYield

LastLoss

LowRisk

LowYield

WALL ST BANKS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

ABS

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

PPIP – Public Private Investment Program

Pool of Bank Loans

Loan

FDIC Guaranteed

Debt

(up to 6:1 leverage)

Private Investors

Loss Position

Cre

dit

Ris

k

Yie

ld

FirstLoss

HighRisk

HighYield

LastLoss

LowRisk

LowYield

BANKS

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

Loan

U.S. Treasury

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

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

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.