Advanced Banking Exercises

Quynh Anh Thi VO

University of Zrich

Spring Term 2011

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Outline

Main Texbook: Freixas, X. and J.C. Rochet "Microeconomics of Banking", MIT Press, second edition
Solving the exercises at the end of each chapter of the book

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Special Session

Financial Crisis 2007: Origins and some Stylized Facts

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Introduction

In 2007 and 2008, the global nancial system experienced a crisis of unprecedented magnitude Acharya, Gujral and Shin (2009):

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Introduction
Timeline of the crisis (Brookings Fixing Finance Series - Paper 3)

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Introduction

Quynh Brookings Advanced Banking Figure: Source: Anh Thi VO (UZH) Fixing Finance Series - Paper 3

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House Price Bubble

Stylized Fact

Continuous increase of house price across US

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House Price Bubble

Housing Demand

Driving forces behind the increase of house price

Household income Interest rate A "contagion" of expectations of future price increases

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Boom in Mortgage Borrowing

Stylized Fact

Mortgage lending is shifted into "non-prime" mortgage

Rapid rise of lending to subprime borrowers helped inate the housing price bubble
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Boom in Mortgage Borrowing

Subprime Mortgages

Subprime borrower (Gorton (2009))

Relatively high probability of default as evidenced by, for example a FICO score of 660 or below Debt service-to-income ratio of 50% or greater Bankruptcy in the last ve years Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months

) These borrowers are riskier

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Boom in Mortgage Borrowing

Subprime Mortgages

How can a mortgage loan be designed to make lending to riskier borrowers possible? Most subprime mortgages are adjustable-rate mortgages (ARMs) with a hybrid structure known as a "2/28" or "3/27"
Initial period (2 or 3 years): xed and "teaser" interest rate
The teaser rate was not particularly low compared to prime mortgages: e.g. national average rate on a 2006 subprime 2/28 mortgage was 8.5%

Second period (28 or 27 years): oating interest rate. It is determined on the basis of some reference rate (e.g. LIBOR)

Subprime mortgages usually have a very high loan to value (LTV) ratio, perhaps as high as 100% (i.e. no down payment) Subprime mortgages have high prepayment penalties
Note that only 2% of prime mortgages have prepayment penalties

=) Subprime mortgages design is based on the expectation that home prices would appreciate over short horizons
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Boom in Mortgage Borrowing

Deterioration in Lending Standards

Average combined LTV for originated subprime loans jumped from 79% to 86%

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Boom in Mortgage Borrowing

Securitization

Traditional Banking (Gorton and Metrick (2010))

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Boom in Mortgage Borrowing

Securitization

Securitized Banking (Gorton and Metrick (2010))

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Boom in Mortgage Borrowing

Securitization

Positive aspects of securitization

Freeing mortgage lenders from the liquidity constraints of their balance sheets Distributing the risk to investors who are most willing to bear it.

History
Government Sponsored Enterprises (GSEs) were pioneers in securitization
They bought mortgage loans that met certain conditions ("conforming loans") from banks in order to facilitate mortgage lending They guaranteed investors who bought their mortgage-backed securities (MBS) against default losses

Securitization was initially established to conforming loans Along the way, the private sector developed MBS backed by non-conforming loans that had other means of "credit enhancement"

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Boom in Mortgage Borrowing

Securitization

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Boom in Mortgage Borrowing

Securitization

Incentive problems with the originate-to-distribute model

Loansoriginators have little or no nancial incentive to make sure that the loan is a good one. Most brokers and specialists are paid based on the volume of loans they process =) incentive to keep the pace of borrowing rolling along. Market discipline seems not to work because securitization process makes sound risk analysis extremely di cult

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Boom in Mortgage Borrowing

High Leverage and Short -Term Borrowing

Capital requirement limits the extent to which banks can lever their equity =) getting around by setting up Structured Investment Vehicles (SIVs) (or Special Purpose Vehicles (SPVs))
O-balance sheet entity: SIVs are separate from the banks, constituting as a "clean break" from a bank balance sheet. s They hold MBS, CDOs as their assets For funding these assets, they issue asset-back commercial paper (ABCP), mostly with very short-term maturity =) need to roll over their debts

Investment banks are not subject to the same capital requirement as commercial banks
They are able to increase leverage to a greater extent They borrow at very short term and held risky longer-term assets The favorite instruments of short-term borrowing for investment banks are the overnight repurchase agreement (repo)

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Boom in Mortgage Borrowing

High Leverage and Short -Term Borrowing

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Boom in Mortgage Borrowing

High Leverage and Short -Term Borrowing

Leverage ratios for the 21 large banks in US, UK and Europe (Acharya, Gujral and Shin (2009))

) the capital structure was getting increasingly levered, i.e. asset growth was increasingly funded by debt
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Boom in Mortgage Borrowing

High Leverage and Short -Term Borrowing

What kind of debt used to support asset growth? Acharya, Gujral and Shin (2009):

) bank debt grew in forms other than deposits

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Boom in Mortgage Borrowing

High Leverage and Short -Term Borrowing

What kind of debt used to support asset growth? Acharya, Gujral and Shin (2009):

) funding long-term asset by short-term debt ) rise in maturity mismatch

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Credit Default Swaps

CDS used to insure holders of MBS, CDOs against mortgage default risk CDS transactions were not overseen by any regulatory body ) no capital requirement or asset requirement for the protection seller

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Credit Rating Agencies

Credit rating agencies are subject to conict of interests

Issuers (not investors) pay for rating services Rating agencies advised CDO issuers on how to structure the CDO with the lowest funding possible

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Regulation and Supervision

No unied system of bank supervision A signicant share of the subprime mortgages were originated by institutions outside the purview of prudential regulation Not su cient attention to systemic risk

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