Lecture 21: Financial Intermediation. David Laibson Economics 1011b April 16, 2013

Transcription

1 Lecture 21: Financial Intermediation David Laibson Economics 1011b April 16, 2013

2 Outline 1. Financial intermediation: definition 2. Structured finance and securitization 3. A bank balance sheet 4. Bankruptcy, receivership, and bank failures 5. Case studies

3 1. Financial intermediation Financial intermediation channels funds from suppliers of capital to users of capital. A financial intermediary is an institution that facilitates this process. For example, savers (households or firms) might deposit funds in a bank, which loans those funds to households (e.g., credit card loans or residential mortgages) or firms (commercial loans and mortgages).

4 Value added Financial intermediation generates four sources of value. 1. Delegated monitoring: savers don t know who to lend their money to and bankers are presumably better at this. 2. Maturity transformation: converting short-term deposits to long term loans (hopefully, all of the depositors won t withdraw their money at the same time) 3. Risk transformation: reducing risk with diversification and reallocating risk with derivatives (e.g., swaps). 4. Scale transformation: matching small deposits with large loans and large deposits with small loans

5 2. Securitization Definition: Securitization (aka structured finance) partially diversifies risk by pooling debt instruments, then creating new securities ( asset backed securities or ABS) backed by the pool. Securitization is often accompanied by some form of credit enhancement, for instance, tranching.

6 Making a collateralized mortgage obligation Source: FDIC

7 Tranching (what goes on inside the red box on the previous slides) Issuer CDO Fund SPV = Collateralized Debt Obligation Fund Special Purpose Vehicle Source: Efraim Benmelech (2010)

8 CDO credit rating vs. Collateral rating (3,912 tranches) CDO Rating Collateral Rating AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ NR Source: Efraim Benmelech (2010)

9 Write-Downs During Financial Crisis ($ millions) Institution ABS CDO Corporate Credit RMBS Other Total AIG 33,190 33,753 66,943 Bank of America 9, ,834 12,855 Citigroup 34,106 4,053 1,319 15,904 55,382 UBS 21, ,716 13,871 37,805 Insurers/Asset managers North American Banks 61,074 6,320 10,386 38, ,126 84,319 23,702 42,272 59, ,305 European Banks 63,464 18,579 26,423 62, ,100 Asia/Emerging Banks 9,358 4,724 5,728 3,743 23,553 Total 218,216 53,324 84, , ,084 Source: Efraim Benmelech (2010)

10 60,000 Total number of downgrades and number of AAA-structured finance securities downgrades 50,000 40,000 All dngs 30,000 AAA dngs 20,000 10,000 -

11 Collapse of securitized lending other than GSE s Source: Deutsche Bank

12 Credit default Swaps (CDS) A CDS is a contract between two counterparties. The buyer makes periodic payments to the seller (quoted in basis points), and in return receives a default guarantee: if an underlying credit instrument defaults, the buyer of the CDS receives the difference between the par value of the defaulted instrument and the market value of the defaulted instrument. For example, after the default of Lehman, Lehman bonds traded at 9 cents on the dollar. Holders of CDS contracts on Lehman bonds, therefore, received 91 cents for each dollar of CDS-insured bonds. CDS s have been issued for many different types of debt, including corporate debt, government debt (e.g., Greece), and collateralized debt obligations (CDO s).

13 1/28/09 CDS prices (quoted in basis points for five-year contracts) at the peak of the financial crisis. For example: If you pay basis points per year on a $100 million bond (see UK), you would pay $1.359 million per year (for five years) for the CDS insurance. That is 1.359% of the face value. You only pay for five years and the insurance only covers five years.

14 Counterparty risk CDS s address counterparty risk: the risk of non-repayment from the borrower But CDS s generate a new form of counterparty risk: the risk that the CDS issuer can t repay For example, AIG (an insurance company) nearly went bankrupt because it issued too many CDS s in the years before the financial crisis.

15 3. Bank Balance Sheets Assets (billions $) Liabilities and stockholders' equity (billions $) Reserves 34 Deposits 295 Loans 221 Short-term borrowing 64 Deposits with other banks 4 Long-term debt 47 Securities 111 Other liabilities 37 Buildings and equipment 6 Other assets 117 Total Liabilities 443 Stockholders' equity 50 Total assets 493 Total Liabilities + Stockholders' equity 493 Wachovia Bank, December 31, 2004 Source: Hubbard and O Brien (2006)

16 Lehman at the start of the financial crisis Assets (billions $) Liabilities and stockholders' equity (billions $) Cash 20 Short-term borrowing 546 Securities and other assets 671 Long-term debt 123 Total Liabilities 669 Stockholders' equity 22 Total assets 691 Total Liabilities + Stockholders' equity 691 Lehman Brothers, November 30, 2007

17 Bank runs Bank runs occur when lenders rapidly withdraw credit from a bank (e.g., depositors withdraw their deposits; institutional lenders don t roll over their overnight loans) If the bank only has illiquid assets it won t be able to raise enough liquidity to pay off the creditors The bank then engages in fire sales, selling its illiquid assets at rock bottom prices If asset prices fall far enough, shareholders equity vanishes, and the bank fails

18 4. Bankruptcy and Bank failures

19 Deposit insurance and loan collateralization The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000. Why does this reduce the frequency of bank runs? The FDIC does not insure loans to investment banks like Lehman. Why not? Moral hazard. How else might lenders make sure that their loans will be repaid? Collateralization.

20 Bankruptcy and receivorship For non-banks there are two bankruptcy options. Under Chapter 7 bankruptcy, the business ceases operations, a trustee sells the assets, and distributes the proceeds to the creditors. Any residual is returned to the shareholders. Under Chapter 11 bankruptcy, the debtor (i.e. the borrowing institution) remains in control of its own business operations as a debtor in possession, and is subject to the strict oversight of the bankruptcy court. Most banks have a different set of rules.

21 Bank failures Banks are typically owned by a holding company Citigroup Inc. is a holding company Citibank is the "bank" (and this is the part of the firm that is tightly regulated) The banks have their own specialized regulators: Office of the Comptroller of the Currency: nationally-chartered commercial banks Office of Thrift Supervision: savings and loan associations (thrift institutions) Federal Housing Finance Agency (FHFA): government sponsored enterprises (GSEs), e.g., Fannie Mae, Freddie Mac, Federal Home Loan Banks.

22 Receivership Normal banks do not enter bankruptcy Instead they enter "receivership," which is a much more streamlined procedure in which the government receiver (typically the Federal Deposit Insurance Corporation) holds all of the cards. The FDIC dictates how the assets will be reassigned, with the goal of keeping the operations of the bank uninterrupted and regaining the confidence of the bank's depositors. This is typically achieved by transferring ownership of the distressed bank to a healthy bank. Typically, the banks owners are wiped out and its lenders may also take a steep haircut.

23 Bank failures during the recent crisis Total failed FDIC-regulated banks ( ): about 300 Total assets of failed banks: about $600 billion (But note that Lehman was NOT an FDIC-regulated bank.) Total loss to FDIC: about $60 billion

24 FDIC bank failures in history through (3/20/2010)

25 5. Case studies Four (quick) case studies: 1. Bear Sterns: Bear was sold (3/16/2008) to JPMorgan Chase. 2. Lehman Brothers: Lehman filed for Chapter 11 protection (9/15/2008) and was dissolved. 3. Washington Mutual: WaMu bank was seized by the Office of Thrift Supervision (9/25/2008) and the banking subsidiary was sold to JPMorgan Chase. Washington Mutual, Inc., the holding company, filed Chapter Citigroup: Citi was protected from failing by the Treasury and the Fed.

26 Bear Bear was the first major investment bank to fail during the current crisis 3/16/2008: Under pressure, Bear signs a merger agreement with JP Morgan Chase The final price ends up being $10 per share (95% fall in value for Bear's shareholders) The Fed makes the deal possible by issuing a nonrecourse loan of $29 billion to JP Morgan Chase. The loan is collateralized by toxic assets on Bear's balance sheet. (Maiden Lane portfolio)

27 Lehman Fed received criticism for bailing out Bear. Critics argued that there was now a moral hazard problem, since Bear's creditors received no haircut (and even Bear'shareholders walked away with $10/share). In response, the Fed vowed to draw a tougher line next time. 9/15/2008: Lehman Brothers fails to receive support from the Fed and files for Chapter 11 protection. This is the largest bankruptcy in U.S. history. Lehman's failure generates a "systemic" shock as creditors lose 90 cents on the dollar.

28 WaMu WaMu was the largest savings and loan association. 9/2008: bank-run depletes 9% of deposits. 9/25/2008 (a Thursday): OTS seizes Washington Mutual Bank from Washington Mutual, Inc. and places it into FDIC receivership. That night, FDIC sells the bank (minus unsecured debt) to JPMorgan Chase for $1.9 billion. Bank re-opens the next day. Stripped of its principal asset, the holding company, Washington Mutual, Inc. files Chapter 11 on 9/26/2008. WaMu equity investors are effectively wiped out.

29 Citi Citi is often claimed to be too big to fail October 2008: TARP investment of $25 billion 11/24/2008: Treasury provides another $20 billion in TARP funds; Treasury, Fed, and FDIC will cover 90% of the losses on a $335-billion portfolio after Citi absorbs the first $29 billion. Citi gives US $27 billion of preferred shares and warrants to acquire stock. The government dictates mortgage modifications, salary caps, and a dividend cap (1 cent a share). 2/27/2009: US takes a 36% equity stake by converting $25 billion into common shares. Year-end 2009: Citi repays remaining $20 billion loan (with $3.1 bl interest), terminates its loss-sharing deal, and government starts to sell its common shares.

30 Outline 1. Financial intermediation: definition 2. Structured finance and securitization 3. A bank balance sheet 4. Bankruptcy, receivership, and bank failures 5. Case studies