Too Big to Fail Financial Institutions The U.S., the Crisis and Beyond Cirano & Ecole Polytechnique Montreal September 16, 2011

Transcription

1 Too Big to Fail Financial Institutions The U.S., the Crisis and Beyond Cirano & Ecole Polytechnique Montreal September 16, 2011 David Min Associate Director for Financial Markets Policy Center for American Progress

2 The History of U.S. Banking Pre-Depression (unregulated banks and thrifts) à Banking crises of the Great Depression Post-New Deal (highly regulated banks and thrifts) à Stagflation, Deregulation and the Savings & Loan Crisis Post S&L Crisis (regulated Agency securitization + unregulated private-label securitization) à The 2008 Financial Crisis Post-Dodd-Frank?

3 A History of Financial Crises Source: David Moss, Reversing the Null: Regulation, Deregulation, and the Power of Ideas (2010)

4 Pre-Depression Banking (pre-1929) Depository institutions (Banks, building & loans, etc.) Local institutions (funding and lending) Largely unregulated Uninsured liabilities Prone to crises and boom-bust cycles

5 The Financial Crises of the Great Depression

6 The Post-New Deal Banking System (1940s-1980s) Depository institutions (banks and thrifts) (originate to hold) Main mortgage finance institutions were thrifts, which were monoline institutions, with access to FHLB advances Localized funding and lending Local monopolies Federal deposit insurance Highly regulated for safety and soundness Glass-Steagall Regulation Q Prohibitions on size and geography Prohibitions on ARMs The Quiet Period enjoyed unprecedented stability in the financial system

7 Stagflation 7 000,0 High inflation, low growth 30,00% 6 000,0 25,00% Billions of Dollars 5 000, , , ,0 20,00% 15,00% 10,00% Percentage GDP (2005 chained dollars) CPI 6-month Treasury bill rate 1 000,0 5,00% 0, ,00%

8 Deregulation of banks and thrifts Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 Garn-St Germain Act of 1982 Followed by state deregulation and regulatory forbearance In the aggregate: Eliminated deposit caps and raised insurance limits from $40k to $100k Eliminated most restrictions limiting thrifts to home loans ARMs, consumer/commercial loans, commercial paper, subordinated debt Allowed thrifts to offer more products to attract funding Checking accounts, money market funds, trust services, credit cards Weak balance sheets masked by regulatory forbearance Over 1000 thrifts were eventually taken over by federal govt, with taxpayer costs of $124 billion

9 Post S&L Crisis- Agency Securitization Government-sponsored enterprises as a bridge between capital markets and lenders E.g., Fannie Mae, Freddie Mac, Farmer Mac, Sallie Mae, FHLB, Farm Credit System Secondary market institutions which guarantee the timely payment of interest and principal on qualifying MBS backed by conforming loans (originate-to-distribute model) Obligations implicitly guaranteed by the U.S. federal government Increasingly global funding, increasingly national lending Regulated for safety and soundness Prudential capital Conforming loan standards Enormous in size and concentration

10 Federally insured deposits à Agency securitization Share of Agency and Thrift Home Mortgage Debt, Short-Term Treasury Bill Rates and CPI, % Agency securitization Thrift holdings 6-month Treasury bill rate Core inflation rate 16,0% Share of Total Outstanding Home Mortgage Debt 60% 50% 40% 30% 20% 10% 0% DIDMCA enacted Garn- St. Germain enacted ,0% 12,0% 10,0% 8,0% 6,0% 4,0% 2,0% 0,0% Treasury / inflation rate Source: Federal Reserve Flow of Funds Report (Tables L218, H15) and Bureau of Labor Statistics

11 Post S&L Crisis- Private-Label Securitization Private-label securitization created by Wall Street in parallel with agency securitization, a bridge between lenders and cap mkts Secondary market institutions, but no guarantee on the timely payment of interest and principal on qualifying MBS backed by conforming loans (originate-to-distribute model) Global funding, global lending Sponsored by large financial institutions (growing concentration) Small depositories increasingly shifted to originate-to-distribute Small depositories increasingly replaced by non-bank lenders Effectively regulated by the rating agencies No insurance or guarantee mechanism A niche financing channel until the 2000s

12 The Rise of Private-Label Securitization, Part 1 Financial Crisis Inquiry Commission, Securitization and the Mortgage Crisis

13 The Rise of Private-Label Securitization, part 2 ABS Issuance by Asset Class Source: Adam Ashcraft (FRBNY), Discussion of Do Global Banks Spread Global Imbalances, available at

14 The Relationship Between PLS and Home Prices PLS share (right axis) House price to income ratio (left axis) % of outstanding home mortgage debt 14

15 90 day delinquency rates by channel and origination year 50,00% 45,00% 40,00% 35,00% 30,00% 25,00% 20,00% GSE PLS 15,00% 10,00% 5,00% 0,00% Source: Federal Housing Finance Agency (using data from Inside Mortgage Finance, Fannie Mae, Freddie Mac, and CoreLogic, Inc.)

16 Comparing the US with Canada In the US, PLS > 35% of residential mortgage finance by the mid-2000s; in Canada, PLS < 3% Basel incentivizes US banks to hold MBS, and Canadian banks to hold insured mortgages Limited financial deregulation/liberalization Credit risk, not interest rate risk 1970s interest rate shock, Vancouver vs. California

17 FRM vs. ARM Originations Source: Andrew Davidson & Anthony Sanders, Securitization After the Fall, February 2009 (Figure 4).

18 Adjustable-rate vs. fixed-rate mortgages Source: Frame, Lehnart, Prescott (using data from the Mortgage Bankers Association)

19 The Evolution of Modern Banking Post-New Deal Post-S&L Agency Post S&L PLS Intermediation Banks/Thrifts (primary) GSEs (secondary) Conduits (secondary) Lending model Originate to hold Originate to distribute Originate to distribute Source of funds Local depositors Global investors Global investors Focus of lending Local underwriting Automated underwriting Institution size Small TBTF TBTF Automated underwriting Govt guarantee Explicit, on deposits Implicit, on MBS/debt Implicit Prudential regulation Yes, stringent Yes, less stringent De minimus Loan standards Dictated by law and prudential regulator Dictated by OFHEO/ FHFA and Congress Dictated by market/ rating agencies Locus of regulation Highly fragmented Concentrated Highly fragmented

20 A History of Government Guarantees Share of outstanding residential mortgages, by source Deposit-Backed Agency PLS Other (including PLS) 80% Single-Family Mortgage Market Share 70% 60% 50% 40% 30% 20% 10% 0% Source: Federal Reserve Flow of Funds Data, Statistical Release Z.1, Table L218 (historical)

21 Increasing banking concentration Share of Total Financial Assets by Largest Financial Institutions Source: Kaufman, The Road to Financial Reformation (2009) (via Scherer 2010)

22 Increasing banking concentration Combined Assets of Top 5 Banks as % of GDP Source: Goldstein & Veron (2011), BIS

23 Characteristics of the U.S. Banking System Today Unprecedented domination by agency securitization Responsible for 90% of mortgage originations (SF and MF) Limited balance sheet lending Virtually no private-label securitization Small banks are highly troubled

24 Dodd-Frank: The end of US exceptionalism in banking Systemically important financial institutions (SIFIs) Identifying non-bank SIFIs Contingent capital Heightened prudential regulation and capital standards Collins Amendment (capital requirements for BHCs) Consumer Financial Protection Bureau Volcker Rule Ban on proprietary trading and hedge fund/pe fund investment Derivatives regulation Hedge fund registration and recordkeeping requirements Credit rating agencies Risk retention and qualified residential mortgages Extension of prudential supervision to holding company level and more consolidated regulatory oversight

25 Dodd-Frank: Sufficient to address concentration? Main provisions to address size/concentration issues Limitations on M&A Resolution authority Higher capital and prudential regulation standards for SIFIs

26 Housing Finance Reform What will replace Fannie Mae and Freddie Mac? Option 1: Privatize the market served by Fannie and Freddie Option 2: Privatize with explicit countercyclical guarantee Option 3: Explicit guarantee to ensure liquidity Will privatization lead to greater concentration? Under this model, is too big to fail the new de facto guarantee? How long will this process take? Fragile state of the housing markets Limited balance sheet lending and PLS

27 Finding Liquidity Can PLS return, given the enormous problems in the securitization chain that have been exposed? How much investor appetite, given credit risk? Alternatives to the status quo: covered bonds and increased bank balance sheet lending In most scenarios, TBTF banks are likely to dominate Increased consolidation following the crisis Multiple sources of liquidity- securitization, deposits, and other Too big to fail subsidy Small banks still facing balance sheet issues

28 Political Dynamic in the US Repeal of Dodd-Frank increasingly a possibility Particularly, Consumer Finance Protection Bureau, Office of Financial Research, derivatives regulation In the meantime, expect continued delays and obstruction The Tea Party view: eliminate all government guarantees, regulations, and simply refuse to bail them out The 2012 election campaign has already begun Strong possibility of the status quo up until the next crisis