The Financial Crisis: A Preliminary View 2009 JRCLS Annual Conference Harvard Law School February...

The Financial Crisis: A Preliminary View

2009 JRCLS Annual ConferenceHarvard Law SchoolFebruary 14, 2009

Randall D. GuynnHead of the Financial Institutions GroupDavis Polk & Wardwell

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Background How did we get here?

How bad is it likely to be?

Timeline of Significant Events

TARP and Other Government Relief Programs

Legal, Regulatory and Political Issues and Reactions

Interesting Factoids

Questions and Answers

3

Background – How did we get here?

Same pattern as almost every other mania, panic and crash before this one: Cheap credit →

Excessive optimism →

Pricing bubble (real estate and commodities) →

Bubble pops (price collapse that is still collapsing) →

Extreme uncertainty about “true” asset values →

Excessive (or wise?) pessimism

4

Background – How did we get here? (Cont’d)

The financial sector is the most immediate and hardest hit

Characteristics of financial institutions High leverage

Illiquid long-term assets

Extremely short-term liabilities (e.g., demand deposits)

These characteristics make financial institutions susceptible to “runs on the bank”

Run on a bank (or other FI) will result in sudden and unexpected death spiral FIs are different from widget companies, which typically slide

slowly into bankruptcy

FIs almost always fail suddenly and unexpectedly

This time is no different from the past

Main Street vs. Wall Street

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Rational response makes things worse Circle the wagons

Increase and hoard cash

Reduce amount of credit extended

Otherwise reduce leverage

Inverse money multiplier effect

Results in severe contraction of credit throughout the system Hurts everyone – FIs, widget companies, consumers

Negative externality like air pollution

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Inverse money multiplier magnifies contraction of credit (money)

– Money multiplier: M * 1/R, where M = amount deposited in a single bank and R = fractional reserve requirement

– Amplifies expansion of credit in normal times when banks are permitted and choose to hold only a fraction of cash reserves to satisfy demand deposit claims

– Magic of money multiplier in normal times: Assume 10% reserve requirement (R), every $100 deposited in a bank will multiply by 10 times into $1,000 of credit throughout system

– Tragedy of inverse money multiplier: If banks are legally required or choose to circle the wagons during a financial crisis, so that reserves grow from 10% to 20%, the amount of credit available in the system will shrink by 50% or $500, not by 10% or $100

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Historical precedents 1700 BC: Joseph in Egypt

– Seven Years of Plenty, Seven Years of Famine (Gen 41)

– By the end, Joseph had bought all the herds of cattle and “all the land of Egypt” for Pharaoh in exchange for food (Gen 47:13-26)

1637: Collapse in tulip prices → banking crisis in Europe

Banking Panic of 1837 (caused failure of Kirtland Safety Society)

Banking Panic of 1907 (JP Morgan restores confidence)

The 1929 Crash and the Great Depression (1930s)

Savings & loan crisis of the late 1980s and early 1990s

– Precipitated by collapse in the price of agricultural commodities, oil and real estate

The Global Financial Crisis of 2008

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Background – How did we get here? (Con’d)

What was different this time?

Global macro economic factors Excess savings in rapidly developing countries (China) invested

in debt of industrialized countries, driving down interest rates

Cheap exports from developing countries (esp. China, India) kept inflation low

Increased productivity kept inflation low

U.S. housing and monetary policy, GSEs and securitization drove down housing interest rates

Excessive optimism and cheap credit resulted in real estate bubble, spike in consumer debt and financial institution leverage

Increased demand from developing countries resulted in bubbles in commodities prices

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Introduction Symptoms

How did we get here?







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Introduction – How bad is it likely to be? (Cont’d)

Who knows?

This crisis is far worse than the S&L crisis of the late 1980s and early 1990s

Will it be as bad or worse than the Great Depression?

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Introduction – How bad is it likely to be?

Factors that made things worse (or better?) this time The very instruments that helped manage credit risk, reduce the

cost of credit and increase the availability of credit

– Securitizations of mortgage loans (e.g., mortgage-backed securities)

– Securitizations of securitizations (e.g., collateralized debt obligations, or CDOs, and CDO-squared)

– Credit default swaps (CDSs)

Excessive confidence (as it now turns out) in financial models

Failure of rating agencies to update credit rating models with changes in the marketplace

Mark to market or model (or “fair value”) accounting rules

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Real-Estate-Related Securities

Investors

Banks

Home Owners

Originators/

Lenders

Securitization

(Underwriters)

AAA

AA

A

BBBResidual/Equity

100%

28%

20%

11%

7%0%

1) Lender makes mortgage loan to home owners

2) Lender issues secured certificates backed by loans

3) Bonds backed by mortgages created in the primary market

4) Investments may become

re-securitized (bonds based on bonds)

Re-Securitization:

CDO

11%

7%

8.6%

Super Senior

AAA

AAA

AAA

BBBResi

5) New CDOs can be created from “select” tranches of existing CDOs with a further “re-rating” of risk

CDO2

AAA

Equity

BBB

HedgeFunds

PensionFunds

OtherInv.

Banks

6) Investors buy customized financial instruments

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Summer 2007•Real estate prices start to collapse

•Spike in early delinquencies of 2006-2007 subprime mortgages

Fall 2007•Leveraged credit market dries up

•Billions of MBS/CDO markdowns

Winter 2007-2008•Sovereign wealth funds to the rescue

•Rescue of Northern Rock by UK govt

Spring 2008•Continued collapse in real estate prices

•Continued large CDO markdowns

•Rescue of Bear Stearns by JPM

•Fed discount window opened to I-banks

•Treasury blueprint

Summer 2008•Interbank credit markets locking up•Spike in oil / agricultural prices

•Fannie, Freddie, FI mkt caps plummet

•Fed as fin markets stability regulator

•Indymac fails

•Treasury gets authority to rescue Fannie/Freddie

Su

mm

er

200

7

Su

mm

er

200

8

Summer 2007 – Summer 2008

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Spike in Early Subprime Loan Delinquencies

Recent Vintages Show Very Poor Underwriting

Source: Federal Reserve staff circulations from First American Loan Performance data

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Residential Housing Bubble and Collapse

Source: Standard & Poor’s

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Summer 2007•Real estate prices start to collapse

•Spike in early delinquencies of 2006-2007 subprime mortgages

Fall 2007•Leveraged credit market dries up

•Billions of MBS/CDO markdowns

Winter 2007-2008•Sovereign wealth funds to the rescue

•Rescue of Northern Rock by UK govt

Spring 2008•Continued collapse in real estate prices

•Continued large CDO markdowns

•Rescue of Bear Stearns by JPM

•Fed discount window opened to I-banks

•Treasury blueprint

Summer 2008•Interbank credit markets locking up•Spike in oil / agricultural prices

•Fannie, Freddie, FI mkt caps plummet

•Fed as fin markets stability regulator

•Indymac fails

•Treasury gets authority to rescue Fannie/Freddie

Su

mm

er

200

7

Su

mm

er

200

8

Summer 2007 – Summer 2008

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Timeline of Significant Events (Cont’d)

Weekend 1 •Freddie, Fannie

bailout

Weekend 2•Lehman Bros fails

•Merrill Lynch sells itself to BofA

Weekend 3•Treasury releases EESA/TARP bill

•MS, GS become bank holdcos

•WaMu fails, JPM buys all deposits

Week 3•AIG rescued

•Treasury proposes $750bn EESA/TARP

•Primary reserve money market fund “breaks the buck”

•Treasury announces guaranty program for money market funds

•SEC temporary ban on short sales

Weekend 4•Citigroup rescues Wachovia

•Fortis, Dexia are nationalized

Sept 30•House rejects EESA/TARP

•Dow falls record 778 pts, $1.3 trillion

September 2008

Sep

tem

ber

20

08

Octo

ber

20

08

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Week 1 •Senate approves EESA / TARP

•House reconsiders and President signs; EESA / TARP enacted

•FDIC insurance coverage increased to $250,000

Novem

ber

20

08

Octo

ber

20

08

October 2008

Week 2 •Fed announces Commercial Paper Funding Facility (CPFF)

•U.K. announces bank rescue package

•Treasury announces bank capital purchase program (policy shift)

•FDIC announces Temporary Liquidity Guarantee Program (TLGP)

Week 4 •First wave of regional banks eligible for Treasury’s capital purchase program are identified

•National City rejected – purchased by PNC with help of CPP money

Week 3 •Swiss National Bank makes $54 bn loan to UBS

•Germany passes €500 bn rescue package

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Week 1•Barack Obama elected President

•Democratic sweep of Congress

Novem

ber

20

08

Octo

ber

20

08

November 2008

Week 2•Fed, Treasury announce expanded investment in AIG, $150 billion

•Democrats urge aid for auto makers

Week 3 •Amex becomes BHC

•Treasury announces that troubled asset purchase program is on hold; stock market drops 20% in two weeks; financial stocks plummet even further

•CIT applies to become a BHC

•Hartford, Genworth, Lincoln National acquire thrifts and apply for TARP

•GMAC announces that it applied to become BHC

Week 4 •Citigroup receives additional $20 billion from TARP plus government guarantee of a $306 billion pool of troubled assets

•Fed announces $200 bn TALF program

•Fed announces $100 bn GSE debt purchase program

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December 2008•TARP loans $17.4 bn to GM and Chrysler

•Madoff ponzi scheme revealed – est $50 bn in potential losses

•Fed approves CIT’s and GMAC’s applications to become BHCs

•TARP gives $6 bn in financial assistance to GMAC

•Consumer spending plummets

•Unemployment spikes

Novem

ber

20

08

Octo

ber

20

08

December 2008 – February 2009

January 2009 •BofA receives additional $20 bn in TARP investment and a $118 bn guarantee of troubled assets

•Bush Administration requests TARP II on behalf of President Elect Obama

•Obama inauguration

•Geithner confirmed as new Treasury Secretary

•UK announces asset guarantee scheme

•Germany announces good bank / bad bank scheme

February 2009 •New limits on executive compensation for FIs who receive TARP money in future

•COP, SIG reports on TARP

•SEC roasted for missing Madoff ponzi scheme

•Fed revises TALF program

•Geithner announces TARP II plans

•Obama $800 bn stimulus bill

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Spike in Unemployment

Source: Bureau of Labor Statistics

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

1998 2000 2002 2004 2006 2008

Une

mpl

oym

ent R

ate

%

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TARP I Capital Purchase Program ($250 billion)

Systemically Significant Failing Institutions Program (AIG)

Targeted Investment Program (Citi, BofA)

Asset Guarantee Program (Citi, BofA)

Automotive Industry Program (GM, Chrysler)

TALF Program (with NY Fed)

TARP II Good bank / bad bank?

Asset purchases?

Treasury’s $50 billion temporary money market guarantee

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Other Government Relief Programs FDIC

– Temporary increase in deposit insurance to $250,000

– Temporary Debt Guarantee Program

– Temporary Transaction Account Guarantee Program

Federal Reserve

– Primary Dealer Credit Facility

– Term Auction Facility

– Temporary Securities Lending Facility

– Commercial Paper Funding Facility

– Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

– Money Market Investor Funding Facility

– Term Asset-Backed Securities Loan Facility (TALF) (non-recourse)

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TARP I — Evolution

Initially, the TARP facility was expected to be used to purchase mortgages and other real-estate related assets.

Asset purchases were intended to establish reliable market values for these illiquid assets.

Instead, TARP’s first use was a Capital Purchase Program (CPP) meant to recapitalize the U.S. banking system.

Two Fundamental Public Policy Shifts

Asset Purchase Program to the CPP

Control for Moral Hazard vs. Encourage Public Confidence

On November 12, 2008, Treasury officially announced that the development of an Asset Purchase Program was on hold.

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Legal, Regulatory and Policy Issues and Reactions

What is the source of Treasury’s, the Fed’s or the FDIC’s legal authority for taking control of or investing in private-sector financial institutions? Fannie and Freddie Conservatorship and Financial Assistance:

Expressly authorized by new federal statute enacted on July 30, 2008

Fed Actions: Section 13(3) of the Federal Reserve Act grants power to lend to anyone under “unusual and exigent circumstances” (first time power exercised since 1932)

AIG: Section 13(3) of Federal Reserve Act

$750 billion TARP (EESA)

Would Raise Serious Legal Issues in the Absence of Express Congressional Authorization See the Steel Seizure Cases (1952), in which the Supreme Court

held that President Truman’s seizure of steel mills during the Korean War was unconstitutional because unauthorized by Congress

31 USC 9102 – Prohibition on federal agency acquiring corporation without express statutory authority

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Legal, Regulatory and Policy Issues and Reactions (Cont’d)

Precedents Reconstruction Finance Corporation (1932): Established by

express Congressional action to recapitalize the troubled U.S. banking industry during the Great Depression. Dissolved in 1957.

Resolution Trust Corporation (1980s): Established by express Congressional action to resolve failed savings associations. Later dissolved.

Government initially followed policy to wipe out common and preferred shareholders and senior debt as a condition to government assistance Common shareholders in Indymac, Bear Stearns, Freddie, Fannie,

Lehman, AIG and WaMu mostly or completely wiped out

Pros: Reduces moral hazard

Cons: Deters new money when a financial institution needs it most; encourages strategic behavior by senior debt counterparties

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Government shifted policy under TARP from asset purchase program to capital purchase program

Government also shifted policy from trying to limit moral hazard caused by intervention to restoring public confidence Only minor dilutive impact on common shareholders

Pari passu with existing preferred stock

Junior to senior and subordinated debt

Rationale: When we find ourselves on the edge of a cliff looking down, we can worry about moral hazard tomorrow. Today’s issue is restoring public confidence to encourage new and existing equity investment from private sector

The most FAQs have become: Is $700 billion enough? Why not just nationalize the banks?

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Perfect Storm for More Regulation

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Regulatory Response - More regulation Likely a lot more and harsh

Main Street vs. Wall Street

Fed will likely become the systemic risk regulator

System-wide regulatory consolidation and rationalization more likely Treasury Blueprint

Federal insurance charter and regulator

CDS clearing house and other regulation of CDS and OTC derivatives

Merger of CFTC and SEC

Merger of OTS and OCC

Scapegoating E.g., FBI investigations of the management of recently failed or

bailed out companies

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Weekend work: rescues almost always happen on weekends when markets are closed Window is from the close of U.S. markets on Friday until the

opening of the Asian markets on Sunday night (U.S. time)

Freddie and Fannie One of the few “genuine” conservatorships in U.S. history (other

conservatorships are virtually all really “pass-through” receiverships / conservatorships to simulate a “bridge bank” device)

Powers exercised were only one month old

AIG Too big and too entangled globally to fail

Not previously regulated by the Fed; almost exclusively regulated by the states or foreign insurance regulators

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Interesting Factoids (Cont’d)

Morgan Stanley / Goldman Sachs Unprecedented “one-day” conversions into bank holding

companies

Instantly ranked among the five largest bank holding companies in the U.S.

Citigroup / Wachovia First use of the “systemic risk” exception to the “least-cost

resolution” condition for an FDIC-assisted open bank transaction

Stampede to Become a BHC: MS, GS, AMEX, CIT, GMAC

Stampede for TARP funds Insurance companies buy thrifts to become S&LHCs to qualify for

TARP money

– Hartford, Genworth, Lincoln National

Auto-industry bailout

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