advanced banking exercises introduction

Advanced Banking Exercises

Quynh Anh Thi VO

University of Zürich

Spring Term 2011

Quynh Anh Thi VO (UZH) Advanced Banking 1 / 25

Outline

Main Texbook: Freixas, X. and J.C. Rochet "Microeconomics ofBanking", MIT Press, second edition

Solving the exercises at the end of each chapter of the book


Special Session

Financial Crisis 2007:Origins and some Stylized Facts


Introduction

In 2007 and 2008, the global �nancial system experienced a crisis ofunprecedented magnitude

Acharya, Gujral and Shin (2009):


Introduction

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


Introduction

Figure: Source: Brookings Fixing Finance Series - Paper 3Quynh Anh Thi VO (UZH) Advanced Banking 6 / 25

House Price BubbleStylized Fact

Continuous increase of house price across US


House Price BubbleHousing Demand

Driving forces behind the increase of house priceHousehold incomeInterest rateA "contagion" of expectations of future price increases


Boom in Mortgage BorrowingStylized Fact

Mortgage lending is shifted into "non-prime" mortgage

Rapid rise of lending to subprime borrowers helped in�ate thehousing price bubble


Boom in Mortgage BorrowingSubprime Mortgages

Subprime borrower (Gorton (2009))

Relatively high probability of default as evidenced by, for example aFICO 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 ormore 60-day delinquencies in the last 24 months

) These borrowers are riskier


Boom in Mortgage BorrowingSubprime Mortgages

How can a mortgage loan be designed to make lending to riskierborrowers 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 primemortgages: e.g. national average rate on a 2006 subprime 2/28mortgage was 8.5%

Second period (28 or 27 years): �oating interest rate. It isdetermined 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 thathome prices would appreciate over short horizons


Boom in Mortgage BorrowingDeterioration in Lending Standards

Average combined LTV for originated subprime loans jumped from79% to 86%


Boom in Mortgage BorrowingSecuritization

Traditional Banking (Gorton and Metrick (2010))



Securitized Banking (Gorton and Metrick (2010))



Positive aspects of securitization

Freeing mortgage lenders from the liquidity constraints of theirbalance sheets

Distributing the risk to investors who are most willing to bear it.

History

Government Sponsored Enterprises (GSEs) were pioneers insecuritization

They bought mortgage loans that met certain conditions("conforming loans") from banks in order to facilitate mortgagelending

They guaranteed investors who bought their mortgage-backedsecurities (MBS) against default losses

Securitization was initially established to conforming loans

Along the way, the private sector developed MBS backed bynon-conforming loans that had other means of "credit enhancement"



Incentive problems with the originate-to-distribute model

Loans�originators have little or no �nancial incentive to make surethat the loan is a good one.

Most brokers and specialists are paid based on the volume of loansthey process =) incentive to keep the pace of borrowing rollingalong.

Market discipline seems not to work because securitization processmakes sound risk analysis extremely di¢ cult


Boom in Mortgage BorrowingHigh Leverage and Short -Term Borrowing

Capital requirement limits the extent to which banks can lever theirequity =) getting around by setting up Structured InvestmentVehicles (SIVs) (or Special Purpose Vehicles (SPVs))

O¤-balance sheet entity: SIVs are separate from the banks,constituting as a "clean break" from a bank�s balance sheet.

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 overtheir debts

Investment banks are not subject to the same capital requirement ascommercial 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 investmentbanks are the overnight repurchase agreement (repo)



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 growthwas increasingly funded by debt



What kind of debt used to support asset growth?


) bank debt grew in forms other than deposits



What kind of debt used to support asset growth?


) funding long-term asset by short-term debt ) rise in maturitymismatch


Credit Default Swaps

CDS used to insure holders of MBS, CDOs against mortgage defaultrisk

CDS transactions were not overseen by any regulatory body ) nocapital requirement or asset requirement for the protection seller


Credit Rating Agencies

Credit rating agencies are subject to con�ict of interests

Issuers (not investors) pay for rating services

Rating agencies advised CDO issuers on how to structure the CDOwith the lowest funding possible


Regulation and Supervision

No uni�ed system of bank supervision

A signi�cant share of the subprime mortgages were originated byinstitutions outside the purview of prudential regulation

Not su¢ cient attention to systemic risk


advanced banking exercises introduction

Documents

credit rating

mortgage borrowinghigh

support asset

mortgage borrowingsubprime

capital requirement

subprime mortgages

mortgage borrowingsecuritization

term borrowing