advanced banking exercises introduction
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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
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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 ofunprecedented 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
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
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House Price BubbleHousing Demand
Driving forces behind the increase of house priceHousehold incomeInterest rateA "contagion" of expectations of future price increases
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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
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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
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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
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Boom in Mortgage BorrowingDeterioration in Lending Standards
Average combined LTV for originated subprime loans jumped from79% to 86%
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Boom in Mortgage BorrowingSecuritization
Traditional Banking (Gorton and Metrick (2010))
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Boom in Mortgage BorrowingSecuritization
Securitized Banking (Gorton and Metrick (2010))
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Boom in Mortgage BorrowingSecuritization
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"
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Boom in Mortgage BorrowingSecuritization
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Boom in Mortgage BorrowingSecuritization
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
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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)
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Boom in Mortgage BorrowingHigh Leverage and Short -Term Borrowing
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Boom in Mortgage BorrowingHigh 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 growthwas increasingly funded by debt
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Boom in Mortgage BorrowingHigh 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 BorrowingHigh 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 maturitymismatch
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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
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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
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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
Quynh Anh Thi VO (UZH) Advanced Banking 25 / 25
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