The Ins and Outs of Banking and Finance

1
The Ins and Outsof Banking and Finance

• A presentation by
• Bert Ely
• at the
• Knight Center for Specialized Journalism
• at a seminar entitled
• The Economy Bringing the Big Picture Home
• April 15, 2009

2
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences

3
Growth in estimated market value of
owner-occupied homes, adjusted for changes in the
home-ownership rate
Estimated market value of owner-occupied
homes divided by personal income
4
Ratio Growth in estimated market value of
owner-occupied homes and mortgage debt relative
to personal income, adjusted for changes in the
home-ownership rate
Estimated market value of owner-occupied
homes divided by personal income
Owners equity
Mortgage debt divided by personal income
5
Homeowners equity in their homesis at its
lowest percentage since 1952Federal Reserve
data, as of quarter-ends
The owners equity percentage has been declining
steadily since 1983
Passage of 1986 Tax Act
Owners equity as a percent of homes market value
6
Ratio Growth in estimated market value of
owner-occupied homes and mortgage debt relative
to personal income, adjusted for changes in the
home-ownership rate
Estimated market value of owner-occupied
homes divided by personal income
Owners equity
Mortgage debt divided by personal income
7
Ratio Growth in estimated market value of
owner-occupied homes and mortgage debt relative
to personal income, adjusted for changes in the
home-ownership rate
Estimated market value of owner-occupied
homes divided by personal income
Owners equity
Mortgage debt divided by personal income
8
Homeowners equity in their homesis at its
lowest percentage since 1952Federal Reserve
data, as of quarter-ends
The owners equity percentage has been declining
steadily since 1983
Passage of 1986 Tax Act
Owners equity as a percent of homes market value
9
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy

10
Outstanding credit as a percentage of GDP
11
Outstanding credit as a percentage of GDP
1986 Tax Act
12
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing

13
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing
• Stock-market crash

14
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing
• Stock-market crash
• Rising unemployment

15
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing
• Stock-market crash
• Rising unemployment
• Deep recession, with slow recovery

16
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing
• Stock-market crash
• Rising unemployment
• Deep recession, with slow recovery
• Global fallout from the collapse of U.S. housing
  bubble

17
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing
• Stock-market crash
• Rising unemployment
• Deep recession, with slow recovery
• Global fallout from the collapse of U.S. housing
  bubble
• United States the worlds largest debtor nation

18
What has happened in the economy

• A classic debt-inflated speculative bubble in
  housing has burst, with predictable consequences
• Compounding the bursting of U.S. housing bubble
• Heavy debt overhang throughout the economy
• Excessive supply of housing
• Stock-market crash
• Rising unemployment
• Deep recession, with slow recovery
• Global fallout from the collapse of U.S. housing
  bubble
• United States the worlds largest debtor nation
• Longer term, entitlements challenge as Boomers
  retire

19
What the Administration is attempting

• Keep the banks and the financial system
  functioning as the economy struggles through the
  recession

20
Banks have not quit lendingAverage monthly loans
outstanding at commercial banks to non-financial
borrowers not seasonally adjusted (dollars in
billions)
Total lending
All other loans
Consumer loans
Loans secured by real estate
Business loans
21
Banks have not quit lendingAverage monthly loans
outstanding at commercial banks to non-financial
borrowers not seasonally adjusted (dollars in
billions)
Down 2.2 from October 2008 peak
Total lending
All other loans
Consumer loans
Loans secured by real estate
Business loans
22
What the Administration is attempting

• Keep the banks and the financial system
  functioning as the economy struggles through the
  recession
• Keep the banks adequately capitalized with TARP
  investments
• TARP increasingly unappetizing to financial firms

23
What the Administration is attempting

• Keep the banks and the financial system
  functioning as the economy struggles through the
  recession
• Keep the banks adequately capitalized with TARP
  investments
• TARP increasingly unappetizing to financial firms
• Get toxic assets off bank balance sheets
• Legacy loans
• Legacy securities

24
What the Administration is attempting

• Keep the banks and the financial system
  functioning as the economy struggles through the
  recession
• Keep the banks adequately capitalized with TARP
  investments
• TARP increasingly unappetizing to financial firms
• Get toxic assets off bank balance sheets
• Legacy loans
• Legacy securities
• Restart asset securitization through the TALF

25
What the Administration is attempting

• Keep the banks and the financial system
  functioning as the economy struggles through the
  recession
• Keep the banks adequately capitalized with TARP
  investments
• TARP increasingly unappetizing to financial firms
• Get toxic assets off bank balance sheets
• Legacy loans
• Legacy securities
• Restart asset securitization through the TALF
• Modify several million home mortgages so as to
  reduce foreclosures

26
What the Administration is attempting

• Keep the banks and the financial system
  functioning as the economy struggles through the
  recession
• Keep the banks adequately capitalized with TARP
  investments
• TARP increasingly unappetizing to financial firms
• Get toxic assets off bank balance sheets
• Legacy loans
• Legacy securities
• Restart asset securitization through the TALF
• Modify several million home mortgages so as to
  reduce foreclosures
• Limit executive compensation, ban executive jets

27
The U.S. Financial Crisis Its All the
Governments Fault
28
The U.S. Financial Crisis Its All the
Governments Fault

• . . . Why we have this mess numerous
• underlying public-policy causes

29
The U.S. Financial Crisis Its All the
Governments Fault

• . . . Why we have this mess numerous
• underlying public-policy causes
• . . . Congress not addressing the
• underlying causes

30
The U.S. Financial Crisis Its All the
Governments Fault

• . . . Why we have this mess numerous
• underlying public-policy causes
• . . . Congress not addressing the underlying
  causes
• . . . Sets the U.S. up for its next financial
• crisis

31
The U.S. Financial Crisis Its All the
Governments Fault

• . . . Why we have this mess numerous
• underlying public-policy causes
• . . . Congress not addressing the underlying
  causes
• . . . Sets the U.S. up for its next financial
  crisis
• . . . For surely the Iron Law of
• Unintended Consequences shall strike
• again, with a vengeance

32
Why do we have this mess?Bad rules produce bad
outcomes Underlying public-policy causes of the
U.S. financial crisis

• Internal Revenue Code
• Detailed prescriptive and proscriptive
  safety-and-soundness regulation
• Discouraging maturity matching in funding assets
• Fair-value accounting
• Enforcement of credit-default swaps (CDS) where
  there is no insurable interest
• Mispriced government deposit insurance

• First Amendment protection for the credit-rating
  agencies
• Government-sponsored enterprises
• The overpromotion of home ownership
• The Glass-Steagall Act of 1933
• Monetary policy holding short term interest
  rates too low too long
• Non-recourse home-mortgage loans in many states
• Down-payment assistance programs

33
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save

34
The dangers of leverage the importance of
having sufficient skin in the game

Asset funding
Assets
Debt (what you owe to others)
Assets (what you own)
Equity Capital (your net worth)
35
The dangers of leverage the importance of
having sufficient skin in the game

Asset funding
Assets
Debt
Assets lose value
Equity shrinks
36
The dangers of leverage the importance of
having sufficient skin in the game

Asset funding
Assets
Assets lose more value
Debt
Equity shrinks more
37
The dangers of leverage the importance of
having sufficient skin in the game

Asset funding
Assets
Assets lose even more value
Debt
Negative equity
Bankruptcy
38
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save
• Unfortunately wealth inequality will increase

39
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save
• Unfortunately wealth inequality will increase
• Acknowledge that technology has greatly reduced
  the efficacy of government regulation by
  facilitating regulatory arbitrage end-running
  the rules

40
Rules create guideposts for the evaders
Complex rules
Simple rule
The path of law evasion
41
Rules create guideposts for the evaders
Complex rules
Simple rule
The path of law evasion
42
Rules create guideposts for the evaders
Complex rules
Simple rule
The path of law evasion
43
Rules create guideposts for the evaders
Complex rules
Simple rule
The path of lawful evasion
44
The mortgage-securitization sausage-grinder --
regulatory arbitrage at work
Mortgage 1
Mortgage 2
Mortgage 3
Mortgage 4
Mortgage 5
Mortgage 6
Mortgage 7
Mortgage 8
Mortgage 9
45
The mortgage-securitization sausage-grinder --
regulatory arbitrage at work
Mortgage 1
Securitiza- tion trust
Mortgage 2
Mortgage 3
Mortgage 4
Securitiza- tion trust
Mortgage 5
Mortgage 6
Mortgage 7
Securitiza- tion trust
Mortgage 8
Mortgage 9
46
The mortgage-securitization sausage-grinder --
regulatory arbitrage at work
Mortgage 1
Securitiza- tion trust
Mortgage 2
Mortgage 3
Mortgage 4
Collateralized debt obligation (CDO)
Securitiza- tion trust
Mortgage 5
Mortgage 6
Mortgage 7
Securitiza- tion trust
Mortgage 8
Mortgage 9
47
The mortgage-securitization sausage-grinder --
regulatory arbitrage at work
Mortgage 1
CDO
Securitiza- tion trust
Mortgage 2
CDO2
CDO
Mortgage 3
CDO
Mortgage 4
Collateralized debt obligation (CDO)
Securitiza- tion trust
Mortgage 5
CDO2
Mortgage 6
Mortgage 7
CDO
Securitiza- tion trust
Mortgage 8
CDO2
CDO
Mortgage 9
CDO
48
The mortgage-securitization sausage-grinder --
regulatory arbitrage at work How well does
Investor 1 on the right understand the risk of
Mortgage 1 on the left
Mortgage 1
Investor 1
CDO
Securitiza- tion trust
Mortgage 2
Investor 2
CDO2
CDO
Mortgage 3
Investor 3
CDO
Mortgage 4
Investor 4
Collateralized debt obligation (CDO)
Securitiza- tion trust
Mortgage 5
Investor 5
CDO2
Mortgage 6
Investor 6
Mortgage 7
Investor 7
CDO
Securitiza- tion trust
Mortgage 8
Investor 8
CDO2
CDO
Mortgage 9
Investor 9
CDO
49
Changes in credit-intermediation sharesQuarterly
data from Q1 1952 to Q4 2008
Rest of the world
Credit supplied by domestic non-financial sectors
Other channels of credit intermediation
Shadow banking
Banks, other depository institutions
50
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save
• Unfortunately wealth inequality will increase
• Acknowledge that technology has greatly reduced
  the efficacy of government regulation by
  facilitating regulatory arbitrage end-running
  the rules
• The policy debate we need
• incentives versus rules

51
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save
• Unfortunately wealth inequality will increase
• Acknowledge that technology has greatly reduced
  the efficacy of government regulation by
  facilitating regulatory arbitrage end-running
  the rules
• The policy debate we need incentives versus
  rules
• Eliminate First Amendment protection for the
  credit-rating agencies

52
The mortgage-securitization sausage-grinder --
regulatory arbitrage at work How well does
Investor 1 on the right understand the risk of
Mortgage 1 on the left
Mortgage 1
Investor 1
CDO
Securitiza- tion trust
Mortgage 2
Investor 2
CDO2
CDO
Mortgage 3
Investor 3
CDO
Mortgage 4
Investor 4
Collateralized debt obligation (CDO)
Securitiza- tion trust
Mortgage 5
Investor 5
CDO2
Mortgage 6
Investor 6
Mortgage 7
Investor 7
CDO
Securitiza- tion trust
Mortgage 8
Investor 8
CDO2
CDO
Mortgage 9
Investor 9
CDO
53
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save
• Unfortunately wealth inequality will increase
• Acknowledge that technology has greatly reduced
  the efficacy of government regulation by
  facilitating regulatory arbitrage end-running
  the rules
• The policy debate we need incentives versus
  rules
• Eliminate First Amendment protection for the
  credit-rating agencies
• Limit CDS to exchange-traded products when no
  insurable interest is being protected

54
Key long-term fixes that are needed

• Eliminate Tax Code incentives to overleverage and
  under-save
• Unfortunately wealth inequality will increase
• Acknowledge that technology has greatly reduced
  the efficacy of government regulation by
  facilitating regulatory arbitrage end-running
  the rules
• The policy debate we need incentives versus
  rules
• Eliminate First Amendment protection for the
  credit-rating agencies
• Limit CDS to exchange-traded products when no
  insurable interest is being protected
• Stop overpromoting home ownership

55
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56
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57
Thank you!

• I welcome your questions