Capital Adequacy In addition to reserve requirements, Reserves/Deposits ≥ “15.5/115.1” calculation a bank must satisfy a capital adequacy ratio Capital/“Loans” ≥ h% where h is from 6 to 12, depending on bank. A new regulation is that people who start a bank have to buy stock in the bank. That is, can’t start a bank with completely other people’s money, must now have skin in the game.

Loan Multiplier Example. Assume banking system “fully loaned up”, simplistic k = 20%, and money supply is increased by 5,000. If banking system proceeds to again become “fully loaned up,” total loans will increase by how much? Reserves in banking system will increase by how much? answer 20,000 answer 5,000

Multiplier Effect (assume “simplistic” k = 20%) week = 0 5,000 deposit (say, money from abroad) Assets Liabilities loans 4,000 reserves 1,000 5,000 deposits week= 1: new loans create 4,000 more in deposits Assets Liabilities loans 7,200 reserves 1,800 9,000 deposits week=2: new loans create 3,200 more in deposits Assets Liabilities loans 9,760 reserves 2,440 12,200 deposits

Banking System Getting Fully “Loaned Up” week=3: new loans create 2,560 more in deposits Assets Liabilities loans 11,808 reserves 2,952 14,760 deposits week=4: new loans create 2,048 more in deposits Assets Liabilities loans 13,446 reserves 3,362 16,808 deposits week=5: new loans create 1,638 more in deposits Assets Liabilities loans 14,757 reserves 3,689 18,446 deposits

Banking System Getting “Fully Loaned Up” week=6: new loans create _____ more in deposits Assets Liabilities loans reserves deposits week=7: new loans create _____ more in deposits Assets Liabilities loans reserves deposits . . week = infinity Assets Liabilities loans 20,000 reserves 5,000 25,000 deposits

Securitization Securitization is the financial engineering practice of repackaging pools of relatively illiquid assets into much more liquid securities (that are easier to market)

Mortgage & Asset Backed Securities MBSs (mortgage backed securities) are created by a securitization process. They are securities whose cash flows are derived from a pool of mortgages. Two types of MBSs: mortgage bonds (created from a pool of mortgages) CDOs (created from a pool of mortgage bonds) MBSs can get extremely complicated. ABSs (asset backed securities) are same as MBSs but cash flows are from a pool of home equity loans, auto loans, student loans, credit card receivables, . . . Now $1.4 trillion in student loans (but not all have been securitized, i.e., made into ABSs).

A Securitization Example A bank creates a trust, ie, special purpose vehicle (SPV). Then lends SPV money to buy many loans of a particular type. Go into a pool. SPV then sells bonds, structured into tranches, to investors to pay back bank with proceeds. Loans in pool pay interest and make principal repayments, which flow through to service the bonds and pay them off. Bank makes money in several ways including: (1) fees for setting up the SPV, (2) annual fees for operating the SPV, (3) by owning bottommost tranche to claim all residual profit after all higher level tranches have been paid off.

Target Rate vs. Actual Sep07 to Sep08 9/22

Peak Financial Crisis 03/17/08 Bear Stearns (taken over by JP Morgan Chase and government guarantees) 09/07/08 Fannie Mae / Freddie Mac (conservatorship) 09/15/08 Lehman Brothers (bankruptcy) 09/16/08 AIG (kept alive by US government and Federal Reserve) 09/21/08 Goldman Sachs & Morgan Stanley become bank holding companies 09/25/08 Washington Mutual (receivership by FDIC and then bankruptcy, an S&L that was 6th largest US bank) 12/31/08 Wachovia (at time 4th largest US bank, taken over by Wells Fargo) 01/01/09 Merrill Lynch (saved from failure by being purchased by Bank of America)

More Realism to Commercial Bank Bal Sheets Simplistic Assets Liabilities & Capital Reserves Loans DEP Capital Less simplistic Assets Liabilities & Capital Reserves Investments Loans DEP Other borrowings Capital 9/27

Fed Balance Sheet (millions), April 2009 Assets Liabilities & Capital Gold & Coin 15,107 Loans to depository institutions - Repurchase agreements 0 US treasury securities 534,969 Agency securities 64,511 MBS 367,590 Term Auction Facility (TAF) 455,799 CP Facility 242,431 Maiden Lane & related 72,163 Other loans 102,988 Other 342,711 2,198,269 Federal Reserve Notes 862,960 Rev Repurchase agreements 64,681 Deposits Depository inst balances 915,773 US Treasury 295,399 Other 13,456 Capital 46,000 2,198,269

MBS (Mortgage Backed Securities) MBSs (mortgage backed securities) are created by a securitization process. They are securities whose cash flows are derived from a pool of mortgages. Two types of MBSs: Mortgage Bonds (created from a pool of mortgages) CDOs (created from a pool of mortgage bonds) MBSs can get extremely complicated.

Term Auction Facility (TAF) As mortgage default problems arose in late 2007, banks began to encounter liquidity problems. Overwhelmed discount window. In Dec 2007, Fed suspended traditional discount window operations in favor of Term Auction Facility (TAF): rather than just overnight, made 28 and 84-day loans accepted other securities, rather than just Treasuries and agency securities, as collateral. originally for depository institutions, extended to non-bank financial institutions. no new loans after March 2010

CP (Commercial Paper) Facility Unsecured promissory notes that mature before nine months (270 days). Proceeds to be used only for operating purposes (inventories, receivables) and not for fixed assets (land, buildings, machinery). Issued by 600 to 800 corporations. Sold at discount, mature at par. Some sold by direct placement, but most sold through dealers . Dealers charge something like one-tenth to one-eighth of a percent of face value to underwrite an issue for a firm.

CP Backup Lines of Credit Except for a few highly-rated firms, usually not possible for an issuer to sell CP without a backup line of credit. Backup line of credit is agreement by which a bank will lend an issuer, if needed, the money necessary to redeem maturing paper. Makes purchasers feel more secure in the event issuer is not able to “roll over” maturing CP (i.e., sell new CP to pay off old CP). Banks charge 10 to 12.5 basis points (on an annual basis) of par amount for backup lines of credit, then market interest rate if money is actually borrowed. Average CP maturity is about 30 days In financial crises, difficult to roll over

CP Rated: prime, desirable, satisfactory. P-1, P-2, P-3 (Moody’s) A-1, A-2, A-3 (S&P’s) Virtually impossible to sell unrated commercial paper Advantage of CP: low interest rates About 30 commercial paper dealers. There is a secondary market and issuers sometimes buy back their commercial paper. Transaction costs in range of about one-eighth of one percent. Normal for $1 trillion in CP to be outstanding at any moment.

Fed Balance Sheet, September 13, 2017 Assets Liabilities & Capital Gold & Coin 13,066 Loans to depository institutions 220 Repurchase agreements 0 US Treasury securities 2,465,458 Agency securities 6,757 MBS 1,782,346 Term Auction Facility (TAF) - CP Facility - Maiden Lane & related 1,708 Other loans - Other 201,829 4,471,174 Federal Reserve Notes 1,533,584 Rev Repurchase agreements 366,719 Deposits Depository inst balances 2,360,190 US Treasury 73,220 Other 96,352 Capital 41,109 4,471,174 9/29

Open Market Injection of $30 Billion 10/3

Technical Factors Cash drains – increased cash holdings by public decrease banking system reserves. Example: Suppose system in equilibrium But people take more money out of their checking accounts than anticipated in advance of a big weekend. Reduces vault cash Banks have harder time meeting RRs Makes Fed Funds rate go up Fed does repurchase agreements to increase temporarily depository institution reserves Causes Fed Funds rate to drop US Treasury transactions can cause shifts in reserves. Fed can offset with calibrated open market transactions (typically ith repos and reverse repos)

Velocity of Money Velocity is annual money supply turnover rate. Velocity * Money supply = GDP Velocity is difficult to predict. For given change in money supply, the Fed can expect direction of change in economy, but cannot ensure the degree.

Subprime Lending Although definition varies, subprime lending is to people with a FICO score of less than 640.

Subprime Mortgages teaser rates pick-a-pay interest only no down payment When rates would reset, told can either sell at profit (because housing prices would go up) or refinance to get another low rate. But prices went down starting in 2006. Couldn’t pay mortgage, couldn’t refinance. Mortgage servicers foreclosed. Mortgage bond holders (many of which were financial institutions) suffered huge losses. Mortgage bonds became toxic securities (nobody would buy them).

Asset-Backed Commercial Paper In addition to normal commercial paper, there is asset-backed commercial paper (ABCP). Typical maturities of ABCP a little longer: 90 to 180 days In run up to financial crisis, issued by up to 1,000 special purpose vehicles to help buy pools of mortgages, car loans, student loans, credit card receivables, etc., but mostly mortgages. Before financial crisis struck, up to $1 trillion of US ABCP outstanding. Then couldn’t roll over, so Fed had to step in.

A Securitization Example A bank creates a trust, ie, special purpose vehicle (SPV). Then lends SPV money to buy many loans of a particular type. Go into a pool. SPV then sells bonds, structured into tranches, to investors to pay back bank with proceeds. Loans in pool pay interest and make principal repayments, which flow through to service the bonds and pay them off. Bank makes money in several ways including: (1) fees for setting up the SPV, (2) annual fees for operating the SPV, (3) by owning bottommost tranche to claim all residual profit after all higher level tranches have been paid off.