Money, Banks, and the Federal Reserve Chapter 13, Part 2 CHAPTER 1

2 Bank becomes insolvent – when its total assets are less than its total liabilities Bank failure – when an insolvent bank goes out of business Banking Panics

Bad Loans Cause Mid-Size Bank to Become Insolvent 3 Total Assets = $850 million and total Liabilities = $875 Total Assets – Total Liabilities = $850 – 875 = $-25 15% of assets are bad

Bad Loans Cause Mid-Size Bank to Become Insolvent 4 Equity Ratio: Calculated as Total Equity/Total Assets. In this example: $125/$1000=12.5%. Lehman Brothers equity ratio was 3% when it failed. 15% of assets are bad

Banking Panics Run on the bank (Bank run) – an attempt by many of a bank’s depositors to withdraw their funds Banking panic – depositors attempt to withdraw funds from many banks simultaneously Bank runs force banks to “close their doors” (unable to honor their depositors’ requests for funds) Even if they were solvent 5

During the Great Depression a large number of banks failed. The creation of the Federal Deposit Insurance Corporation in 1933 strengthened faith in the stability of the banking system. Even during the financial crisis of 2008–2009, bank failures were far fewer than in the 1930s. Bank Failures in the United States, 1921– FDIC created in 1933 About 10,000 banks (1/3 of banks in the US) failed during the Great Depression

Banking Panics Largely eliminated after 1933 Federal Reserve – learned important lesson during the Great Depression - ready to lend to banks more quickly in a crisis Federal Deposit Insurance Corporation insures deposits up to $250,000 Increased government regulation of banks 7

Bank Regulation Continuous monitoring of bank financial condition with a focus on the shareholders’ equity (called bank capital) Legal capital requirements: Banks must hold a percentage of their assets as equity (bank capital, 5% to 8%) Dr. Neri does not believe the percentage is high enough. High equity encourages banks to lend responsibly because the owner’s loose if lend recklessly. 8

Bank Regulation Capital ratio (equity ratio) –A bank’s capital (shareholder equity) as a percentage of its total assets 9

Bank Regulation Why require higher capital ratios –Greater incentives to avoid risky loans Reduces the likelihood of bank failures that pass losses onto non-owners –Some argue (the banks, duh!) this reduces the amount of interest-earning assets a bank can hold for each dollar of capital that the owners have invested Reduces the rate of return to the bank’s owners Discourages people from forming or investing in banks ( I don’t believe this) 10

Banking Panics Look at the slide on bank failures. What happened in the 1980s and 90s? – many undercapitalized banks – many without FDIC insurance Banks were poorly regulated – banks made bad loans and had low capital ratio Reminder of the need for deposit insurance and high capital requirements. 11

Shadow Banking System To understand “shadow banking” must first understand banks (depository) Banks share four characteristics: 1. Have short-term liabilities in the form of deposits that can be demanded back on short notice 2. Invest in long-term assets 3. Their liabilities include deposits that are government-insured (FDIC) 4. Closely regulated by government, capital requirements 12

The Shadow Banking System 13 I really do not like this term, implies something illegal, and its not. - non-depository financial intermediary less strictly regulated than a bank (non- bank) - and with no government-guaranteed deposits

The Shadow Banking System Shadow Banks share four characteristics: 1.The have short-term liabilities. Not deposits! Rely on b orrowed funds which mature in a matter of days or weeks. Depend on “Roll-Over” 2. Invest in Long-term assets 3. Liabilities do not include government- insured deposits 4. Not closely regulated by government Lehman Brothers, an investment bank is an example. Ford Motor Credit, GMAC, GE Credit, …………… 14

Lehman Brothers and Bear Sterns, investment banks that failed Ford Motor Credit and GMAC, GE Capital Fannie Mae Examples of The Shadow Banks 15

Banking Panics Run on a shadow - bank – Lenders simply say “no”. – meaning these non-banks can not “roll- over” short-term loans. –Lenders essentially withdraw their funds Assets Liab. + Equity –year Mortgage Loans Over-night loan

The Shadow Banking System During the 1990s and 2000s – the shadow banking system grew: larger, more complex, and more interconnected with the regular banking system When the financial crisis hit – it became clear that bank regulations had not struck the right balance – financial institutions around the world failed and governments had to come to the rescue 17

The Financial Crisis of – The collapse of housing prices in 2007 – Followed by a recession in 2008 Commercial banks and “shadow banks” invested heavily in mortgages and mortgage-backed securities which fell in value as housing prices fell. Estimates of total losses in asset values at U.S. banks: well beyond $1 trillion. Even more in “shadow banks” –Look at the Mid-Size Bank example 18

Mortgage-backed securities: Securitization 19 Mortgages are loans and bonds are securities. Securitization is the process of pooling a lot of mortgage loans together and dividing them into smaller bonds called mortgage back securities A mortgage pool might be hundreds of mortgages totaling $100 million divided into 10 thousand $10,000 bonds. The bonds are sold to investors who receive monthly payments from the pool of mortgages

The Financial Crisis of 2008 How did these losses come about? – With the collapse of housing prices, came the recession and declining income Millions of homeowners began to default on their mortgages – No one wanted to buy mortgage-backed securities at prices anywhere close to their previous value – Bank capital declined – Look at the Mid-Size bank example 20

Bad Mortgage Loans Cause Mid-Size Bank to Become Insolvent 21 Mortgages Mid-size bank becomes insolvent because equity is less than 0. It has $850 million in assets but owes $875 million.

The Financial Crisis of 2008 As capital declined, banks and “shadow banks” had three choices: 1. Acquire more equity capital by issuing and selling new shares - unappealing 2. Reduce the risk of their assets by selling risky assets and replace them with safer ones Banks tried to do this, but all at the same time, becomes a fire sale! Asset prices fell - unappealing. 3. Wait and hope 22

The Financial Crisis of 2008 Wait-and-hope strategy was followed by many banks in the U.S. Deposit insurance With FDIC insurance, commercial banks avoided a “banking panic” Side effect: Increased reluctance to lend to banks. Everyone new bad loans existed, but did not know where! Banks would have to sell even more assets to pay back the debts coming due Causing the market value of the assets to fall further 23

The Downward Spiral for Banks 24 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Feedback effect!

The Financial Crisis of 2008 Shadow - bank situation more dire than for banks – they do not have insured deposits, only short-term debt – lenders wanted their money back –Cannot use the “wait-and-hope” strategy Not closely regulated Held very little capital relative to their assets 25

The Financial Crisis of 2008 Shadow - bank situation more dire than for banks – not closely regulated and held very little capital relative to their assets – many non-bank held 3% or less (Lehman Brothers and Bear Stearns) – were very highly leveraged Commercial banks held about 10% capital Bears Stearns and Lehman Brothers failed 26

Government to the Rescue The Federal Reserve – extended emergency loans to financial institutions, even non-banks! October 2008, Congress approved the Troubled Asset Relief Program (TARP) – the government purchased shares of stock in banks and, A major non-bank (the insurance company AIG) A major automobile company (General Motors) 27

Government to the Rescue TARP –Helped restore confidence in some of the nation’s largest banks and financial institutions –Helped to keep the financial system running –Prevented the recession from being even worse than it was 28

Bank Failures and Government Rescue The Dodd-Frank Act (1,000 pages!) –The Dodd- Frank Wall Street Reform and Consumer Protection Act of 2010 –To prevent the need for another TARP-like rescue in the future –Extended the regulatory power of the Federal Reserve allowing the Fed to impose minimum capital ratios on any financial institution Bank or non-bank 29

Leverage at Financial Institutions 30

Capital and Leverage at Financial Institutions The greater the leverage ratio –The more interest-earning assets the bank can acquire with each dollar of its capital (shareholders’ equity) –They borrow more! –The greater the return it can earn for its shareholders 31

Capital and Leverage at Financial Institutions Deleveraging –The process of reducing leverage –Reducing the risk to your capital from any further declines in asset prices How to lower leverage ratio –Increasing capital –Sell off assets rapidly –Stop lending! Called a credit crunch. 32

Understanding Leverage Appendix to Chapter 4 33

Understanding Leverage Leverage –Magnification of gains and losses through borrowing Using borrowed money to buy a home –10% higher housing prices More than 10% capital gain –10% lower housing prices More than 10% capital loss 34

Understanding Leverage Appendix to Chapter 4 35

Understanding Leverage In this example, you earn $50,000 on $100,000 investment – 50% Simple leverage ratio = “Rate-of-return multiplier” Rate of return on the (leveraged) investment –Rate of change in a home’s price times the leverage ratio –10% x ($500,000/$100,000) –10% x 5 = 50% 36

Understanding Leverage When asset prices rise –Leverage increases your rate of return dramatically When asset prices fall –Leverage increases the chance of wiping out your entire investment 37