Elements of the Financial Crisis: Morons, Con Men, and Monday Morning Quarterbacks

Elements of the Financial Crisis: Morons, Con Men, and Monday Morning Quarterbacks

Christensen, Peter Ove

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Publication date:

2009

Citation for published version (APA):

Christensen, P. O. (2009). Elements of the Financial Crisis: Morons, Con Men, and Monday Morning Quarterbacks.

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Elements of the Financial Crisis:

Morons, Con Men, and Monday Morning Quarterbacks

Peter Ove Christensen

Introduction

I Were all (central) bankers Morons and Con Men?

I According to some – Monday Morning Quaterbacks – the answer is yes!

I It is truly a second-best world we live in!

I Some macro economists blame Greenspan for keeping interest rates too low for too long – too much debt in the world – real imbalances

I Maybe we (believed we) were getting close to the ideal of perfect and complete …nancial markets – maybe even too close

I Overcon…dence in the e¤ectiveness of macro economic policy and, in particular, monetary policy – the Greenspan put

I Very small margins means larger positions if you must produce reasonable returns-on-equity (cf. investment banks, hedge funds etc.)

I Overcon…dence in risk management strategies (…nancial engineering, Value-At-Risk, and time-series econometrics)

I Re‡ected in bank regulation (Basel II: risk-weighted assets) and

…nancial reporting (FASB and IASB: fair value accounting)

Traditional Banking

I Traditional banking is about taking deposits and providing loans

Loans Deposits Equity

I Enormously important intermediary role for economic prosperity in developed economies – key infrastructure in modern economies

I Maturity mismatch between short-term deposits and long-term loans

I Providing loans means taking credit risk, and this is how it should be

I Close to customers (and may thus resolve the inherent informational asymmetries) – the key intermediary role in evaluating credit risk

Traditional Banking...

I Maturity mismatch implies

I Interest rate risk

I Liquidity risk (depositors may want their money back)

I No matter how good you are evaluating credit risk, providing loans means

I Credit risk following from operational risks of your borrowers

I In traditional banking, the three types of risks resides with the bank (and their equity holders)

I The consequence is

I High margins (borrowing rates substantially higher than rates on deposits – say 500 basis points)

I High capital ratios (equity/assets >8%) to provide a bu¤er for interest rate, liquidity, and credit risk, but also to prevent bank runs

I Would it not be better to share the risks in the capital market (e¢ cient risk sharing)?

The New Banking Model

I Get the interest rate, liquidity, and default risk o¤ the bank’s balance sheet

I Securitizing the loans, and selling these securities (CDOs) to well-diversi…ed investors in the capital market

Deposits Loans

Equity

=)

Cash Deposits Loans CDOs

Equity

I “Perfect match” between Cash versus Deposits, and Loans versus CDOs mean lower required margins and equity capital

I Selling the CDOs require ratings by recognized and trustworthy (three) credit rating agencies (AAA, AAa,...)

Investment Banking

I Given the perfect match between Cash versus Deposits, this leg of the business is not really necessary: provide loans and sell them directly as CDOs

Cash Deposits Loans CDOs

Equity

=) ^{Loans CDOs}

Equity

I Even less equity capital is required, and strong competition between investment banks drives down the margins

I From OTC markets with high margins to low competitive market determined margins, and highly e¢ cient risk sharing

I As close as you get to perfect and complete …nancial markets

The Danish Model

I We invented this model more than two hundred years ago!

I Kreditkassen af Husejere i Københavnwas incepted in 1797 after the big …re of Copenhagen

I Initially owned by lenders, after Realkreditloven af 1850 owned by borrowers in Mortgage Unions with unlimited liability – and after Realkreditreformen 1989 organized as corporations with limited liability mainly owned by foundations

I The maintained principle over the full time-span is theBalance Principle on long-term loans:

I Direct-pass-through-system: payments on loans = payments on MBSs

I Until 1989 credit risk was covered by credit pools created by borrowers, and paid back to the borrowers in the pool, when the mortgage was fully repaid – perfect alignment of credit incentives

I Recently, the picture has become a little more blurred

The Danish Model...

I The balance sheet of a Mortgage Union

Loans MBSs

Credit pool Equity

I Extremely e¢ cient system:

I No defaults on Danish MBSs ever!

I Extremely low margins (say 50 basis points) – but how much fun is it to run a company like that?

I Very low returns-on-equity (say 3%): Increase the size of the business (provide more loans), or get back to more OTC-like markets: …nancial innovation and SDOs

Conclusion on Modern Banking

I Movement towards market-based …nancing, i.e., o¤-loading risks to investors in the capital market

I This means smaller margins

I Smaller margins require bigger positions (cf. economics of scale) to make reasonable returns-on-equity

I It certainly looks like we have moved much closer to perfect and complete markets – but probably also much more fragile markets

I Bigger positions and higher levels of leverage require excellent risk management systems, cf., for example, continuously rebalancing of portfolio to replicate an option in a Black-Scholes world

I Require reliable credit ratings, i.e., counterparty credit risks – outsourcing credit evaluation

I But what happens if we miss the fat tails, sudden changes in correlation structures, or if the credit agencies start “sleeping” with the banks selling the CDOs?

Mark-to-Fire-Sale

I The FASB and IASB and other constituencies have pushed for more extensive use of “fair value” accounting

I Historical (amortized) cost accounting leads to outdated information in the balance sheet – cf., for example, the savings and loans crisis in the US in the 1980s and early 1990s

I Fair values in the form of market values give timely information about values of assets and liabilities

I In a second-best world, mark-to-market accounting may drive otherwise healthy …nancial institutions into bankruptcy

I Mark-to-market accounting may even fuel bubble prices in …nancial and real markets

I As always in economics, there are important trade-o¤s to be made

Accounting in Financial Institutions

I Operating assets and liabilities

I Historical (amortized) cost or fair value including impairment

I Financial Assets and liabilities

I Mark-to-market if active market for the asset

I Or “imputed fair value” including impairment using generally accepted valuation models

I Capital requirement

I The ratio of equity to total assets must exceedk%

I All of this may change as we speak!

I Stay tuned at www.ifrs.com and www.fasb.org

Mark-to-Market Accounting in Perfect Markets

I Nothing beats mark-to-market accounting in perfect markets

I Market prices equal fair values: the market price is equal to the net present value of future cash ‡ows

I Objective and cannot be manipulated: default risk is priced in a competitive market

I Subjective impairments can be manipulated

I Perfect markets

I No information asymmetries

I No incentive problems

I No need for capital requirements

I No use of accounting information – accounting only takes on substance in imperfect markets (i.e., with information asymmetries and non-trivial incentive problems)

Mark-to-Market Accounting in Imperfect Markets

I Market prices may not equal fair values – we might not even know what fair values really mean

I Asymmetric information about …nancial asset values – Akerlof: The Market for Lemons, QJE, 1970

I Illiquidity created by the accounting and capital requirements – Brunnermeier and Pedersen: Market Liquidity and Funding Liquidity, RFS, 2009

I Bubble pricing fuelled by the accounting and leverage targeting – Plantin, Sapra, and Shin: Fair Value Accounting and Financial Stability, WP University of Chicago, 2009

Asymmetric Information

I Even the best accounting can never reveal all details of a book of complex …nancial securities

I Mortgage-backed bond portfolios is an example

I Subprime mortgage-backed bond portfolios

I Danish mortgage-backed bonds (from the perspective of foreigners)

I Financial institutions themselves is another example

I Credit rating institutions: assessing and attesting to the quality of securities and …nancial institutions, i.e., resolve information

asymmetries between sellers and buyers of securities

I Deposit insurance: Cover small deposits to avoid bank runs

I Governments: Cover the rest for large too-big-to-fail …nancial institutions (systemic risk – keep the …nancial infrastructure system running)

Price

Quality

Mark-to-Market:

before Moody’s and S&P lost their innocence and when we still believed in “too big to fail”

OA Balance Sheet

E V V

L Fair

Value

qH

qL

PL

PH

PH

20%

PH

E OA =

+

L L 0 P =q =

Price

Quality

Mark-to-Market for Lemons

OA Balance Sheet

E V V

L Fair

Value

2

L H

q +q qH

qL

PL

PH

2

L H

P +P

2

15%

L H

P P E OA + =

+

Price

Quality

Mark-to-Market for Lemons

OA Balance Sheet

E V V

L Fair

Value

2

L H

q +q qH

qL

PL

PH

2

L H

P +P

2

15%

L H

P P E OA + =

+

Price

Quality

Mark-to-Market for Lemons

OA Balance Sheet

E V V

L Fair

Value

2

L H

q +q qH

qL

4

L H

q +q PL

PH

4

L H

P +P

4

10%

L H

P P E OA + =

+

Price

Quality

Mark-to-Market for Lemons

OA Balance Sheet

E V V

L Fair

Value

2

L H

q +q qH

qL

4

L H

q +q PL

PH

4

L H

P +P

4

10%

L H

P P E OA + =

+

Price

Quality

Mark-to-Market for Lemons

OA Balance Sheet

E V V

L Fair

Value

2

L H

q +q qH

qL

4

L H

q +q PL

PH

8

L H

P +P %

8 5

L H

P E

A P

O + =

+

Price

Quality

Mark-to-Market for Lemons

OA Balance Sheet

E V V

L Fair

Value

2

L H

q +q qH

qL

4

L H

q +q PL

PH

PL

2%

PL

E OA =

+

Fin an sie l S ta bilit et

Hva’Dæln’Do We Do?

I Market froze worldwide for anything mortgage related: increasing spreads between treasuries and mortgage-backed securities (cf. Jyske Invest Market-Neutral Hedge)

I Interbank market froze worldwide (short-term borrowing and lending between banks): enormous increases in interbank rates

I Restore con…dence in credit agencies

I They are in the market for assurance services

I Reputation takes too long to rebuild

I But they are working hard at it: downgrading anything that can downgraded, i.e., securities, …nancial institutions and countries

I Deep pocket guaranties for counterparty risks

I Has worked for the interbank market

I Maybe much turmoil could have been avoid if counterparty risks were guarantied initially in the Lehman Brothers collapse – Monday Morning Quarterbacking

Hva’Dæln’Do We Do?...

I Signalling of credit quality

I One of the standard approaches to overcome the Market-for-Lemons problem – put your money where your mouth is

I Must be very hard evidence – no single Danish mortgage bond has ever defaulted over the last two hundred years – otherwise, very costly and very ine¢ cient risk sharing

I Weathering temporary market breakdowns

I Increase the equity bu¤er through right o¤erings to existing

shareholders – avoids perceived wealth transfers between existing and new shareholders when there is great uncertainty about the fair value of the stock

I The existing shareholders must have the liquidity to buy their share of the issue – may be blocked by a large shareholder lacking su¢ cient liquidity

I Nordea did this on a big scale – Danske Bank did not

I Mandatory right o¤erings of equity (instead of government subordinated credit lines) avoids the adverse stock market reaction

Illiquidity Created by the Accounting

I Perfect markets for homogeneous assets: unlimited demand at fair values

I Shock to the real economy in imperfect market

I Levered …nancial institutions mustbalance pro…tability against the risk of violating capital requirement thresholds

I Fundamentalists canfocus exclusively on pro…tability but can only providelimited liquidity

I Note that capital requirement thresholds are stated in terms of book values of equity and assets – not in terms of fair values

I The accounting may create a spiral of increasing spreads between market prices and fair values

Price of FA

Quantity

Mark-to-Market Accounting:

perfect markets

Fair Value

Demand

Supply

Price of FA

Quantity

Mark-to-Market Accounting:

perfect markets

OA FA

Balance Sheet

E V V

L E

OA+FA= 20%

Fair Value

Price of FA

Quantity

Shock to Operating Assets

OA FA

Balance Sheet

E V V

L E

OA+FA= 15%

Fair Value

Price of FA

Quantity Fundamentalists

Shock to Operating Assets

OA FA

Balance Sheet

E V V

L E

OA+FA= 15%

Fair Value

Price of FA

Quantity Fundamentalists

Mark-to-Illiquidity Accounting

OA FA

Balance Sheet

E V V

L E

OA+FA= 10%

Fair Value

Price of FA

Quantity Fundamentalists

Mark-to-Illiquidity Accounting

OA FA

Balance Sheet

E V V

L E

OA+FA= 5%

Fair Value

Price of FA

Quantity Fundamentalists

Mark-to-Illiquidity Accounting

OA FA

Balance Sheet

E V V

L E

OA+FA= 5%

Fair Value

Hva’Dæln’Do We Do?

I Right o¤erings of equity to existing shareholders is again a possibility for weathering temporary illiquidity pricing

I Again, it may be blocked by a large shareholder lacking liquidity

I Abandon mark-to-market accounting

I Use amortized cost for loans and mortgage bonds

I Rush revision of IAS 39 (Fall 2008) allowing …nancial institutions to reclassify certain assets out of the trading portfolio (mark-to-market) and into the portfolio for held-to-maturity (amortized cost)

I Danske Bank and Jyske Bank did this, but most others did not (fair 2008 result, but missed the upside in the Spring 2009)

I Use fair value accounting less impairment (model prices) as for some operating assets and liabilities

I No one knows the fair value if the market price is not set in perfect competition between fundamentalists

I Subject to manipulation

I Extensive use of model prices based on data from illiquid markets may propagate through the system to other asset classes

Hva’Dæln’Do We Do?

I Bring back the fundamentalists

I The liquidity problem is caused by leverage and capital requirements

I Fundamentalists = long-term and unleveraged investors

I Private pension funds

I Public funds (such as government pension funds, cf. Den Sociale Pensions Fond)

I Increase the liquidity of fundamentalists

I Make certain that there is su¢ cient competition between fundamentalist in order establish a fair market price

I Ban the use of Gordon’s growth model and forward price-earnings ratios

I Fundamental stock values can only be understood when earnings prospects are assessed across the business cycle

Bubbles and Bank Busts Fuelled by the Accounting

I Suppose the bank has decided to maintain a leverage ratio of 10 (equity is very costly is the argument)

I Further assume the bank uses mark-to-market accounting for all assets

Securities,100 90, Debt 10, Equity

leverage = 100

10 =10.00

The Creation of a Bubble

I Suppose the security increases by 1%

Securities, 101 90, Debt 11, Equity

leverage = 101 11 =9.18

I Take on additional debt and buy additional units of the security to maintain a leverage ratio of 10

Securities,110 99, Debt 11, Equity

leverage = 110

11 =10.00

I The demand curve is upward-sloping!

Bank Busts

I Suppose there is a shock to the security price so that

Securities,109 99, Debt 10, Equity

leverage = 109

10 =10.90

I Sell securities worth 9 and pay back debt of 9 to maintain a leverage ratio of 10

Securities,100 90, Debt 10, Equity

leverage = 100

10 =10.00

I The supply curve is downward-sloping!

Perverse Demand and Supply Curves

I What is the aggregate impact of these perverse demand and supply curves?

I Increasing security prices, increases the demand for the security, which will increase the price even further

I Decreasing security prices, increases the supply of the security, which will decrease the price even further

I The aggregate impact is likely to amplify price cycles: arti…cial volatility created by the accounting!

I A remedy could be pro-cyclical capital requirements: high capital requirements in good times and lower capital requirements in bad times

Banking Regulation

I Deposit insurance …nanced by the banks themselves, explicit and implicit to-big-to-fail government guaranties, and systemic risk: a well functioning …nancial market is crucial for the prosperity of modern economies

I Society has a legitimate interest in regulating the …nancial markets and banks, in particular, to avoid market failures such as

I incentives for equityholders for excessive risk taking caused by limited liability of equityholders, deposit insurance and government

guaranties: if things go well, we get all the bene…ts, but if things go badly, it is someone else’s problem (cf. Jensen and Meckling, 1976)

I Traditionally, a main component of bank regulation was in the form of a capital ratio of at least 8%, i.e., equity/assets >8%

I Since the issue at hand is to limit excessive risk taking, this was a stupid rule! Does not account for the risk of the portfolio of assets, but it was a simple rule hard to game

Risk-Weighted Assets

I Traditional capital ratio rule

Cash, 100 270, Liabilities Securities, 100

Loans, 100 30, Equity

capital ratio = 30

300 =10%

I Basel II capital ratios based on VAR measures (in principle – lots of details and managerial discretion)

Cash, 100 (0%) 270, Liabilities Securities,100 (50%)

Loans, 100 (100%) 30, Equity

capital ratio = 30

150 =20%

I Great idea: re‡ects the downside risk of the portfolio of assets!

The New Banking Model +

I Get the risks o¤ the bank’s balance sheet (Structured Purpose Vehicle), cf. Acharya and Richardson (2009, Chapter 2)

Balance Sheet Loans Deposits

Equity

=)

New Bank Balance Sheet Cash Deposits

Equity

O¤ Balance Sheet Conduit Loans CPs

I Now you can do fun stu¤ with the cash!

Capital Requirements Arbitrage

I The short-term commercial papers (CPs) backed by the loans are sold o¤ to investors in the capital market (recall e¢ cient

market-based risk sharing)

I AAA ratings of the CPs required guaranties from the supporting bank: liquidity and credit risk

I E¤ectively, the risks stayed on the bank’s balance sheet, so what is the point?

I Di¤erential Basel II capital requirements

I Loans count 100% in risk-weighted assets: 8%

I O¤ balance sheet guaranties count only 10% of notional: 0.8%

I Investors are not Morons: lost con…dence in the guaranties by the supporting banks – the short-term CPs could not be re…nanced

I The loans had to be returned to the banks’balance sheets: the banks were getting into trouble with the capital requirements, because they didn’t retain the cash but did fun stu¤ with it

What is it about Leverage in Banks?

I It looks like the banks have been playing a leverage game with ever increasing leverage, but why and is it really true?

I Discussing leverage, a good place to start is Modigliani-Miller (1958)

I First no-arbitrage argument in the literature: The value of the …rm (the assets) does not depend on how it is …nanced – the value of a pizza does not depend on how you slice it (between equity and debt)

I In market value terms (like a balance sheet):

V_L =S+D=V_U

I In expected rates of returns R_U = ^S

VR_E +^D

VR_D , ^RE =R_U +^D

E (R_U R_D)

I In expected accounting rates of returns: return-on-equity ROE =ROA+^NFO

BVE (ROA FE)

What is it about Leverage in Banks?...

I If the expected return-on-asset (ROA) is higher than the expected borrowing costs (FE), then the expected return-on-equity is increasing in leverage

ROE =ROA+^NFO

BVE (ROA FE)

I Is this an argument for leverage: Modigliani and Miller say NO!

I At …rst sight (by Monday Morning Quarterbacks) it might look like banks think YES!

I The Modigliani-Miller argument is that the higher expected

return-on-equity merely re‡ects the compensation for additional risk on return-on-equity: in CAPM terms

β_E =β_U+^D

E (β_U β_D),

I That is, the same operational dollar risk pertains to fewer dollars of invested equity: the risk per dollar of invested equity increases

What is it about Leverage in Banks?...

I Boards, CEOs and CFOs of banks are probably not all Morons and Con Men!

I We have to be a little careful when we apply Modigliani-Miller to banks – recall we are talking about a pizza of a …xed size

I What is the business of a bank: scrue people depositing money (o¤er low interest rates), and scrue people who wants to borrow money (charge a high interest rate)

I As opposed to other types of businesses, banks make money on their

…nancing!

I We need to clearly separate between operating and …nancing activities:

I Zero NPV activities are classi…ed as …nancial activities

I All other activities are classi…ed as operating activities

I Unfortunately, …nancial reports are not organized in this way but, of course, they should be! See AAA discussion paper on conceptual framework

Separating Operating from Financial Activities in Banks

Loans (OA) Deposits (OL) Securities (FA) Market Debt (FL)

Equity

=)

Loans Market Debt – Deposits –Securities

NOA NFO

Equity

I Now we can apply Modigliani-Miller to how we make the split between Equity and NFO – increasing NFO and decreasing Equity does not a¤ect the size of the pizza (zero NPVs)

I Typical (old fashion) capital ratios around 1% - 5% depending on whether market or book values are used

I Modigliani-Miller capital ratios well above 50% and even above 100% in many cases

M&M Capital Requirements

I Reasonable M&M capital ratios (Equity/NOA) depend on the risk in the return-on-net-operating-assets RNOA,i.e., how well the

operating assets hedge the operating liabilities

I They may very well be above 100%, i.e., the bank holds net-…nancial-assets as opposed to net-…nancial-obligations

I The fact of the matter is that many banks had too low capital ratios in the current …nancial crisis to weathering market breakdowns

I Modigliani and Miller (1963): with corporate taxes, increasing leverage increases the size of the pizza due to tax deductibility of interest payments, while net-dividends to equity are not tax deductible – Miller (1977) also includes investor taxes

I Kinky incentive contracts for boards members, CEOs, CFOs, and traders may induce a preference for leverage – get all the bene…ts if things go well, but leave the mess to someone else if things get ugly

I Still, there are lots of good reasons to have kinky incentive contracts – can only be properly understood by examining a second-best world (see next)

Modigliani and Miller Meet Holmström

I Leverage and incentive contracting in a second-best world with hidden knowledge and hidden actions

I This will have to be some other day!

Conclusion

I Most certainly, the public outrage will result in new regulation constraining banks and …nancial markets

I It will be imperfect – politicians’main objective is to get re-elected

I It will be at the expense of real investments with inherent operational risks and economic prosperity

I A new …nancial crisis will most certainly happen again within our lifetime

I A suggestion for a more sustainable change in regulation

I Make certain that it will be in the shareholders’, the board members’, the CEOs’and the CFOs’own best interest to hold substantial amounts of equity on their balance sheets (bu¤ers) – some of which is invested in …nancial assets at fair returns

I Eliminate the tax-advantage of debt for banks

I Eliminate corporate taxes for banks, and substitute it with taxation of equities on an accrual basis – leads to conservative accounting and buildup of bu¤ers