C. Tannenbaum

1
Credit, Capital, and CollateralLessons for
Banks, and Those Who Supervise Them

• C. Tannenbaum
• Federal Reserve Bank of Chicago
• Community Bankers Symposium
• November, 2009

2
Any views expressed here are the authors, and
not necessarily those of the Federal Reserve Bank
of Chicago or the Federal Reserve System
3
A Hypothesis

• While the extent and magnitude of the recent
  financial crisis were certainly unexpected, the
  groundwork for such an event was formed gradually
  over the past generation by evolution in the
  financial services industry.

4
Banking in 1970

• The rule of threes
• Heavily regulated
• Interest rate ceilings
• Branch banking restrictions
• Limited product sets
• Consistently profitable
• Stable employment

5
Three-Month Treasury Bill Rates
Source Federal Reserve
6
Paradise Lost
Interest Rates Spike
Depositors Look Elsewhere
More Risks Taken
Direct Delivery of Assets to Investors
Strain on Traditional Sources of Bank Profit
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Growth of Securitization Markets
Source SIFMA
8
Most Debt is Provided by SourcesOutside of the
Banking System
Source Federal Reserve
9
Earnings Move Outside the Margin
Source Federal Reserve
10
Reflections

• Growing earnings in the originate to sell system
  meant doing more deals every year
• In some areas, it appears that incentives were
  misaligned
• Capital rules accelerated the trend
• Oversight of the shadow system was largely left
  to the markets
• When the music was playing, everyone dancedand
  when it stopped

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The Crisis Dynamic
Markets Reverse
Pressure to Sell
Capital Depleted, Risk Appetite Falls
Did technology take the place of perspective?
Rumor Travels Faster Than Fact
Margin, Collateral Calls
Rating Downgrades
12
Lessons Learned Credit Markets

• Bankers, investors and rating agencies should
  have been asking a lot more questions
• In some cases, firms gave away both sources of
  repayment (cash flow and collateral)
• Models got way ahead of themselves
• Past is not always prologue models should not
  assume so
• Procyclical features reinforces upside, deepens
  downside

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The Role of Collateral
Asset
Cash
Secured Lender
Asset
Pledge
Cash
Secured Lender
Asset
Pledge

• On the way up leverage supports asset prices
• When it breaks, unwinds violently

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How This Trickled Down to Community Banks

• Some had invested in complex securities
• Some relied on selling assets into the credit
  markets (i.e. home mortgages)
• Some had adjusted pricing/underwriting to compete
  with large organizations
• Some had increased reliance on secured and
  wholesale funding sources
• The financial crisis caused a severe recession

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Real GDP Growth
Source BEA
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Labor Market Trends
Nonfarm Payroll Employment(change, thousands)
Unemployment Rate (percent of labor force)
Source BLS
17
Unemployment and CRE
Source REIS/TWR
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Vacancy and Rents
Source REIS/TWR
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Loan Quality No Green Shoots
Source Call Reports
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Senior Loan Officer SurveyNet Percent of
Respondents CRE Loans
Source Federal Reserve
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District Provision ExpensesPercent of Total
Assets
Source Call Reports
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Two Areas of Focus

• Points of departure from recent history

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Reserve Coverage Still in Downward Trend
Source Call Reports
24
The Strain on Capital

• Earnings under pressure
• Markets less receptive
• Government support was popular a year ago, a
  stigma now?
• The dreaded denominator effect

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Return on AssetsSeventh District Community Banks
Source Call Reports
26
Major Sources and Uses of CapitalSeventh
District Community Banks
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Number of Banks Less than Well-CapitalizedSeventh
District
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Trends in Bank LendingYear over Year Change in
Total Loans
Source Federal Reserve
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Assets of Commercial Banks
Ratio of Loans Leases to Total Assets (All
Commercial Banks, SA)
Ratio of Cash to Total Assets
(All Commercial Banks,
SA)
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What Was the Stress Test?

1. A simultaneous capital exam of the 19 largest US
   bank holding companies
2. An exercise to determine whether systemically
   important institutions can withstand a severe
   recession
3. A review chartered by the Treasury Department and
   carried out by all major banking regulators
4. An endurance test for 200 well-meaning people
   without personal lives to speak of
5. All of the above

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Considering a More Adverse Scenario
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Why Should Firms Do Stress Tests?

• Good management practice increases the chance of
  having adequate reserves in challenging
  environments
• A useful component of an overall capital planning
  effort for firms contemplating CPP retirement
• Past rules of thumb for capital buffers (1 above
  minimums) no longer as valuable
• Stock analysts are doing them better to get out
  in front of the message
• The journey is as valuable as the destination
• All of the above!

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Differentiating Loan Portfolios

• CI
• Rating
• Industry
• Collateralization
• ABL
• Margin Lending
• Loan Size
• Small Business

• CRE
• LTV
• DSCR
• Property Type
• Owner -Occupancy
• Geography

Mortgage 1st/2nd Geography LTV Primary/Broker
Origination FICO Score
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Looking Ahead Capital Waterfalls
Well-capitalized minimum 6
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What Now?

• The banking system cannot possibly
  re-intermediate all of the credit that has been
  created
• Securitization still has a multitude of benefits
• Lower costs of capital
• Portfolio diversification
• Enhanced liquidity
• Risk tailoring
• The key question what is the new normal?

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Asset-Backed Securities Issuance
37
In the MeantimeFederal Reserve Assets
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Designed to Sunset
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Lessons LearnedBanks and Supervisors

• The business cycle is not dead beware of
  pricing for perfection
• Risk can accumulate in the financial system and
  come home to our balance sheets
• Liquidity can evaporate more quickly than capital
• Risk management discipline cannot be compromised
• Follow-up re-capitalize, revitalize, re-privatize

40
Credit, Capital, and CollateralLessons for
Banks, and Those Who Supervise Them

• C. Tannenbaum
• Federal Reserve Bank of Chicago
• Community Bankers Symposium
• November, 2009