Financial Crisis Management and Bank Resolution

John Raymond LaBrosse, Rodrigo Olivares-Caminal, Dalvinder Singh

• Publisher: Informa Law from Routledge
• Year: 2020
• Print ISBN: 9781843118381
• eBook ISBN: 9781000285895
• Edition: 1
• Topic: Law
• Subtopic: Banks & Banking
• Index: Law

Financial Crisis Management and Bank Resolution provides an analysis of the responses to the recent crisis that has beset the international financial markets taking a top down approach looking at the mechanisms to manage a financial crisis, to the practicalities of dealing with the resolution of a bank experiencing distress. This work is an interdisciplinary analysis of the law and policy surrounding crisis management and bank resolution. It comprises contributions from a team of leading experts in the field that have been carefully selected from across the globe. These experts are drawn from the law, central banks, government, financial services and academia. This edited collection will provide a new and important contribution to the subject at a crucial time in the debate around banking resolution and crisis management regimes, and help to plug the gap in our knowledge and understanding of the law of bank resolution and restructuring.

CHAPTER 1

THE FINANCIAL TURMOIL OF 2007–20XX: CAUSES, CULPRITS AND CONSEQUENCES

George G. Kaufman

INTRODUCTION

The ongoing financial crisis that started in the summer of 2007 has been characterised by the failure or near-failure of large banks in a wide range of countries, including banks in most, if not almost all industrial countries; the need for direct government or central bank liquidity and capital assistance to enable bank, non-bank financial and non-bank non-financial firms to keep operating (which may involve at least temporary partial or full nationalisation); the “credit crunch” in the form of slow growth or reductions in both bank and non-bank lending to firms and households; loss of faith in financial markets and institutions; and sharp declines in stock prices and personal wealth. This has spilt over to the macro-economy through an adverse feedback loop, causing low or negative real growth and high unemployment globally and igniting or magnifying an otherwise “normal” recession. In the US, the crisis also resulted in sharp increases in mortgage defaults and foreclosures and a potential shift in national economic structure for large firms from greater emphasis on market regulation and private ownership to greater emphasis on government regulation and quasi-public ownership. The period threatened to be the most significant peace-time economic and financial crisis in most countries since the 1930s. The crisis raised a number of important questions:

• How did problems in the relatively small sub-prime mortgage market in the US spread so quickly and strongly both to banks throughout the world and to other sectors?

• What happened to the promised benefits of risk-sharing, diversification and optimal risk allocation from securitisation?

• Why did it take so long for most bank regulators and the private sector to wake up to the magnitude of the problem?

• Why were so many proposed public policy prescriptions so poorly received by market participants and the public at large and appear to be ineffective?

• What is the future of market-oriented systems, the role of market discipline, and financial regulatory structures?

This chapter will not answer these questions, but focuses instead on identifying and discussing the US culprits in the crisis. This is important because the problem started there before spreading virtually worldwide. However, because many of the culprits identified in the US had counterparties abroad, much of the analysis also applies to other countries.

The US and the world crisis were both triggered by the end of the housing price bubble in the US which started in 2006. If there had been no real-estate bubble, there probably would not have been a severe crisis. The first indication of trouble was the failure in 2007 of two medium-sized German banks and a few relatively small US and French Hedge Funds due to investments in securitised US sub-prime mortgages. Only shortly afterwards, the first visible bank run in the UK in over 100 years occurred at the mortgage specialist Northern Rock, which had been weakened by bad mortgage loans and excessive reliance on short-term funding. The run was intensely reported by the British news media and called widespread public attention to the fragility of the UK’s financial system.

US CULPRITS

Downturns or crises expose sins that may have long existed but were covered up or hidden during the good or boom times when asset prices increased and few if any investors in those projects requested withdrawals. As the successful investor Warren Buffet has observed it is “only when the tide goes out that you can learn who’s been swimming naked”. Sins continue to accumulate in the booms until the last one is the straw that breaks the camel’s back. In 2007, this was the end of the housing bubble in the US. The list of culprits who contributed to the crisis is long and housed in a broad array of sectors, both private and public (government). There were both market and regulatory failures. In the words of the old US comic strip hero, Pogo, “we have met the enemy and they are us”.

The crisis was the result of a perfect storm. If any of the culprits had not contributed, the magnitude of the turmoil would have been considerably smaller. The culprits, in alphabetical order, include:¹

• central bankers (monetary policy);

• commercial bankers (initial and ultimate lenders);

• credit rating agencies;

• financial engineers;

• government (congress and the administration);

1. I have omitted academics who, on the whole, should also share the blame for seeing neither the crisis coming nor its depth when it did come.

• investors (ultimate lenders);

• mortgage borrowers;

• mortgage brokers (salesmen); and

• prudential bank regulators.

Some of their sins are catalogued and described below.

Central bankers

The Federal Reserve appears to have maintained short-term interest rates too low for too long in the early 2000s after the end of the 2001 recession.² This is likely to have both helped to fuel the sharp rise in house prices nationwide and encouraged excessive corporate and household leverage, including by Hedge Funds and private equity firms. Moreover, the Fed appears to have not been sufficiently sensitive both to the adverse impact of a potential bursting of the banking system bubble and the macro-economy and to the full magnitude of the impact of equity extraction from residential mortgages when household borrowers refinanced at lower interest rates on current and future aggregate consumption and the riskiness of the loans.

Commercial banks

The banks operated with far too little capital (excessive leverage) for their scale of operations and the risks they assumed. They increasingly based their basis for originating residential mortgage loans on expected continued increase in house prices rather than on the ability of the home buyer to meet monthly payments out of his/her current income. The banks engaged in poor and insufficient credit analysis of mortgage borrowers and outsourced much of the credit analysis of the complex securitised mortgage instruments that they purchased on the capital markets to credit rating firms. The banks introduced compensation schemes that relied heavily on loan production rather than on loan collection and on loan performance over too short a time period before defaults had a chance to occur. Such schemes encouraged excessive risk taking. The banks also tended to hold in their own portfolio only the senior, AAA-rated tranches of the complex mortgage-based securities, such as collateralised debt obligations (CDOs) that they packaged and sold (see below) rather than the junior, lower-rated tranches, which would have required more careful monitoring and would have shown earlier signs of trouble.

The banks created many of the CDOs outstanding, but did so through off-balance sheet entities, such as structured investment vehicles (SIVs), to reduce the banks’ reported risk exposure. The banks sold streams of pooled cash flows from their whole long-term mortgages or mortgage-backed securities to the SIVs that financed them by borrowing short-term and transforming them into multi-tranched securities. The borrowing would be repaid when the CDOs were sold. However, as the name of the originating bank was associated with the CDO, there were implicit agreements that, to minimise their reputational risk, the banks would repurchase and thereby put back on their own balance sheets CDOs that encountered credit problems. In both their collection of data on the volume of CDOs and CDO-like securities and their monitoring of performance to measure the risk exposure of banks, the regulators failed to recognise the contingent liability of the banks and did not fully include the obligations of the SIVs. Thus, they greatly underestimated both the size of the CDO market and the risk exposure of the banks.

2. Taylor, Getting Off Track (Stanford: Hoover Press, 2009).

Credit rating agencies

The credit rating agencies conducted incomplete credit analyses of the new complex mortgage securitised products, such as CDOs, particularly with respect to losses given default. In their testing, the agencies basically assumed no major nationwide bursting of the real estate price bubble, as no such serious price declines had occurred in recent memory. Thus, they failed to include extreme or tail values in their test simulations. Homes that were foreclosed and sold because of defaults were assumed to be sold at small if any losses and credit ratings on the new securities were assigned accordingly. Although the agencies were reasonably correct on their estimates of the probability of defaults, when the bubble burst, losses from defaults were substantially larger than had been anticipated and assumed in the ratings. The higher-rated tranches of the multi-tranched CDO securities, which received the first cash flows, from the underlying mortgages were downgraded, often by numerous ratings at a time, as the junior tranches, which received the last cash flows and cushioned the higher rated tranches, suddenly became worthless.

The agencies also failed to emphasise sufficiently to ratings users that the letter grade assigned was basically a relative grade within a class of securities and not a cross-security class. For example, an AAA CDO was not the same as an AAA corporate bond. Because the rating fee is paid by the issuer, the issuer may be able to influence the rating obtained by threatening to use another agency or none at all if the rating assigned by the agency was too low. As is shown later, the agencies were also pressured by some investors to upgrade their ratings so that some investors, who are restricted to higher rated securities by legislation or regulation, would have a greater range of eligible securities to choose from.

Financial engineers

Banks hired financial engineers knowledgeable more for their quantitative skills than their financial skills both to quantify the risk exposures of the institution and to develop new securities. The complexity of the risk models developed was often beyond the ability of even senior financial executives to understand thoroughly so they did not fully appreciate their own risk exposures (black-box risk). Likewise, many of the securities innovations were highly opaque, highly complex, highly leveraged and, again, beyond the ability of many bankers and investors to understand. It has been estimated that a single mortgage CDO could pool as many as 750,000 individual whole mortgages with accompanying documentation running to some 30,000 pages.³ Lastly, the engineers apparently failed to recognise that information, particularly soft information, does not travel well down a chain of securities. Parts are lost or modified in the process. Thus, the quality of information varies more among individual investors in complex securities than for simpler securities and asymmetric information problems become more severe.

Government

The US government actively promoted home ownership, in particular for low income and minority households. In the process, it encouraged and, at times, required mortgage lenders to provide loans to high-risk low-income and minority borrowers, often at below market rates of interest for that borrower’s risk class. Such lending was not sustainable on a profitable basis and led to the ultimate demise of both large quasi-government housing finance agencies – Fannie Mae and Freddie Mac. These two agencies had been permitted by the government to operate at capital ratios considerably lower than those for commercial banks and with weaker regulatory supervision. The government also encouraged the use of low down-payment mortgage loans, often through government agencies, such as the Federal Housing Administration (FHA). These highly leveraged mortgages performed poorly and frequently defaulted when the borrower experienced financial difficulties.

Investors

Investors (buy side) are the ultimate lenders. Many failed to do proper credit evaluations and due diligence on the complex mortgage securities that they purchased. To do such work required more financial knowledge and training than many individual investors possessed. As noted earlier, mortgage CDOs often were based on a large number of individual mortgages with documentation running into tens of thousands of pages. Many investors outsourced the credit analysis to credit-rating agencies, which, again as noted earlier, failed to be as careful and accurate in their analyses as generally perceived. In addition, as many of these complex securities were new, opaque and little understood, they incurred innovation risk that accompanies almost ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Acknowledgements
• Table of Contents
• Contributors’ Biographies
• Table of Cases
• Table of Statutes, Statutory Instruments and European Legislation
• Introduction: The Credit Crunch, De-Globalisation and De-Conglomeration?
• Chapter 1. The Financial Turmoil of 2007-20XX: Causes, Culprits and Consequences
• Chapter 2. International Responses to the Global Financial Crisis
• Chapter 3. Regulating Hedge Funds in the Shadow of the Recent Financial Crisis: The EU Response
• Chapter 4. Towards a Coherent Crisis Resolution Mandate
• Chapter 5. Transparency and the End of Doing Good by Stealth
• Chapter 6. The Role of Government, Central Banks and Regulators in Managing Banking Crisis
• Chapter 7. Defining the Public Interest: Public Law Perspectives on Regulating the Financial Crisis
• Chapter 8. Rethinking the Role of Deposit Insurance: Lessons from the Recent Financial Crisis
• Chapter 9. Understanding, Awareness and Deposit Insurance
• Chapter 10. The European Deposit Guarantee Directive: An Appraisal of the Reforms
• Chapter 11. The Global Financial Crisis: Lessons for Deposit Insurance Systems in Developing Countries
• Chapter 12. Bank Crisis Resolution: The Banking Act 2009
• Chapter 13. Protecting Creditors of Insolvent Banks: How Should the Rights of Different Types of Creditors be Best Managed?
• Chapter 14. International Experience and Policy Issues in the Growing Use of Bridge Banks
• Chapter 15. The “Failing Firm Defence” in Failing Markets: The Case for Bank Mergers
• Chapter 16. Mitigating Moral Hazard in Dealing with Problem Financial Institutions: Too Big to Fail? Too Complex to Fail? Too Interconnected to Fail?
• Chapter 17. Cross-Border Insolvency: The Case of Financial Conglomerates
• Chapter 18. Resolving Crises in Global Financial Institutions: The Functional Approach Revisited
• Chapter 19. Resolution Methods for Cross-Border Banks in the Present Crisis
• Index