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Credit Crisis of 2007 - 2009

n Lenders Made Sub-Prime Mortgages
n Borrowers had insufficient income to
make monthly payments
n Many mortgages had teaser rates
n Low payments resulting in negative
amortization
n Multiple Mortgage Banks Fail
n As the mortgages write-downs were
recognized, the mortgage banks
capital was depleted

Banking and the

Financial Services
Industry

Credit Crisis of 2007 - 2009

Credit Crisis of 2007 - 2009

n Collapse and/or Failure of:

n Government Response

n Bear

Stearns
n Lehman Brothers
n Countrywide
n Washington Mutual
n Wachovia

n Fannie

Mae and Freddie Mac placed

into conservatorship
n Loaned AIG over $150 billion
n Insured money market mutual funds
n Created Commercial Paper Funding
Facility
n Increased FDIC coverage to $250,000
n
3

Temporarily through 2009

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Credit Crisis of 2007 - 2009

Credit Crisis of 2007 - 2009

n Government Response

n Impact on Banks and the Banking

n Established

Troubled Asset Relief

Program TARP
n Established Term Asset-Backed
Securities Loan Facility TALF
n Invested $125 billion in nine large U.S.
banks
n Promoted mortgage loan modifications

Environment
n Biggest

impact of declining real estate

values concentrated in the areas that
experienced the largest run-up in real
estate values
n

Many large banks experienced large

losses while many small banks did not

Credit Crisis of 2007 - 2009

Credit Crisis of 2007 - 2009

n Impact on Banks and the Banking

Environment
n Largest

Investment Banks

Goldman Sachs and Morgan Stanley

Bear Stearns and Merrill Lynch

Lehman Brothers

Converted to Financial Holding Companies

Absorbed by other financial institutions
Failed
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How Do Banks Differ?

How Do Banks Differ?

n Global Banks
n Offer

a wide array of products and

services globally

n Super-Regional Banks
n Similar

to global banks but smaller in

size and market penetration

n Community Banks
n Smaller

trade area with total assets

under $1 billion
9

How Do Banks Differ?

10

How Do Banks Differ?

n Bank Holding Companies
n Owns

controlling interest in one or

more commercial banks
n Parent Organization versus
Subsidiaries
n
n

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One-Bank Holding Companies

Multibank Holding Companies

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How Do Banks Differ?

How Do Banks Differ?

n Financial Holding Companies
n The primary advantage to forming an FHC
is that the entity can engage in a wide
range of financial activities not permitted
in the bank or in a BHC
n Authorized to engage in:
n Underwriting and selling insurance and
securities
n Commercial banking
n Merchant banking
n Insurance company portfolio investment
activities
13

14

How Do Banks Differ?

How Do Banks Differ?

n Financial Holding Companies

n Financial Holding Companies

n Fed

may not permit forming an FHC (or

converting a BHC to an FHC) if any of
its insured depository institution
subsidiaries are:
not well capitalized,
not well managed,
n did not receive at least a Satisfactory
rating in its most recent CRA exam
n
n

15

n An

FHC can own a bank or BHC or a

thrift or thrift holding company
n

Each of these companies owns

subsidiaries, while the parent financial
holding company also owns other
subsidiaries directly

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How Do Banks Differ?

How Do Banks Differ?

n Holding Company Financial

Statements
n The

consolidated financial statements

of a holding company and its
subsidiaries reflect aggregate or
consolidate performance

17

How Do Banks Differ?

18

How Do Banks Differ?

19

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How Do Banks Differ?

21

How Do Banks Differ?

22

How Do Banks Differ?

n Holding Company Financial

Statements
n While

the consolidated financial

statements of a holding company and
its subsidiaries reflect aggregate
performance, it is useful to examine
the parent companys statements alone

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How Do Banks Differ?

n Holding Company Financial Statements
n The parent typically pays very little in
income tax because 80 percent of the
dividends from subsidiaries is exempt
n Taxable income from the remaining 20
percent and interest income is small
relative to deductible expenses
Under IRS provisions, each subsidiary actually
pays taxes quarterly on its taxable income
With a consolidated tax return, however, the
parent company can use taxable income from
its subsidiaries to offset its loss
26

25

Organizational Structure and

Financial Services Business Model

Organizational Structure and

Financial Services Business Model

n S-Corporation Banks

n S-Corporation Banks

n Have

favorable tax treatment because a

qualifying firm does not pay corporate
income tax
n

The firm allocates income to shareholders on

a pro rata basis and each individual pays tax
at personal tax rates on the income allocated
to them
Given the opportunity to avoid double taxation at
the firm and individual level, many closely held
banks have chosen S-corporation status

The primary limitation to qualifying for Scorporation status is a requirement that the
bank must have no more than 100
shareholders
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Organizational Structure and

Financial Services Business Model

Organizational Structure and

Financial Services Business Model

n Financial Services Business Models

n Financial Services Business Models

n The

n The

principal advantage of being a

depository institution is access to FDIC
deposit insurance
The FDIC charges banks a premium for the
insurance, which ensures qualifying deposit
holders that the FDIC will guarantee the
principal amount of each deposit up to the
maximum allowed
n The existence of deposit insurance allows
depository institutions to pay low rates on
insured deposits and ensures that such
deposits are relatively stable in times of crisis
n

primary disadvantage of operating as a

bank (or BHC) is that the firm is subject to
regulation as a bank
n Prior to 2008, investment banks avoided
regulation as banks, which allowed them to
operate with substantially lower equity
capital per dollar of risk assets and enter
lines of business not generally available to
commercial banks
n

The combined effect was greater financial

leverage and business operations in many
high-risk areas such as proprietary trading

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30

Organizational Structure and

Financial Services Business Model

Organizational Structure and

Financial Services Business Model

n Transactions Banking Versus

n Transactions Banking Versus

Relationship Banking
n Transactions

Relationship Banking

Banking

n Relationship

Involves the provision of transactions

services such as checking accounts,
credit card loans, and mortgage loans
that occur with high frequency and
exhibit standardized features
n Because the products are highly
standardized, they require little human
input to manage
n

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Banking

Emphasizes the personal relationship

between the banker and customer
For example, the key feature of a loan that
is relationship driven is that the lender
adds real value to the borrower during the
credit granting process
In addition to the provision of funds, the
lender may provide expertise in
accounting, business, and tax planning
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Organizational Structure and

Financial Services Business Model

Organizational Structure and

Financial Services Business Model

n Transactions Banking Versus

n Transactions Banking Versus Relationship

Banking
n Securitization

Relationship Banking
n Relationship

Banking

Lending institutions generally charge

higher rates and often hold the loans in
portfolio
n Aggressively market noncredit
products and services to such
customers in order to lock in the
relationship
n

The process of pooling a group of assets with

similar featuresfor example, credit card
loans or mortgagesand issuing securities
that are collateralized by the assets
The securities are sold to investors who receive the
cash flows from the loans net of servicing,
guarantee, and trust fees
The entire process adds liquidity to the market
because the loan originators regularly repeat the
process knowing that investors will demand the
securities

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34

Organizational Structure and

Financial Services Business Model

Organizational Structure and

Financial Services Business Model

n Transactions Banking Versus

n Transactions Banking Versus

Relationship Banking

Relationship Banking
n Originate-to-Distribute
n

n Originate-to-Distribute

(OTD)

When loan origination is separated

from ownership
The flaw is that lenders who originated the
loans knew they would not own the loans
long term
They were, therefore, less concerned about
the quality of the assets originated
35

(OTD)

In order to grow their business and continue

originating loans, they increasingly made
loans to less qualified borrowers
When the underlying assets defaulted at
higher-than-expected rates, investors in the
securities did not receive the promised
payments
The net result is that liquidity largely dried up
for most securitizations
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Organizational Structure and

Financial Services Business Model

Organizational Structure and

Financial Services Business Model

n Universal Banking

n Universal Banking

n Refers

to a structure for a financial services

company in which the company offers a
broad range of financial products and
services
Combined traditional commercial banking
that focused on loans and deposit gathering
with investment banking
n Underwrote securities, advised on mergers
and acquisitions, managed investment assets
for customers, took equity positions in
companies, bought and sold assets for a
speculative profit, offered brokerage services,
and made loans and accepted deposits
n

37

n The

presumed advantage of universal

banking is the ability to cross-sell
services among customers
n Participation in diverse products and
services would presumably increase
the information advantage and allow
the bank to serve customers more
efficiently and at better prices
38

Organizational Structure and

Financial Services Business Model
n Universal Banking
n There

is no consensus on whether
universal banking is successful
n U.S. firms that tried to achieve this goal
of a one-stop financial supermarket
have not outperformed more traditional
competitors

39

40

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Different Channels for Delivering

Banking Services
n Branch Banking
n Automated Teller Machines

Banking and the

Financial Services
Industry

n Internet (Online) Banking

n Call Centers
n Mobile Banking

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