Credit Crisis

Where Will Banks Find Capital?

Ian McAllister — Thu, 03 Jul 2008 15:08:00 -0400

Bond insurers are in trouble again, and banks will be forced to look for more capital. But the sovereign funds that bailed out investment banks in the winter may have lost their appetite for financials. A recent short-list of potential investors for Washington Mutual was absent of eight sovereign wealth funds the bank approached earlier. Merrill Lynch overcame investor reluctance in its last round of capital raising by agreeing to strict restrictions on subsequent share offerings.

Snapshot asks, as banks face further write-downs and seek to raise capital, will better deals lure sovereign wealth funds back into financials?

Financial Times - Learning from the Banks
Bloomberg - Merrill, Citigroup Estimates Cut by Meredith Whitney
Business Week - Morgan Stanley to sell half its MSCI shares
Guardian - Merrill may have to sell $10 bln BlackRock stake
Financial Week - Foreign funders take a bank pass

Kohn and Others on Credit Crisis

Sam Sherraden — Tue, 20 May 2008 15:08:00 -0400

Federal Reserve Vice Chairman Donald Kohn says conditions in the credit markets are improving. Equities prices have rallied, spreads on high-grade corporate bonds have fallen considerably, and firms have not had trouble raising funds in credit markets. These positive signs are the result of the Fed's efforts to boost liquidity, ability of financial institutions to raise capital, and better than expected economic data.

Despite some positive signs, credit conditions are not optimal. Many investors remain skeptical of credit quality and the securitization market of mortgages has fallen dramatically. Because the market for securitized loans has deteriorated, banks cannot bundle and sell loans and other assets. As credit conditions deteriorate and the risk of default increases, financial institutions have had to de-leverage their balance sheets.

Snapshot asks, are credit markets improving or have we only begun to see a drawn out process of de-leveraging?

Federal Reserve Bank of New York - May You Live in Interesting Times: The Sequel
Don Kohn - May 20th Speech
Financial Times - Fears of Prolonged Credit Crisis Hit Wall Street

Where did the Sovereign Wealth Funds Go?

Sam Sherraden — Mon, 21 Apr 2008 15:36:00 -0400

Since November, sovereign wealth funds have injected $41 billion of a total of $105 billion into struggling financial institutions. Since the purchases, the weighted average of those investments is down 40%. Many sovereign wealth funds are somewhat protected by buying mandatory convertible bonds, which pay large dividends to their holders before paying out to those with common stock. Still, sovereign funds were hasty in their investments and have spent the last couple months licking their wounds.

Snapshot asks, when will sovereign wealth funds move back into financials?

Reuters - Gulf Arabs put brakes on buying spree, await bargains
Wall Street Journal - SWF Losses
Bloomberg - Bear Stearns's Ruin Will Shake Sovereign Funds
IMF (Box 1.2) - Global Financial Stability Report

Doubts Raised Over Libor

Sam Sherraden — Thu, 17 Apr 2008 15:34:00 -0400

The Libor (London inter bank offered rate), or the interest rate that banks lend to other banks, has been called under question as a reliable indicator of banks' access to credit. Because of the tightening of credit conditions worldwide and hesitance to reveal the sting of the credit crunch, banks may not be reporting the actual rates at which they are able to borrow from other banks. The repercussions for the unreliability of Libor are catastrophic. Interest rates on home loans, auto loans, and student loans worldwide depend on the Libor rate. Citigroup's Scott Peng believes that Libor could be underestimated by as much as .3 percent, causing all banks to lend money cheaper than they should.

Snapshot asks, if Libor is underestimated, how much more pressure will it put on banks?

Wall Street Journal - Bankers Cast Doubt on Key Rate Amid Crisis
Wall Street Journal - Bank Group Expedites Libor Probe
Financial Times - Lenders examine Libor alternatives
Bank of International Settlements - Interbank rate fixings during the recent turmoil

'Sub Sub Sub Subprime' Borrowers 100 Million Strong Worldwide and Growing

Jamie Zimmerman — Thu, 17 Apr 2008 12:00:00 -0400

It's all we hear about these days: The U.S. subprime mortgage bubble -- created by poor and at times predatory lending practices and lax banking regulation and creative investment products -- has burst. Of the approximately 7.7 million subprime loans outstanding, over 2 million are at risk of foreclosure and 600,000 borrowers are expected to lose their homes this year. The majority of us are left in shock as we watch the devastation unfold, the bubbles aftermath wreaking havoc on the U.S. (and increasingly global) economy, ensuing fears of recession and economic pain to come, and leaving politicians, economists, and regulators all scrambling to pick up the pieces.
However, in the meantime, the 2006 Nobel Peace Prize winner on Tuesday proudly hailed microfinance -- the innovation of providing small loans to poor, traditionally financial excluded individuals, mainly women -- as "sub sub sub subprime" lending. That means that globally, more than 3300 microfinance institutions provide such "super-subprime" loans to over 100 million clients and growing. Just to be clear: I'm a huge fan of microfinance. However, I'm left perplexed by this dichotomy: How can a lending practice that is almost singlehandedly dragging the whole of the U.S. economy in to a hole simultaneously and sustainably end third world poverty?

Well according to Yunus, the answer is simple - the U.S. subprime crisis was fueled by "sloppy business practices" and complex product, which simply don't exist in the microfinance industry. Finding ways to extend access to credit and financial services to those with less than stellar or no credit or financial history, if done properly, can provide asset-building opportunities to those traditionally excluded and economically disadvantaged. In that sense (and this may come as a shock to those who only know of subprime as it related to the current crisis), subprime lending is not inherently a bad thing.

However, when discussing this issue last night at a CGAP cocktail reception, the answer seemed to be about as complicated as a 5/1 balloon ARM disclosure. Expert discussants, considering the similarities and differences between these sub-prime markets, concluded that microfinance products and services are indeed different from the complex mortgages and bundled securities of the U.S. mortgage market. However, they all cautioned the microfinance industry to take a close look at how certain similarities - the perverse incentives for quantity over quality; the potential of similar "irrational exuberance" of both clients and lenders; the growing influx of new players, products and dis-intermediated capital that could lead to predatory products and practices; similarly, competition among providers that could lead to "race to the bottom" practices and products; the risk of information asymmetries and moral hazard created by increase in disintermediation (which creates distance between borrowers and lenders), and finally, the lack of regulation in many markets -- indeed mirrors characteristics of the sub-prime mortgage market in the United States.

So, my original question remains unanswered, but these new insights beg related, and perhaps more pertinent questions. In our haste to extend the power of micro-credit to the millions living in poverty around the world, how much, if at all, should we head the warnings derived from the subprime crisis? Can light-touch regulation and more concerted efforts enhance consumer awareness provide the balance between providing as much access as quickly as possible to as many as possible and quality of products and practices? Would putting such regulatory brakes on this exploding industry help us to avoid the possibility of a global sub-prime bubble or just deprive the needy of access to finance?

If some predictions are right, then the tightening of capital in the global financial markets -- essentially the effect of failing to address these issues U.S. until it was too late - may inadvertently apply those brakes before we get the chance to answer the question. But with others predicting the opposite (even more capital being diverted into more lucrative, global markets (i.e., microfinance investment)) then we may need to look at these issues more closely, ASAP.

No, Larry, CRA Didn’t Cause the Sub-Prime Mess

Ellen Seidman — Tue, 15 Apr 2008 14:55:00 -0400

It has lately become fashionable for conservative pundits (Larry Kudlow, George Will) and disgruntled ex-bankers (Vernon Hill, for example, in his March 7 American Banker editorial) to blame the current credit crisis on the Community Reinvestment Act. This is patent nonsense. The sub-prime debacle has many causes, including greed, lack of and ineffective regulation, failures of risk assessment and management, and misplaced optimism. But CRA is not to blame.

First, the timing is all wrong. CRA was enacted in 1977, its companion disclosure statute, the Home Mortgage Disclosure Act (HMDA) in 1975. While many of us warned against bad subprime lending before the turn of the millennium, the massive breakdown of underwriting and extension of risky products far down the income scale-without bothering to even check on income-was primarily a post-2003 phenomenon. To blame a statute enacted in 1977 for something that happened 25 years later takes a fair amount of chutzpah.

It's even more outrageous because of the good CRA clearly did in between. The 1990s were the heyday of CRA enforcement-for a variety of reasons including the raft of mergers and acquisitions that followed the 1994 Riegle-Neal Interstate Banking and Branching Act, increased scrutiny of lending practices by the media and activism by housing advocacy groups and tougher enforcement by the Clinton Administration.That period saw increased home mortgage lending to lower income households and in lower income communities by the banks and thrifts covered by CRA, and a steady increase in the homeownership rate, especially for lower income and minority families. (See The Joint Center for Housing Studies ). In addition, there was significant investment in affordable rental housing, community facilities and broader community economic development, directly by banks and thrifts earning investment credit under CRA or indirectly through bank investment in Community Development Financial Institutions and other community-based organizations.

New research by Ingrid Gould Ellen and Katherine O'Regan of NYUWagner, presented at a conference sponsored by the Philadelphia Federal Reserve Bank, convincingly demonstrates that property values went up dramatically in low and very low income urban census tracts during the 1990s, reversing severe declines during the prior two decades. While Ellen and O'Regan point out that this does not necessarily mean that everyone in those communities benefited, relating the improvement in home values in distressed communities to the effects of a statute designed to increase access to mortgage credit in those communities, during a period when the statute was vigorously enforced, is a reasonable connection.

Second, CRA does not either encourage or condone bad lending. Bank regulators were decrying bad subprime lending before the turn of the millennium (see Interagency Guidance on Subprime Lending), and warning the CRA-covered institutions we regulated that badly underwritten subprime products that ignored consumer protections were not acceptable. Lenders not subject to CRA did not receive similar warnings.And we also explained to those we regulated how to serve lower income communities and borrowers in a manner that was good for the borrower, good for the bank, and earned CRA credit.

For example, in October 2000, when I spoke to the National Association of Affordable Housing Lenders, a group of CRA-covered lenders, I said, "key to successful community reinvestment activity is being a responsible lender. Being responsible means making loans on responsible terms to people who can afford to pay them back, and making certain borrowers both understand the terms of the loan and have the opportunity to get the best terms available given their credit and financial position. But it also means expanding both the market for and affordability of loan products. It means working with customers to make them more bankable, helping families find the loan that is right for them, and investing in their success and yours by supporting organizations that assist you by counseling these individuals on the front and the back end of a loan."

CRA enforcement became a lower priority for bank regulators after 2001. My successor at the Office of Thrift Supervision, in fact, led an effort-eventually thwarted-to unilaterally loosen CRA regulations for institutions with more than $1 billion in assets. See 70 Fed. Reg. 10023. Nevertheless, CRA regulations were eased more generally in 2005. See 70 Fed. Reg. 44256.

The years that coincided with reduced CRA enforcement are also the years when CRA-covered entities wandered deeper into "higher priced loans," a category that includes, but is not limited to, "exploding ARMs" and other particularly pernicious kinds of loans. Thanks to the valiant efforts of late Fed Governor Ned Gramlich, starting in 2004 we have data about "higher priced loans." In that year, bank, thrifts and their subsidiaries-the entities covered by CRA-made about 37% of high cost loans. By 2006, the bank, thrift and subsidiary percentage was up to 40.9%. That a lack of interest in CRA enforcement coincided with CRA-covered entities getting into higher priced lending does not seem to me an argument for less CRA enforcement. Rather, it's an argument for better enforcement of a statute that, when well enforced, had proven its worth in helping both borrowers and communities.

Finally, it is nevertheless the case that CRA-covered lenders are not the source of the problem. One of CRA's major failings, in fact, is that it only applies to banks and thrifts. Remember all the investment banks who demanded product and then sliced and diced loans until it was impossible to understand their quality?They're not covered. Neither are the independent mortgage banks, the kinds of firms that have gone bankrupt or nearly so because of their abysmal lending practices, who regularly made about 50% of the high cost loans. Bank affiliates, another uncovered group, made about 12% of the high cost loans.

Janet Yellin, President and CEO of the Federal Reserve Bank of San Francisco recently made this point, saying "Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans, and studies have shown that the CRA has increased the volume of responsible lending to low- and moderate-income households." And a recent study by Traiger & Hinckley LLP (See also the addendum).

CRA is not perfect. It doesn't cover a substantial portion of the financial services landscape. It has become complex, and the primary focus is on numbers of loans, with less attention to the quality of those loans. Asset-building depository and other services are given short shrift. And banks and thrifts have been allowed to "count" loans made by affiliates that are not subject to effective regulatory scrutiny. Governor Gramlich was right when he said that these entities-like the independent mortgage bankers-should be subject to far greater regulatory scrutiny, for many reasons. Certainly banks should not be allowed to count loans made by these affiliates for CRA purposes without such scrutiny.

But these are not reasons to repeal CRA or blame it for a mess caused primarily by those not subject to its reach during a period when even those under its umbrella were not encouraged to take it seriously. Rather, our challenge is to respond to the ongoing credit crisis in part by modernizing CRA, expanding its reach and making it even more effective than it was in the 1990s.