Quiz 2 Flashcards

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1
Q

The new deal: government involvement in housing

A

FHA formed in 1934 radically changed mortgage contract to facilitate homebuyer demand by extending mortgage contract to 30 years, lowered down payment, eliminated balloon payments at maturity by introducing amortization of principle balance. FHA also guaranteed standard mortgages

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2
Q

Why was Fannie Mae created?

A

Formed in 1938 Fannie Mae was created to augment mortgage capital and accelerated mortgage origination by purchasing FHA insured mortgages loans to free up capital on bank balance sheets

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3
Q

Evolution of Fannie Mae

A

1938: formed to augment mortgage market
1954: equity is partially owned by private investors
1968: government incentive to remove Fannie’s debt on its balance sheet so they split off Ginnie Mae which became a government agency with full faith and credit of the US government and Fannie became a private shareholder owned company designated as a GSE
1970: listed on NYSE
1981: sell pass-through securities to augment ability to purchase mortgages

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4
Q

Fannie Mae Pass-through security

A

Pass through security allowed investors to receive a share of the cash flows from the mortgages based on their percentage ownership of the mortgage loan. Mortgages placed into a trust and financed by a private investor so that Fannie could guarantee the payments of the mortgage and private investors received the mortgage payments. Eliminate interest rate and prepayment risk

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5
Q

Why was Freddie Mac created?

A

Created in 1970 because Congress wanted competition for Fannie. Identical business model to Fannie:
Bought mortgages from financial firms
Funded with private capital
Implicit government guarantee because of GSE status
Freddie primarily purchased mortgages from savings and loan corporations whereas Fannie purchased from commercial banks

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6
Q

Government Sponsored Enterprise (GSE)

A

Charter authorized by Congress, still privately managed but the president nominates the board of directors, it has special lending and guarantee businesses. Special funding cost advantage over banks, can raise capital at a much lower rate than banks can. There is also no regulatory risk limit on banks investing in GSE’s

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7
Q

Implicit guarantee for GSE

A

Debt capital providers implicitly believe that the government will provide support to GSE’s if necessary because they are regarded as the US government in disguise.

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8
Q

Why is the implicit guarantee risky

A

Implicit guarantee gives GSE’s a high credit rating despite massive leverage (high risk in volatile markets)

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9
Q

Fannie & Freddie business operations

A

Buy loans from mortgage originators
Pool mortgages in a trust
GSE receives a fee for guaranteeing performance or underlying mortgages
Sell interest in the pool as MBS
Take on credit risk that the guarantee fee will cover any default losses
Retain 100% of the mortgage pool credit risk
Pre 2008 Pass-through securities NOT on balance sheet but risk remained

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10
Q

Fannie & Freddie competitive funding advantage

A

Investors believe that they have an Implicit guarantee and would be bailed out if necessary, not subject to bankruptcy code, debt issuances are exempt from state and local income tax (big one) for the bond holder and corporate profits are also tax exempt. have a lower regulatory burden compared to banks

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11
Q

What is a conforming mortgage

A

Mortgages that conform to the guidelines set by the GSE’s
Mortgage amount: size limited to $584000 or less
Priority: must be first lien
Credit score: borrower must meet minimum standard
Loan-to-value: property value must be enough to support the principle of the loan
Loan-to-income: borrower must have enough income to service the mortgage payments

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12
Q

non-conforming: jumbo vs sub-prime

A

Non-conforming: don’t conform to GSE standards so they pay a premium —> jumbo and subprime
Jumbo: loan size too large for GSE’s to purchase
Subprime: credit rating below standard so default risk is much higher

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13
Q

Who regulates Fannie and Freddie?

A

Housing and urban development (HUD): primary regulator
Federal Housing Enterprises Financial Safety and Soundness act: 1992
Federal housing finance agency (FHFA): created during 2008 housing act

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14
Q

Housing and Urban Development (HUD)

A

Regulated equity requirement and allowable leverage for Fannie and Freddie
Monitored mortgage purchases so GSE’s we’re aligned with HUD’s affordable housing goals

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15
Q

HUD lending goals for moderate income households

A

Set goals for the fraction of loans that went to lower income mortgage borrowers
Increased those goals during the housing bubble because the subprime market was so large
Eventually decreased those goals post 2008 because of the crises that they helped fuel

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16
Q

What was the community reinvestment act (CRA)

A

Required federal regulators to encourage banks to serve all communities including low and moderate income neighbourhoods if they were chartered and could not partake in redlining

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17
Q

Statutory capital requirements of Fannie and Freddie

A

40x leverage for mortgages held which is significantly higher than banks
222x levered for the credit guarantee. Historical default rate is low but the cushion is razor thin.
Regulators could not increase statutory capital requirements only congress could (lobbying helped)
Moral hazard for GSE shareholders led to major political donations to influence congress not to raise capital requirements.

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18
Q

What are the risks for mortgage lenders?

A

Default risk
Prepayment risk
Interest rate risk
Real estate risk
Liquidity risk

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19
Q

What is the default risk for mortgage lenders?

A

Mortgage borrower does not pay the loan
Mortgage lender faces exposure to the real estate market through default recover. If the recovery rate is low and default rate is high that’s a massive drag on cash flows for the originator

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20
Q

Prepayment risk for mortgage lenders?

A

Mortgage lender has to reinvest capital prepaid at the prevailing rate which is likely lower than the interest rate earned from the mortgage. Prepayment means the lender earns less on interest over the long term

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21
Q

Interest rate risk for mortgage lender

A

Most mortgages are fixed rate over the lifetime of the loan but interest rates can change so if interest rates rise but the rate of the loan doesn’t that’s a significant loss for the lender. The value of the mortgage contract changes significantly with changing interest rates.

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22
Q

Real estate risk for mortgage lender

A

Lower real estate values increase likelihood of default
Lower collateral value decreases recover and increases expected losses

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23
Q

Liquidity risk for mortgage lender

A

mortgages are illiquid assets and can be expensive to liquidate
Mortgage lenders wanting to sell mortgages may face significant costs (fire sale) if there is a liquidity crunch

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24
Q

What was the demise of Fannie and Freddie?

A

Equity holders had an incentive to use massive leverage because they made a bunch of money when the market was good. Politicians pushed regulators to use the GSE’s for social good but with the leverage this increased the risks and when the housing market speculative boom ended up busting and volatility spiked GSE guarantees caused massive losses.

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25
Q

Reasons the housing crisis was caused by a bubble

A

No mortgages were designed to fail, all of the existing financial instruments had been widely used for several years, regulation had not changed for several years, information was easily accessible and risks were clear. It was a price bubble that caused the meltdown

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26
Q

Why equity will fall at US banks: The Bear Case

A

Regulators and politicians punish existing equity holders at stressed banks (think CS UBS merger), regulators focus on balance sheet stability and loss absorption, highly levered firms are fragile and equity holders are paid out last,

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27
Q

Why bank equity will rise: The Bullish Case

A

Franchise value will raise stock price of bank stocks already depressed, US needs a healthy banking system and society has protected them in the past, SVB and signature failures led to Fed and Treasury protective action to reduce the spread, FDIC costs high leading to regulatory forbearance, liquidations are costly so system will do whatever it takes to prevent them

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28
Q

What is the FDIC? What does it do?

A

Independent non-profit government agency founded in 1933 to provide additional stability to the banking system that charges banks a premium to insure up to $250000 of deposits through the deposit insurance fund. Also inspects, monitors and examines banks to manage risk of losses

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29
Q

What is deposit insurance?

A

Protection in the event a banks assets are deficient to repay depositors. Insurance pays the insured depositors losses from the bank failure

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30
Q

Drawbacks of deposit insurance

A

Creates moral hazard for risk taking at banks for depositors insulated from investment risk (heads you win tails FDIC loses)
Depositors are unconcerned with the risk of the banks only care about interest on the deposits
Banks have an incentive to use less equity and take options it’s on the insurer

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31
Q

Benefits of deposit insurance

A

Centralized monitoring of banks
Coordinated monitoring reduces costs
Efficient monitoring for party insuring depositor

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32
Q

Before deposit insurance

A

Depositors had incentives to monitor bank operations but assymetric information increased the likelihood of bank panic and a bank run

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33
Q

What did the FDIC do during the great financial crisis?

A

Increased line of credit with treasury to address solvency issues in the banking system
Have unlimited tied FDIC insurance for non-interest bearing transaction accounts
Imposed premiums on banks to replenish depleted DIF
Temporary liquidity guarantee program

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34
Q

FDIC debt guarantee program

A

FDIC guaranteed (fully backed) new debt issuances for a fee
Banks able to borrow at extremely attractive terms relative to the market rate of interest

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35
Q

Transaction account Guarantee program

A

Fully insured non-interest bearing accounts
Depositors able to avoid FDIC insurance limits if they accept zero interest

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36
Q

What is the Systemic risk exception

A

Gives the FDIC ability to do whatever is necessary to stabilize the banking system
Ex: AIG bailout, citibank and B of A special assistance

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37
Q

What is the national depositor preference law?

A

Limit the cost of failed banks on the FDIC by giving depositors superior claims to creditors in bankruptcy ie depositors were senior to creditors which gave depositors a higher recovery rate in bankruptcy

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38
Q

What are the unintended consequences to the depositor preference law?

A

General creditors required higher risk premium given the lower recover rate
Banks could always sell assets to lower the claim of depositors
Bond holders would require a higher interest to compensate for lower priority

39
Q

What is Regulatory Forbearance

A

waiting to address troubled asks in the hope of recovery

40
Q

What are some important outcomes of regulatory forbearance?

A

Troubles banks can become more troubled but if they are able to sort themselves out this is way less expensive. Cost to unwind banks is high so in 2008 regulatory forbearance and TARP actually saved banks by preventing fire sales unlike in the S&L crisis where taxpayers list billions

41
Q

What are Contingent payoff securities?

A

A derivative contract whose value is derived from another underlying asset for example auto insurance is contingent on an accident

42
Q

Call option

A

Right go buy a security at a strike price

43
Q

Put option

A

Right to sell a security at a strike price

44
Q

Options model to value deposit insurance

A

FDIC deposit insurance is contingent on a bank run so they have a put option on the banks assets whereas depositors have a call option on the banks assets

45
Q

How does bank competition affect risk taking and stability

A

More competition gives customers better rates but lower margins depress the franchise value which can’t stabilize banks and incentivize intense risk taking to make more money

46
Q

What was regulation Q?

A

Capped deposit rates banks could pay their customers which lowered the competition of rates helping banks be more profitable and increase stability

47
Q

Why did financial firms introduce MMMF’s?

A

To compete with banks, offer bank like deposits with interest like payments but invested in only short dated liquid assets so they were less risky thank banks, they are also regulated by the SEC

48
Q

What does full faith and credit actually mean?

A

It’s more of a symbol of confidence than anything, if the whole system collapses the DIF of the FDIC does not have nearly enough capital to insure the deposits at more than just a few banks.

49
Q

What are the depository financial institutions in the US

A

Credit unions: member owned no FDIC insurance
Savings and loan: focused on residential mortgages, had FDIC insurance
Commercial banks: primary depository institutions, regulated by fed and OCC or FDIC

50
Q

Investment banks

A

Banks focused on corporate advisory or corporate transactions such as M&A, divestitures and strategic changes, securities underwriting, capital and debt markets, brokerage services and trading.

51
Q

Who are the main bank regulators

A

FDIC
Federal Reserve
Office of the comptroller of the currency (OCC)
SEC

52
Q

Who does the FDIC regulate

A

State charter non-member banks, state charter thrifts

53
Q

Who does the fed regulate?

A

Bank holding companies, state charter member banks, Systemically important financial institutions (SIFI’s), foreign ops, foreign banks

54
Q

Who does the OCC regulate?

A

National charter banks
National thrifts (S&L)

55
Q

Who does the SEC regulate?

A

Investment banks, credit ratings agencies, hedge funds and other spv’s

56
Q

What was the Glass-Steagall act of 1933

A

Commercial banks were prohibited from brokerage, insurance, or investment banking activities. Separation was created to limit the conflict of interest between commercial loans given to corporate clients and investment banking activities to raise equity for those clients. Also prohibited banks from having non-investment grade securities in their portfolio

57
Q

How did Glass-Steagall inhibit competition between banks

A

Investment banks receive high fees to issue securities with no competition from commercial banks and investment banking earn multiple rents (fees) for a multitude of services so they are extremely profitable under Glass-Steagall

58
Q

What happened in the gradual repeal of Glass-Steagall?

A

Regulation Q allowed investment banks to compete for depositors, Money market accounts offered by investment banks to compete for deposits, bank holding companies could create affiliates that issued securities

59
Q

What was the justification for repealing Glass-Steagall?

A

Other countries allowed universal banking and the US needed to compete, investment banks could offer products that commercial banks could not, investment banks had a monopoly on securities underwriting and extracted high fees from that. The original justifications for Glass-Steagall were disproven

60
Q

Arguments for Glass-Steagall’s return

A

Universal banks are too big and rip too risky, separating commercial and investment banks limits bank size, commercial banks are supposed to be conservative with deposits while universal banks won’t be (aka investment bankers are greedy). Investment bankers want high returns and will sacrifice stability for them

61
Q

What would have happened if Glass-Stegall was law in 2009

A

Merril Lynch would have failed, Bear sterns would have failed, MS and GS would not be bank holding companies Lehman would not have been taken over by Barclays.

Commercial banks rescued investment banks

62
Q

What was the Volcker Rule

A

Restricted commercial bank investment in hedge funds and private equity
Restricted proprietary trading of securities
Allowed for market making
Increased transparency

63
Q

What is proprietary trading?

A

Financial institutions buy and sell securities for their own account rather than on behalf of clients

64
Q

What was the McFadden act

A

Restricted interstate branching and limited competition between banks across state lines

65
Q

Dodd-Frank act

A

Increased regulation benefits large financial institutions that can scale regulatory burden, skin in the game regulation prevents competition from smaller financial institutions

66
Q

What are central banking activities?

A

Nations primary monetary authority, determine money supply, supervising, monitoring and regulating banks, providing banking services for the government, lending and providing liquidity to banks during times of crisis, promoting financial policies to protect consumers

67
Q

What is the federal open market commission (FOMC)

A

They are the committee responsible for setting monetary policy like the target fed funds rate/target interest rate.

68
Q

What is the target fed funds rate?

A

Interbank overnight lending rate that the fed wants banks to lend at

69
Q

What is the effective fed funds rate?

A

The actual rate that banks lend to each other overnight

70
Q

How does the fed align the effective fed funds rate with the target fed funds rate?

A

If the effective rate is higher than the target the FOMC will inject liquidity into the market to lower market rates by buying treasuries. If the effective rate is lower than the target the FOMC will withdraw liquidity to raise the market rate by selling treasury securities

71
Q

What is the Fed dual mandate

A

Price stability, maximum employment, moderate long-term interest rates

72
Q

What are the Feds tools to achieve its dual mandate?

A

Short-term interest rate targets: fed funds and discount rate
Open market operations (system liquidity decisions)
Reserve requirements (ability for banks to leverage deposits)
Interest on reserves held at the fed (affects bank profits and incentives)

73
Q

What are the main functions of the fed today?

A

Maintain security and soundness of financial institutions and members, conducting monetary policy, promoting systemwide financial stability, consumer protection and community development, promote an efficient payment a settlement system

74
Q

What constitutes a member bank with the federal reserve

A

Have to purchase preferred stock in the fed regional bank, and be subject to fed regulation

75
Q

Similarities between member and non-member banks

A

Access to discount window
Cheque clearance and payment services
Similar reserve requirements

76
Q

What are the sources and uses of income for the Fed

A

Assets: Low risk interest generating debt securities
Liabilities: currency
Equity: member banks purchase preferred equity at regional fed banks
Operational costs paid out of revenue from the balance sheet
Dividends paid to member banks holding preferred equity
Residual net revenue remitted to the US treasury

77
Q

Federal reserve act section 13 article 3

A

Gave broad powers to fed under unusual and exigency circumstances

Allowed for emergency uncapped loan making
Can give credit to individuals, partnerships and corporations
Restricted by Dodd frank

78
Q

Examples of unprecedented programs during the financial crisis

A

Term action facility (TAF): cash to banks
Term securities lending facility (TSLF): treasuries for mortgages
Term asset-backed securities loan facility (TALF): non recourse
Primary dealer credit facility (PDFC): repo corporates, municipal, MBS, ABS
Asset-backed commercial paper MMMF liquidity (AMLF): bought commercial paper

79
Q

Federal reserve asset purchases via special purpose vehicles

A

Mortgage assets if bear sterns and its eventual rescue and merger: Maiden lane
Commercial paper via commercial paper funding facility (CPFF)
Investment on MMMF
Mortgage and credit assets if AIG: maiden lane 2 and 3

80
Q

What was the term auction Facility (TAF)

A

Program design to inject liquidity into banks without the stigma of using the discount window by auctioning loans off to the highest bidder where the highest bidder would receive fully collateralized loans from the fed

81
Q

What was the Term Securities Lending Facility (TSLF)

A

Fed lent treasuries against risky assets to provide funding at a low cost for risk

82
Q

Term Asset-backed securities loan facility

A

Non-recourse funding for AAA backed securities (auto, credit card, student loans)
Massive subsidy to large hedge funds and asset managers

83
Q

What were the department of treasury actions during the crisis

A

Conservatorship of Fannie and Freddie ran by FHFA
TARP program
Public-private investment program for legacy assets
Temporary guarantee of MMMF

84
Q

What is LIBOR?

A

Market interest that banks charge other banks

85
Q

What is OIS?

A

Transaction is an interest rate swap where 1 received compounded floating rate interest and the other received a fixed rate

86
Q

LIBOR - OIS spread

A

Compare LIBOR rate to the fixed leg of an OIS to measure the credit risk and liquidity
Higher spread indicates fear and unwillingness of banks to lend
Low spread indicates confidence in the banking system by other banks

87
Q

Maiden Lane 1 - bear stearns - JPM merger

A

$30 billion of mortgage assets owned by Bear that JPM didn’t want so the NY Fed created an LLC to purchase those assets

LLC lent $28.81 billion for up to 10 years at a discount rate and JPM lent $1.15 billion at a discount of +450 bps then bear sterns sold the assets to the LLC. Any losses by the LLC were borne by the treasury

88
Q

AIG rescue - Maiden Lane 2

A

Fed gave $85 billion loan to AIG to prevent bankruptcy lending against AIG RMBS
Fed bought $20.8 billion of RMBS securities and NY Fed provides $19.8 billion 6 year loan

89
Q

More AIG rescue - maiden lane 3

A

AIG took significant credit risk in subprime mortgages via CDO’s and insured against them by selling CDS but were required to post collateral once insurance prices soared so the Fed created maiden lane 3 to buy the insurance contracts to guarantee performance

90
Q

What does the office of the comptroller of the currency (occ)

A

Regulates nationally chartered banks and thrifts. Has a cease and desist orders and ability to revoke charters as well as examining national credit standards and changes

Oversees systemic risk of nationally chartered banks

91
Q

SEC extraordinary measures in the financial system

A

SEC banned shoe sales of equity if financial institutions in September 2008

92
Q

What is the process of selling short

A

Borrow shares from a stock owner, sell the borrowed shares short in the market then purchase shares in the future and return them to the lender. You profit if the stock falls

93
Q

Macro prudential regulation

A

Regulators must consider broad economic risks when addressing troubled financial institutions
Bank loses increase leverage and risk of insolvency which further destabilizes the bank, leverage can be raised by selling assets or raising equity but there is an incentive for banks to not lend rather than raise equity

94
Q

CAMELS - regulators ratings metric for banks

A

C - capital adequacy: leverage and equity levels
A - asset quality: stability of the assets
M - management: executives manage ops and risk
E - earnings: earnings power to generate new capital
L - liquidity: can assets be converted to cash to pay depositors
S - sensitive: risk exposure of a bank