Other Concepts Outline

OTHER CONCEPTS

1. Shadow Banking System

   1. Features

      1. Similar to traditional banking

      2. Outside regulation

      3. Riskier

   2. Lending Side

      1. Commercial Paper

         • Unsecured corporate debt (vs. standard secured bank loans)

           • Alternative to traditional Commercial & Industrial Loans

         • Short-term (generally 60 days, 90 days, or 120 days)

         • Cheaper than traditional commercial bank loans

         • Flexible

           • Could be rolled over when became due

         • Restrictive

           • Only the most credit worthy firms had a market for their CP

      2. Repos

         • Repurchase Agreements: Sell securities on the balance sheet per contract committing to repurchase said security at a specified time in the future (short-term - usually the next day) at a higher price

           • They would do this for the purpose of getting short-term liquidity to speculate in an attempt to obtain quick returns on the cash

         • CONTRAST TO COMMERCIAL BANKS

           • Banks would use repurchase agreements for the primary purpose of hiding assets on the books right before quarterly evaluations (hide bad loans from regulators)

   3. Deposit Side

      1. Money Market Funds

2. Securitization

   1. Steps

      1. Step 1: Borrower gets loan

      2. Step 2: Lender sells loan to issuer and borrower begins making payments to servicer (the bank, sometimes the same entity as lender)

      3. Step 3: Issuer creates a Trust (e.g., SIV or SPV) where the loans are pooled and then sells securities to investors

         • Underwriters assist in sale

         • Credit Rating Agencies rate the securities

         • Credit Enhancement may be obtained

      4. Step 4: Servicer collects monthly payments from borrower and remits payments to issuer

         • The servicer and the trustee manage manage delinquencies per pooling and servicing agreement. The servicer gets paid for the servicing work.

   2. The issued Securities were simply an interest in the income stream from the loans

   3. The securities were tranched whereby each tranche would receive a credit rating

      1. The lower rated tranches were later repooled and sold as CDOs on the theory of diversification

         • This was a disaster

3. Uses of Capital

   1. Executive Compensation

   2. Proprietary Trading

   3. Retain as Cushion

   4. Mergers & Acquisitions

   5. Pay Dividends

   6. Stock Buyback

   7. Invest (e.g. Research and Development)

   8. Conventional Activities (e.g. make loans)

4. FACTORS that Led to the Financial Crisis

   1. Private Label Securitization

      1. Severed the link of accountability to portfolio and GSE loans

         • Portfolio: If loan stayed on the books, the bank had to bear the risks of default

         • GSEs: When the banks sold loans to the GSEs for securitization, the loans had to meet strict underwriting standards

   2. Credit Rating Agencies

      1. Compensated by Issuers (perverse incentive)

      2. "Quants" used Flawed Models

      3. Cultural Pressure

         • People who worked for the rating agencies were often Wall Street rejects and thereby wanted to be accepted by the Wall Street bankers

           • This caused them to be more likely to succumb to Wall Street's will

   3. Regulatory Failures

      1. competence

      2. information asymmetry

      3. inertia (no one wanted to upset the status quo whereby everyone was making money)

      4. revolving door between Wall Street and Government

      5. Ideology (mistaken belief that market would always self-correct)

      6. Fee dependence (e.g. OTS and AIG/WaMu)

   4. Euphoria

      1. Distorted risk assessment

      2. BUBBLES

         • "Housing prices will never go down!"

   5. Inconsistent Government Response

      1. Bear Sterns vs. Lehman Brothers

   6. Perverse Management Pay

      1. Incentivized short-term gain over long-term stability

   7. Glass-Steagall

      1. Both official repeal and regulatory erosion prior to official repeal

   8. Debt is Good Mentality

      1. Firms became over-leveraged (e.g. Repos and Lehman Brothers - had to get short-term financing every day)

         • Lehman funded billions everyday - 30-40:1 Leverage Ratio

      2. Pervaded all of society

      3. Income inequality led to people filling the gap with debt

   9. Rise of the Shadow Banking System

      1. Vast zones of unregulated activities (banking)

      2. Derivatives not regulated (e.g. AIG, CDSs, and the lack of any requirement to hold sufficient capital to meet such obligations in the event they come due)

      3. Think Watters of which closed the door on state regulation of mortgage brokers who were subsidiaries of national banks

   10. Preemption

       1. Watters v. Wachovia

          • Precluded state regulation in a lot of cases

          • Connected to reg. failures

   11. Proprietary Trading

       1. Using insured deposits to make bets

   12. Actions by Investment Banks/Undisclosed Short-selling

       1. Think Goldman Sachs of whom was taking both sides of a bet and even issuing products of which it was secretly betting against

   13. Business Model of Global Conglomerate in Banking

       1. Citigroup

       2. Created systemic risk and too big to fail problem

       3. Moral Hazard

   14. Deterioration of Underwriting Standards

       1. Banks were paid by the issuers for the number of loans made not for the quality. The incentive became to make as many loans as possible, notwithstanding the potential down the road default of such a loan

   15. Transparency Problem

       1. Shadow Banking, undisclosed short-positions, etc.

5. Dodd-Frank

   1. Consumer Financial Protection Bureau

      1. Independent Head: Led by an independent director appointed by the President and confirmed by the Senate.

      2. Independent Budget: Dedicated budget paid by the Federal Reserve system.

      3. Independent Rule Writing: Able to autonomously write rules for consumer protections governing all financial institutions – banks and non-banks – offering consumer financial services or products.

      4. Examination and Enforcement: Authority to examine and enforce regulations for banks and credit unions with assets of over $10 billion and all mortgage-related businesses (lenders, servicers, mortgage brokers, and foreclosure scam operators), payday lenders, and student lenders as well as other non-bank financial companies that are large, such as debt collectors and consumer reporting agencies. Banks and Credit Unions with assets of $10 billion or less will be examined for consumer complaints by the appropriate regulator.

      5. Consumer Protections: Consolidates and strengthens consumer protection responsibilities...

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