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Balance Sheet Adjustments in the 2008 Crisis

Zhiguo He, In Gu Khang, and Arvind KrishnamurthyUniversity of Chicago and Northwestern University

April 1, 2010

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Objectives

• Fact-finding: Understand how securitized mortgage/credit assets have shifted across the financial sector– Who has sold? How much?– Buyers? How have they financed?– We measure mortgage/credit assets because it is a large asset

class, and probably the source of the biggest problems.• Why is this interesting?

– Theories about link between asset trading decisions and financing conditions

– Try to understand how theories fit together in the big picture

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Data

• Assets: – Hedge funds, – Broker/dealers,– Insurance companies, – Commercial banks

• Government support– Fed, Treasury, GSEs

• Liabilities: – Repo financing, – Bank debt– Equity capital

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Theory: Leverage Constraints

1. E = equity capital (cant raise more)2. L = maximum leverage provided by lenders

• For example, L = 1/repo haircut

3. Total funds = E L4. Asset demand increasing function of E L

• Sellers in a crisis: Gromb and Vayanos (2003), Geanokoplos and Fostel (2008), Brunnermeier and Pedersen (2009), Adrian and Shin (2009), …

• Buyers in a crisis: Allen and Gale (many), Shleifer and Vishny (1995),…

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Theory: Equity Risk Capital

1. E = equity capital (cant raise more)2. Manager/trader makes portfolio choices, doesn’t want to lose

wealth (go bankrupt, lose job, lose wages, etc.)• Cost of financial distress• Endogenous risk aversion

3. More E means lower risk of distress, less risk averse in portfolio choices

4. Risky asset demand increasing in E.

• Managerial risk aversion: – Sellers: Xiong (2001), Brunnermeier and Sannikov (2010) – Buyers: He and Krishnamurthy (2009)

• Risk-based capital requirements: Kashyap and Stein (2004)

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Financial Sector

Securities 7% 12% Hedge Funds

Agency, non-Agency, Other -492 to -754 -456 to -682

Broker/Dealers Only Non-Agency -205 to -472 -172 to -261

Insurance Companies Agency and non-Agency 36 to -247 62 to -206

Commercial Banks Agency and non-Agency 407 to 731 490 to 814

Total (medium scenario) -305 -105

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Money Market Q4 2007 Q1 2009 Repo Agreements and Fed Funds Liabilities Commercial Banks 1327 463 Broker/Dealers 1223 419 Assets (main holders) Rest of the World 1100 583 Mutual Funds 713 603 Bank Financing Checkable Deposits 587 666 Small Time and Savings Deposits 4078 4755 Large Time Deposits 1927 1725 Corporate Bonds 688 1216

Table 14: Source: Flow of Funds of Federal Reserve ($ Billions)

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Computations

• Suppose we measure assets at time as At

At+1 – At = Purchases – Losses – Maturity

• We roughly see if purchases balance out, SUM (purchases) =0

• t is Q4 2007 and t+1 is Q1 2009

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Maturing Assets

• Suppose assets mature between t and t+1• Then assets will shrink, but not because the

assets were sold.• Maturity rate:

– We compute aggregate repayment rate in 2008 across all ABS and MBS from Bloomberg = 17%

– We compute aggregate new issuance = 10%– Assume shrinkage rates of 7%, 12%

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Measurement Issues (1)

• Double counting– Suppose bank makes a $100 repo loan to a hedge

fund, that uses the $100 to buy an MBS– Hedge fund liquidates the MBS back to the back

• i.e. Hedge fund assets fall by $100

– Total bank assets (MBS + Repo Loan) remains the same

• SUM may not be zero– This problem is most pronounced for repo and we

will try to exclude repo from our computations

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Measurement Issues (2)

• Suppose banks improperly value assets.• For example suppose banks mark books at t+1

at $100 too high a value• But also report $100 smaller losses than true

100+ At+1 – At = Purchases – (Losses – 100)

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Measurement Issues (3)

• Sum = 0 applies only for a specific asset measured (i.e. single class of MBS)– The data is only available at higher levels of

aggregation. • We measure across a broad class

– Agency MBS, non-Agency MBS, ABS• Large (supply is $10tn to $15tn)• We have data on non-Agency MBS, ABS for

commercial banks

Debt Market

Table 1: Mortgage and Credit Securities ($ billions)Source: SIFMA (2007 Q1)

• There is an additional $12tn of mortgage/credit loans in financial institutions’ portfolios.

Mortgage and Credit Related Securities Outstanding

Total ABS (including auto, credit card, home equity, manufacturing, student loans, CDOs of ABS)

2480

ABS CDOs 400 Mortgage Related 8990 Agency GSE MBS 6094 Non-Agency MBS 2897 Corporate Bonds 6043 Asset-Backed Commercial Paper 1250 Total for Securities 17513

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Financial Institutions

Financial Institution Total Assets Commercial Banks 11192 Insurance Companies 6308 GSEs 3174 Brokers and Dealers 2519 Hedge Funds 5530

Table 2: Financial Institution Assets ($ billions)Sources: Flow of Funds of Federal Reserve 2007, Barclays Hedge Fund Report

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Losses

Financial Institution Total Losses

Commercial Banks 500 Insurance Companies 207 GSEs 153 Brokers and Dealers 100 Hedge Funds 170

Table 3: Financial Institution Losses ($ billions) Sources: Bloomberg WDCI (2009), Hedge Fund Flow Report by Barclay

Hedge (2009)

•Note: losses are as reported by institutions

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Hedge FundsStrategy Q4 2007 Q1 2009 Redemptions and Trading Losses Convertible Arbitrage 42 11 31 Distressed Securities 176 69 107 Emerging Markets 353 125 228 Equity Strategies 538 303 235 Event Driven 162 57 105 Fixed Income 160 69 91 Macro 91 61 30 Merger Arbitrage 39 5 34 Multi-Strategy 224 122 102 Other 61 20 41 Sector-Specific 130 58 72 Hedge Fund Industry 1975 973 1002

Table 4: Equity Capital (or Assets under Management) of Hedge Fund Industry ($ billions)Sources: Hedge Fund Flow Report by Barclay Hedge (2008, 2009)

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Mortgage/Credit Capital

• Main source of error: what are the relevant strategies?

• Three scenarios1. Fixed Income2. Fixed Income and Macro3. Fixed Income, Macro, Distressed, proportion of

Multi-strategy and sector specific

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Leverage Ratios

• Leverage ratios by strategy in 2006 from TASS– e.g., Fixed Income = 4.5– Gives us initial assets

• Industry average leverage ratio in 2008 = 2.3• But haircuts rose most in fall 2008

– AAA CMOS: 10% in 2007 and 30% in fall 08– Assume haircuts double over 08, but average

leverage is 2.3, where is final leverage?– Answer: 1.7

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HaircutsRepo Haircuts

Spring 2007

Spring2008

Fall 2008

Spring

2009

US Treasuries (short-term) 2% 2% 2% 2%

US Treasuries (long-term) 5 5 6 6

Agency Mortgage-Backed Securities 2.5 6 8.5 6.5

Corporate BondsA-/A3 or above

5 10 20 20

Collateralized Mortgage Obligations (CMOs) AAA

10 30 40 40

Asset Backed Securities (ABS)AA/Aa2 and above

10 25 30 35

Table 3: Repo Haircuts in the CrisisSource: Krishnamurthy (2009)

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Net Trade

• Scenario 1: $-492bn• Scenario 2: $-546bn• Scenario 3: $-754bn

• Caveats– There is more than just MBS/ABS in these figures.

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Brokers and Dealers

Year End 2007 Total Assets Trading Assets Goldman Sachs 1120 453 Merrill Lynch 1045 375 Morgan Stanley 1020 317 Citigroup Global Markets 664 274 Bank of America Securities 922 308 JP Morgan Investment Bank 612 423 Lehman Brothers 691 313 Bear Stearns 395 138 Total 6469 2601

Table 5: Trading Assets of Broker/DealersSource: SEC Filings

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Pure Broker/Dealers

Assets Nov 2007 Feb 2008 March 2009

Goldman Sachs Trading Assets 453 499 350 Credit and Mortgage Related 93 89 40

Morgan Stanley Trading Assets 375 446 259 Credit and Mortgage Related 148 161 83

Merrill Lynch Trading Assets 317 312 188 Credit and Mortgage Related 122 124 59

Total Credit and Mortgage Related Assets 363 374 182

Table 6: Trading Assets of Investment Banks($ billions)Source: SEC Filings of the above-listed Broker/Dealers

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Scaling

• We scale up to the industry based on the three firms we measure.

• Main error: How representative are the firms• Three scenarios

1. Goldman Sachs (lowest shrinkage rate of assets)• $-205bn

2. All firms• $-254bn

3. Merrill Lynch (highest shrinkage)• $-307bn

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Caveats

• We have not accounted for derivative hedges– For example, AIG sold CDS to broker/dealers to

hedge ABS exposure.• We have included all credit assets, some of

which may not be ABS

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Insurance Companies

Insurance Companies Q4 2007 Q1 2009 AIG 184 45 Hartford Financial Services 30 17 Berkshire Hathaway 4 3 Allstate 23 12 Travelers 6 6 Liberty Mutual 17 15 CNA Insurance 11 7 Progressive 3 2 Total 279 107

Table 7: Mortgage and ABS Holdings of Top 8 Insurance Companies ($ billions)Source: SEC Filings

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Computation• Scenario 1: Scale all to the rest of the

insurance industry (34% of total assets by Flow of Funds)• $-247bn

• Scenario 2: Scale, excluding AIG• $-50bn

• Scenario 3: Scale using 3 lowest growth firms• $36bn

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Commercial Banks

Q4 2007 Q1 2009 Cash and Reserves 76 813 Securities 2253 2419 Loans and Leases 6807 7031 Other assets 243 800 Total Financial Assets 9379 11063

Table 9: Assets of Commercial Banks ($ billions)Source: Flow of Funds of Federal Reserve (L109 minus L112)

Note: Data is from Flow of Funds, which is back-filled to reflect the effect of mergers.

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Securities Q4 2007 Q1 2009 US Chartered Commercial Banks ABS 84 140 MBS Agency and GSE-backed 929 1085 Privately Issued 272 237 Savings Institutions MBS Agency and GSE-backed 169 175 Privately Issued 111 47 Foreign Banking Offices Agency and GSE-backed Securities 57 45 Bank Holding Companies Agency and GSE-backed Securities 10 22 Banks in US Affiliated Areas Agency and GSE-backed Securities 27 23 Total Securities 1659 1774

Table 10: Holdings of Securities by Commercial Banks ($ billions)Sources: Flow of Funds of Federal Reserve, FDIC Statistics on Depository Institutions Report

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Securities Q4 2007 Q1 2009 US Chartered Commercial Banks ABS 84 140 MBS Agency and GSE-backed 929 1085 Privately Issued 272 237 Savings Institutions MBS Agency and GSE-backed 169 175 Privately Issued 111 47 Foreign Banking Offices Agency and GSE-backed Securities 57 45 Bank Holding Companies Agency and GSE-backed Securities 10 22 Banks in US Affiliated Areas Agency and GSE-backed Securities 27 23 Total Securities 1659 1774

Table 10: Holdings of Securities by Commercial Banks ($ billions)Sources: Flow of Funds of Federal Reserve, FDIC Statistics on Depository Institutions Report

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Changes

• Main issue is assigning reported losses of $500bn

• Scenario 1: Assign all to securities. • $731bn

• Scenario 2: Assign fraction (secs/loan+secs) • $313bn

• Scenario 3: Assign losses to ABS and Agency MBS

• $176bn

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Did banks buy the sold assets?

• We have no idea.• We know they grow.

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Bank Mergers

• WaMu and Countrywide mergers– Will not affect Flow of Funds data, because of

back-filling• Merrill Lynch and Bear Stearns

– No immediate effect on bank assets– Slow effect: Transfer of assets from broker/dealer

to commercial bank• Reflective of buying power among commercial

banks

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ABCP

• ABCP (including SIVs) outstanding fall from • Summer 07: 1250bn• December 07: 833bn• December 08: 650bn

• Most of this is taken back on to bank balance sheets– ABCP investors lose 1.7% (Acharya,Schnabl, Suarez,

2009)

• Banks did not take back the assets and sell them (as other sectors likely would have).

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JP Morgan ChaseQ3 2008 Q4 2008 Q1 2009

Total AFS $151bn $206bn $334bn

of which

Agency MBS 95bn 127bn 199bn

Non-Agency MBS 13bn 13bn 13bn

ABS 21bn 23bn 31bn

Fraction of Level 1 Assets 63% 58% 52%

Fraction of Level 2 Assets 30% 36% 45%

Fraction of Level 3 Assets 7% 6% 4%

Source: SEC Quarterly and Annual Filings.

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Did banks buy the sold assets?

• We have no idea. • We know they grow when other sectors

shrink.• What makes them different?

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Commercial Bank MBS

07Q4 08Q1 08Q2 08Q3 08Q4 09Q1$0

$200,000,000

$400,000,000

$600,000,000

$800,000,000

$1,000,000,000

$1,200,000,000

$0

$50,000,000

$100,000,000

$150,000,000

$200,000,000

$250,000,000

$300,000,000

$350,000,000

$400,000,000

$450,000,000

$500,000,000

$751,405,385$789,737,125

$853,899,921

$992,010,860$945,670,124 $928,180,736

$185,017,108$202,026,114

$232,542,620$222,647,254

$208,290,204 $211,210,512

top20 g1

Figure 2: MBS Holdings of US Commercial Banks ($ Billions)Source: FDIC Call Reports

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Foreign Holdings of MBS/ABS 6/30/2007 6/30/2008 Total: Agency MBS 570 773 Non-Agency MBS 594 458 Other Non-Agency MBS 308 301 Of Which, Foreign Official Holdings: Agency MBS 236 435 Non-Agency MBS 26 18 Other Non-Agency MBS 18 23

Table 12: Foreign Holdings of Asset Backed Securities ($ billions)

Source: U.S. Treasury Report on Foreign Portfolio Holdings of U.S. Securities

• Net sales of corporate bonds (including non-Agency Asset backed Securities), over the six-month period from October 2008 to March 2009 totaled $24.4bn

• Total purchase: $45bn

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Other Private Buyers

• BlackRock Assets under Management in Fixed Income Funds– Q4 07: $513 bn– Q1 09: $474 bn

• Pension funds– The increase in holdings of GSE securities (which

includes both MBS and straight Agency debt) plus all corporate and foreign bonds over the relevant period is about $70bn

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Other Repayment Scenarios

Securities 7% 12% Hedge Funds

Agency, non-Agency, Other -492 to -754 -456 to -682

Broker/Dealers Only Non-Agency -205 to -472 -172 to -261

Insurance Companies Agency and non-Agency 36 to -247 62 to -206

Commercial Banks Agency and non-Agency 407 to 731 490 to 814

Total (medium scenario) -305 -105

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Next

• Government intervention• Bank and non-bank funding

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Government Purchase of MBS

• As of 3/25/09 Fed owned $236bn of GSE-backed mortgage debt in secondary market– No purchases of non-agency debt

• Part of Fed initiative to purchase up to $1.25tn of GSE-backed MBS.

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GSEs Q4 2007 Q1 2009 Fannie Mae Agency MBS 289 314 Non-Agency MBS 112 97 GSE Guaranteed Securities 2422 2640 Freddie Mac Agency MBS 405 548 Non-Agency MBS 234 192 GSE Guaranteed Securities 1382 1380 Total Agency MBS 694 862 Non-Agency MBS 346 290 GSE Guaranteed Securities 3804 4020

Table 14: Government-Sponsored Enterprises ($ billions)Source: Monthly Volume Summaries from Fannie Mae and Freddie Mac (2007 and 2009)

Total Increase: $112bn

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Direct Government Purchase

• Agency MBS– $348 bn from Fed and GSEs

• Can resolve the “hole” in our computation– Although the picture on Agency and non-Agency

securities, separately is not clear to us.

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Fed/Treasury

Table 13: Federal Reserve/Treasury Source: Caballero and Kurlat (2009)

Facilities Maximum Total Assets

First Loss Borne by Insured Party

% Exposure of Remainder

Net Maximum Exposure

Maiden Lane (Bear Stearns) 30 1 100% 29 Maiden Lane II (AIG) 20 0 100% 20 Maiden Lane III (AIG) 30 5 100% 25 Citigroup 306 29 90% 249 Bank of America 118 10 90% 97 Total 504 44 421

On January 16, 2009, Chief Executive Ken Lewis announced Bank of America has received the federal guarantee for $118 billion of toxic assets, most of which were accrued in its acquisition of Merrill Lynch. However, on May 7, 2009, after the “stress test” Bank of America tried to terminate this deal unilaterally, and in the end this facility failed. The data is included because at the end of Q1 2009, markets operated under the assumption that the deal was still in force.

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Money Market Q4 2007 Q1 2009 Repo Agreements and Fed Funds Liabilities Commercial Banks 1327 463 Broker/Dealers 1223 419 Assets (main holders) Rest of the World 1100 583 Mutual Funds 713 603 Bank Financing Checkable Deposits 587 666 Small Time and Savings Deposits 4078 4755 Large Time Deposits 1927 1725 Corporate Bonds 688 1216

Table 14: Source: Flow of Funds of Federal Reserve ($ Billions)

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FDIC Guarantee Program (TLGP)

• As of March 31, 2009– $336bn of FDIC guaranteed senior unsecured debt

issued by banks– Mostly issued 4Q08 and 1Q09– Banks pay a fee for guarantee (25 - 50 bps)– Maximum 3 year bond issue

• Limits– Total program capped at $769 bn – Only 44% of total used

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Federal Home Loan Bank

• Lending only to commercial banks– 2006: $640bn– 2007: $800bn– 2008: $900bn

• Peak: $1011bn on 9/30/08

– 9/30/09: $677bn• Lending to largest 20 banks rises by $60bn

from Q407 to Q109

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Bank Capital and Book Leverage

Q1 2009 Total Assets 7608 Total Liabilities 6845 Equity Capital 763 Preferred Stock (including TARP) raised in 2008 233 “True” Capital 530 Leverage at 763 of Equity Capital 10.0 Leverage in Q4 2007 10.4 Leverage at 530 of Equity Capital 14.4 Leverage if true Assets are lower by 150 19.6 Leverage if true Assets are lower by 300 31.8

Table 20: Top 19 Commercial Banks ($ billions)Source: FDIC

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Bank Leverage

Q1 2009 Total Assets 7608 Total Liabilities 6845 Equity Capital 763 Preferred Stock (including TARP) raised in 2008 233 “True” Capital 530 Leverage at 763 of Equity Capital 10.0 Leverage in Q4 2007 10.4 Leverage at 530 of Equity Capital 14.4 Leverage if true Assets are lower by 150 19.6 Leverage if true Assets are lower by 300 31.8

• IMF loss estimates as of Oct 2008: >$1.5tn (banks say $500bn)• Level 3 assets (a subset of securities carried at fair value): $225bn

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Fact Summary

• Repo market tightening hits hedge fund and broker/dealer sector– Substantial shrinkage

• Commercial banking sector grows– Government guaranteed financing– Leverage increases– Banks do not saturate debt guarantees

• Government– Significant amount of “ring-fenced” asset purchase by

government (stays on bank books)– Government has been active in purchasing Agency MBS

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One more fact and theory

• Risk/liquidity premia high in 2008– Asset prices low

• Theory: Leverage constraints– Lose money, tighter debt constraints– Deleveraging, asset sales

• Theory: Equity risk capital– Low equity capital leads to “risk averse” behavior

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Leverage Constraints

• Fits the behavior of the shadow banks– High haircuts, contraction in repo– Asset sales by hedge funds and broker/dealers

• Inappropriate for commercial banks– No apparent debt constraint– They grow!

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Asset Pricing

• If you exclude the government (market orders…)

• Marginal buyer is the commercial banking sector– Purchase (or don’t downsize) because of ability to

borrow using government guarantee• What considerations drive the asset pricing

decisions of the banking sector?

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Marginal pricing condition of buyers

• Leverage constrained buyers?– Allen-Gale papers: limited buyers with limited cash

• But banks have had ample access to funds• Government lending facilities have been

unprecedented, and have been used, but not saturated

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Marginal pricing condition of buyers

• Bank risk aversion = f(equity capital)– He and Krishnamurthy (2009)

• Buyers have low capital, so risk averse, and hence require high premia to purchase– Given equity constraint, any purchases have to be

financed by debt– Consistent with high leverage of banking sector

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Our account

• Leverage constraints affected the shadow bank sector

• Government buys assets and props up banking sector

• Reintermediation into traditional banking sector

• Equity/risk capital constraints affect price and quantity in the reintermediation

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Risk Seeking

• Government financing has made banks risk-seek– But, then risk premia should be low– Lowest for the most risky assets– Banks should be loading up on toxic assets and

selling Agency MBS

• Seems implausible