The Financial Crisis A Preliminary View 2009 JRCLS

The Financial Crisis: A Preliminary View 2009 JRCLS Annual Conference Harvard Law School February 14, 2009 Randall D. Guynn Head of the Financial Institutions Group Davis Polk & Wardwell

The Financial Crisis: A Preliminary View Background § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 2

Background – How did we get here? Same pattern as almost every other mania, panic and crash before this one: § Cheap credit → § Excessive optimism → § Pricing bubble (real estate and commodities) → § Bubble pops (price collapse that is still collapsing) → § Extreme uncertainty about “true” asset values → § Excessive (or wise? ) pessimism 3

Background – How did we get here? (Cont’d) The financial sector is the most immediate and hardest hit Characteristics of financial institutions § High leverage § Illiquid long-term assets § Extremely short-term liabilities (e. g. , demand deposits) These characteristics make financial institutions susceptible to “runs on the bank” Run on a bank (or other FI) will result in sudden and unexpected death spiral § FIs are different from widget companies, which typically slide slowly into bankruptcy § FIs almost always fail suddenly and unexpectedly § This time is no different from the past § Main Street vs. Wall Street 4

Background – How did we get here? (Cont’d) Rational response makes things worse § Circle the wagons § Increase and hoard cash § Reduce amount of credit extended § Otherwise reduce leverage § Inverse money multiplier effect Results in severe contraction of credit throughout the system § Hurts everyone – FIs, widget companies, consumers § Negative externality like air pollution 5

Background – How did we get here? (Cont’d) Inverse money multiplier magnifies contraction of credit (money) – Money multiplier: M * 1/R, where M = amount deposited in a single bank and R = fractional reserve requirement – Amplifies expansion of credit in normal times when banks are permitted and choose to hold only a fraction of cash reserves to satisfy demand deposit claims – Magic of money multiplier in normal times: Assume 10% reserve requirement (R), every $100 deposited in a bank will multiply by 10 times into $1, 000 of credit throughout system – Tragedy of inverse money multiplier: If banks are legally required or choose to circle the wagons during a financial crisis, so that reserves grow from 10% to 20%, the amount of credit available in the system will shrink by 50% or $500, not by 10% or $100 6

Background – How did we get here? (Cont’d) Historical precedents § 1700 BC: Joseph in Egypt – Seven Years of Plenty, Seven Years of Famine (Gen 41) – By the end, Joseph had bought all the herds of cattle and “all the land of Egypt” for Pharaoh in exchange for food (Gen 47: 13 -26) § 1637: Collapse in tulip prices → banking crisis in Europe § Banking Panic of 1837 (caused failure of Kirtland Safety Society) § Banking Panic of 1907 (JP Morgan restores confidence) § The 1929 Crash and the Great Depression (1930 s) § Savings & loan crisis of the late 1980 s and early 1990 s – Precipitated by collapse in the price of agricultural commodities, oil and real estate § The Global Financial Crisis of 2008 7

Background – How did we get here? (Con’d) What was different this time? Global macro economic factors § Excess savings in rapidly developing countries (China) invested in debt of industrialized countries, driving down interest rates § Cheap exports from developing countries (esp. China, India) kept inflation low § Increased productivity kept inflation low § U. S. housing and monetary policy, GSEs and securitization drove down housing interest rates § Excessive optimism and cheap credit resulted in real estate bubble, spike in consumer debt and financial institution leverage § Increased demand from developing countries resulted in bubbles in commodities prices 8

The Financial Crisis: A Preliminary View Introduction § Symptoms § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 9

Introduction – How bad is it likely to be? (Cont’d) Who knows? This crisis is far worse than the S&L crisis of the late 1980 s and early 1990 s Will it be as bad or worse than the Great Depression? 10

Introduction – How bad is it likely to be? Factors that made things worse (or better? ) this time § The very instruments that helped manage credit risk, reduce the cost of credit and increase the availability of credit – Securitizations of mortgage loans (e. g. , mortgage-backed securities) – Securitizations of securitizations (e. g. , collateralized debt obligations, or CDOs, and CDO-squared) – Credit default swaps (CDSs) § Excessive confidence (as it now turns out) in financial models § Failure of rating agencies to update credit rating models with changes in the marketplace § Mark to market or model (or “fair value”) accounting rules 11

Real-Estate-Related Securities Home Owners Originators /Lenders Securitization Re-Securitization: (Underwriters) CDO 100% 28% 20% AA 8. 6% BBB 7% Residual/Equity 0% 1) Lender makes mortgage loan to home owners 2) Lender issues secured certificates backed by loans AAA Hedge Funds BBB Super Senior AAA A 11% Investors Pension Funds Equity Other Inv. Banks 11% AAA Banks CDO 2 3) Bonds backed by mortgages created in the primary market 7% AAA AA A BBB Resi 4) Investments may become re-securitized (bonds based on bonds) 5) New CDOs can be created from “select” tranches of existing CDOs with a further “rerating” of risk 6) Investors buy customized financial instruments 12

The Financial Crisis: A Preliminary View Introduction § Symptoms § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 13

Timeline of Significant Events Summer 2007 – Summer 2008 Summer 2007 • Real estate prices start to collapse • Spike in early delinquencies of 2006 -2007 subprime mortgages • Continued collapse in real estate prices • Continued large CDO markdowns • Rescue of Bear Stearns by JPM • Fed discount window opened to Ibanks • Treasury blueprint Summer 2008 Spring 2008 Fall 2007 • Leveraged credit market dries up • Billions of MBS/CDO markdowns Winter 2007 -2008 • Sovereign wealth funds to the rescue • Rescue of Northern Rock by UK govt Summer 2008 • Interbank credit markets locking up • Spike in oil / agricultural prices • Fannie, Freddie, FI mkt caps plummet • Fed as fin markets stability regulator • Indymac fails • Treasury gets authority to rescue Fannie/Freddie 14

Spike in Early Subprime Loan Delinquencies Recent Vintages Show Very Poor Underwriting Source: Federal Reserve staff circulations from First American Loan Performance data 15

Residential Housing Bubble and Collapse Source: Standard & Poor’s 16

Timeline of Significant Events Summer 2007 – Summer 2008 Summer 2007 • Real estate prices start to collapse • Spike in early delinquencies of 2006 -2007 subprime mortgages • Continued collapse in real estate prices • Continued large CDO markdowns • Rescue of Bear Stearns by JPM • Fed discount window opened to Ibanks • Treasury blueprint Summer 2008 Spring 2008 Fall 2007 • Leveraged credit market dries up • Billions of MBS/CDO markdowns Winter 2007 -2008 • Sovereign wealth funds to the rescue • Rescue of Northern Rock by UK govt Summer 2008 • Interbank credit markets locking up • Spike in oil / agricultural prices • Fannie, Freddie, FI mkt caps plummet • Fed as fin markets stability regulator • Indymac fails • Treasury gets authority to rescue Fannie/Freddie 17

Timeline of Significant Events (Cont’d) September 2008 Weekend 1 • Freddie, Fannie bailout Weekend 4 • Citigroup rescues Wachovia • Fortis, Dexia are nationalized • Lehman Bros fails • Merrill Lynch sells itself to Bof. A October 2008 September 2008 Weekend 2 Week 3 • AIG rescued • Treasury proposes $750 bn EESA/TARP • Primary reserve money market fund “breaks the buck” • Treasury announces guaranty program for money market funds • SEC temporary ban on short sales Sept 30 • House rejects EESA/TARP • Dow falls record 778 pts, $1. 3 trillion Weekend 3 • Treasury releases EESA/TARP bill • MS, GS become bank holdcos • Wa. Mu fails, JPM buys all deposits 18

Timeline of Significant Events (Cont’d) October 2008 Week 1 • Senate approves EESA / TARP • House reconsiders and President signs; EESA / TARP enacted • FDIC insurance coverage increased to $250, 000 • Fed announces Commercial Paper Funding Facility (CPFF) • U. K. announces bank rescue package • Treasury announces bank capital purchase program (policy shift) • FDIC announces Temporary Liquidity Guarantee Program (TLGP) November 2008 October 2008 Week 2 Week 3 • Swiss National Bank makes $54 bn loan to UBS • Germany passes € 500 bn rescue package Week 4 • First wave of regional banks eligible for Treasury’s capital purchase program are identified • National City rejected – purchased by PNC with help of CPP money 19

Timeline of Significant Events (Cont’d) November 2008 Week 1 • Barack Obama elected President • Democratic sweep of Congress Week 2 November 2008 October 2008 • Fed, Treasury announce expanded investment in AIG, $150 billion • Democrats urge aid for auto makers Week 3 • Amex becomes BHC • Treasury announces that troubled asset purchase program is on hold; stock market drops 20% in two weeks; financial stocks plummet even further • CIT applies to become a BHC • Hartford, Genworth, Lincoln National acquire thrifts and apply for TARP • GMAC announces that it applied to become BHC Week 4 • Citigroup receives additional $20 billion from TARP plus government guarantee of a $306 billion pool of troubled assets • Fed announces $200 bn TALF program • Fed announces $100 bn GSE debt purchase program 20

Timeline of Significant Events (Cont’d) December 2008 – February 2009 • TARP loans $17. 4 bn to GM and Chrysler • Madoff ponzi scheme revealed – est $50 bn in potential losses • Fed approves CIT’s and GMAC’s applications to become BHCs • TARP gives $6 bn in financial assistance to GMAC • Consumer spending plummets • Unemployment spikes January 2009 • Bof. A receives additional $20 bn in TARP investment and a $118 bn guarantee of troubled assets • Bush Administration requests TARP II on behalf of President Elect Obama • Obama inauguration • Geithner confirmed as new Treasury Secretary • UK announces asset guarantee scheme • Germany announces good bank / bad bank scheme November 2008 October 2008 December 2008 February 2009 • New limits on executive compensation for FIs who receive TARP money in future • COP, SIG reports on TARP • SEC roasted for missing Madoff ponzi scheme • Fed revises TALF program • Geithner announces TARP II plans • Obama $800 bn stimulus bill 21

Spike in Unemployment Source: Bureau of Labor Statistics 22

The Financial Crisis: A Preliminary View Introduction § Symptoms § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 23

TARP and Other Government Relief Programs TARP I § Capital Purchase Program ($250 billion) § Systemically Significant Failing Institutions Program (AIG) § Targeted Investment Program (Citi, Bof. A) § Asset Guarantee Program (Citi, Bof. A) § Automotive Industry Program (GM, Chrysler) § TALF Program (with NY Fed) TARP II § Good bank / bad bank? § Asset purchases? Treasury’s $50 billion temporary money market guarantee 24

TARP and Other Government Relief Programs § FDIC – Temporary increase in deposit insurance to $250, 000 – Temporary Debt Guarantee Program – Temporary Transaction Account Guarantee Program § Federal Reserve – Primary Dealer Credit Facility – Term Auction Facility – Temporary Securities Lending Facility – Commercial Paper Funding Facility – Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility – Money Market Investor Funding Facility – Term Asset-Backed Securities Loan Facility (TALF) (non-recourse) 25

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TARP I — Evolution Initially, the TARP facility was expected to be used to purchase mortgages and other real-estate related assets. § Asset purchases were intended to establish reliable market values for these illiquid assets. Instead, TARP’s first use was a Capital Purchase Program (CPP) meant to recapitalize the U. S. banking system. Two Fundamental Public Policy Shifts § Asset Purchase Program to the CPP § Control for Moral Hazard vs. Encourage Public Confidence On November 12, 2008, Treasury officially announced that the development of an Asset Purchase Program was on hold. 28

The Financial Crisis: A Preliminary View Introduction § Symptoms § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 29

Legal, Regulatory and Policy Issues and Reactions What is the source of Treasury’s, the Fed’s or the FDIC’s legal authority for taking control of or investing in private-sector financial institutions? § Fannie and Freddie Conservatorship and Financial Assistance: Expressly authorized by new federal statute enacted on July 30, 2008 § Fed Actions: Section 13(3) of the Federal Reserve Act grants power to lend to anyone under “unusual and exigent circumstances” (first time power exercised since 1932) § AIG: Section 13(3) of Federal Reserve Act § $750 billion TARP (EESA) Would Raise Serious Legal Issues in the Absence of Express Congressional Authorization § See the Steel Seizure Cases (1952), in which the Supreme Court held that President Truman’s seizure of steel mills during the Korean War was unconstitutional because unauthorized by Congress § 31 USC 9102 – Prohibition on federal agency acquiring corporation without 30 express statutory authority

Legal, Regulatory and Policy Issues and Reactions (Cont’d) Precedents § Reconstruction Finance Corporation (1932): Established by express Congressional action to recapitalize the troubled U. S. banking industry during the Great Depression. Dissolved in 1957. § Resolution Trust Corporation (1980 s): Established by express Congressional action to resolve failed savings associations. Later dissolved. Government initially followed policy to wipe out common and preferred shareholders and senior debt as a condition to government assistance § Common shareholders in Indymac, Bear Stearns, Freddie, Fannie, Lehman, AIG and Wa. Mu mostly or completely wiped out § Pros: Reduces moral hazard § Cons: Deters new money when a financial institution needs it most; encourages strategic behavior by senior debt counterparties 31

Legal, Regulatory and Policy Issues and Reactions (Cont’d) Government shifted policy under TARP from asset purchase program to capital purchase program Government also shifted policy from trying to limit moral hazard caused by intervention to restoring public confidence § Only minor dilutive impact on common shareholders § Pari passu with existing preferred stock § Junior to senior and subordinated debt § Rationale: When we find ourselves on the edge of a cliff looking down, we can worry about moral hazard tomorrow. Today’s issue is restoring public confidence to encourage new and existing equity investment from private sector The most FAQs have become: Is $700 billion enough? Why not just nationalize the banks? 32

Perfect Storm for More Regulation 33

Legal, Regulatory and Policy Issues and Reactions (Cont’d) Regulatory Response - More regulation § Likely a lot more and harsh § Main Street vs. Wall Street Fed will likely become the systemic risk regulator System-wide regulatory consolidation and rationalization more likely § Treasury Blueprint § Federal insurance charter and regulator § CDS clearing house and other regulation of CDS and OTC derivatives § Merger of CFTC and SEC § Merger of OTS and OCC Scapegoating § E. g. , FBI investigations of the management of recently failed or bailed out companies 34

The Financial Crisis: A Preliminary View Introduction § Symptoms § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 35

Interesting Factoids Weekend work: rescues almost always happen on weekends when markets are closed § Window is from the close of U. S. markets on Friday until the opening of the Asian markets on Sunday night (U. S. time) Freddie and Fannie § One of the few “genuine” conservatorships in U. S. history (other conservatorships are virtually all really “pass-through” receiverships / conservatorships to simulate a “bridge bank” device) § Powers exercised were only one month old AIG § Too big and too entangled globally to fail § Not previously regulated by the Fed; almost exclusively regulated by the states or foreign insurance regulators 36

Interesting Factoids (Cont’d) Morgan Stanley / Goldman Sachs § Unprecedented “one-day” conversions into bank holding companies § Instantly ranked among the five largest bank holding companies in the U. S. Citigroup / Wachovia § First use of the “systemic risk” exception to the “least-cost resolution” condition for an FDIC-assisted open bank transaction Stampede to Become a BHC: MS, GS, AMEX, CIT, GMAC Stampede for TARP funds § Insurance companies buy thrifts to become S&LHCs to qualify for TARP money – Hartford, Genworth, Lincoln National § Auto-industry bailout 37

The Financial Crisis: A Preliminary View Introduction § Symptoms § How did we get here? § How bad is it likely to be? Timeline of Significant Events TARP and Other Government Relief Programs Legal, Regulatory and Political Issues and Reactions Interesting Factoids Questions and Answers 38