the United States. The industry at that time had a combined asset base of $14.6 trillion. However, 106 firms had assets greater than $10 billion and this group accounted for about 80 percent of the industry’s assets, illustrating a high level of concentration among the largest institutions. More astonishing, 36 banking institutions in the United States had assets at or above $50 billion and these firms accounted for 70 percent of all banking assets in the country.
The performance of the banking sector not surprisingly ebbs and flows with regional and general economic conditions as seen in Figure 1.3. The figure shows how in the period immediately following the financial crisis, net income for the sector was negative, driven to a great extent by mounting credit losses taking place around mortgages. With extraordinary measures taken by the Federal Reserve and Treasury Department to support banking, in time net incomes rose and the industry has stabilized since that time. Another way to look at the relative performance of the industry is to compare net interest margin (NIM) by bank asset size category (Figure 1.4). Net interest margin is defined as the difference between interest income and expense as a percent of average assets. NIM has steadily declined for banks since 2010, reflecting lower income from mortgages as interest rates began rising over time and banks started to see erosion in its fixed income sales as interest rates began coming off very low levels after the crisis.
Figure 1.3 Bank Net Income over Time
Source: FDIC Quarterly Banking Profile, 2013.
Figure 1.4 Bank Net Interest Margins Over Time
Source: FDIC Quarterly Banking Profile, 2013.
Figure 1.5 provides insight into the extent of damage done to the banking sector during the crisis as reflected in nonperforming loans (loans that are 90 days past due or worse). Banks write off (charge-off) bad loans as they become apparent and during the crisis, the noncurrent loan rate was five times that of 2006 levels and the charge-off rate was about six times 2006 levels. Since peaking at the end of 2009, credit performance has significantly improved.
Figure 1.5 Bank Trends in Credit Performance
Source: FDIC Quarterly Banking Profile, 2013.
SifiBank did not escape the financial crisis and in fact in the months following the failure of Lehman Brothers in September 2008 and both mortgage government sponsored enterprises Fannie Mae and Freddie Mac were placed into conservatorship under their regulator, SifiBank saw its stock price nearly evaporate from a price of $50 to just under $2 per share. Bank management realized that it was in trouble both in terms of liquidity and capital. It had not adequately developed its contingency liquidity plan; a framework for maintaining a level of liquidity that would allow the firm to operate under extreme conditions in which funding dried up and/or became prohibitively expensive, for the crisis that unfolded proved to be devastating to capital markets. The bank suffered several downgrades in the months leading up to receiving this special financing. It had been rated by all three credit rating agencies as AA but by October 2008, it was rated C making it more difficult and costly to raise capital. In October of 2008, the U.S. Treasury offered a financial lifeline to SifiBank in the amount of $250 billion to ensure the company would be able to weather further erosion in financial markets.
SifiBank got into this situation through a combination of errors in the way the company was managed that led it to take oversized risks as well as by way of systemic risk to the entire financial system that created a contagion effect throughout the industry. The degree of interconnectedness of capital markets and financial institutions during the year leading up to the crisis led to a sort of financial flu that spread across the sector like a viral pandemic.
In the years leading up to the crisis, senior management ignored repeated warnings from its enterprise CRO regarding an excessive buildup of mortgage loans and securities in its HFI and AFS portfolios. The bank during that period had compounded their problems by originating a set of brand-new mortgage products that had variable payment terms and other features that while flexible for borrowers often meant that they would likely run into payment shock if and when interest rates rose in the future. There had been no prior experience with such products from which to develop an estimate of credit losses and yet the bank accelerated its production of these loans at the request of senior management.
The bank, as stated earlier, had been under pressure to grow earnings and these new nontraditional mortgages enabled SifiBank to originate mortgages at spreads to Treasuries that were significantly above mortgages originated and sold to Fannie Mae and Freddie Mac. The business line CRO for the bank whose bonus was dependent in part on the success of this program acquiesced to a significant amount of risk layering taking place in credit underwriting on these new loans to the point that significant credit risk was embedded in the products for which the bank was not being appropriately compensated. Risk layering occurs when individual risk attributes such as credit score and loan-to-value (LTV) ratio are combined in ways that materially raise the credit risk profile of the loan. For instance, allowing a lower credit score for a low downpayment mortgage raises the likelihood of default for the loan beyond a loan that has both higher FICO and lower LTV (i.e., is less risky). The bank had little historical information on which to base its loan loss reserve or price these new loans and so its models reflected the low level of risk that had been present for the last decade. As a consequence it vastly underestimated the amount of credit risk it was putting on its books.
During this same period, the bank continued to reduce its corporate risk management staff believing that they would be able to save costs by avoiding redundancies with the business risk functions. Moreover, when the products were presented to the board, the CFO and president of the consumer loan division of SifiBank were the corporate officers engaged with the board on this initiative with negligible input from the enterprise CRO. Compounding this problem was the fact that none of the board members had any mortgage or risk background and so little pushback from the board occurred on the potential risks of these products.
Simultaneous to the bank’s origination of these loans, SifiInvestment Bank realized that it could expand its structured finance business by selling CDS that had mortgages as the reference asset. Senior management of the capital markets group convinced the board that these new products would be able to serve a wide range of investor appetites and transform credit risk transfer in the mortgage market by allowing CDS buyers to seek credit protection against mortgage defaults while allowing credit investors to participate in mortgage financing without actually originating or owning the loans on balance sheet. For SifiInvestment Bank it could both be involved in creating the CDS for market as well as take positions (i.e., sell CDSs) and create a stable income stream over time from the premiums paid by CDS buyers. With the bank projecting very low defaults looking into the future, it seemed like a sound business decision in 2004. By 2008 SifiInvestment Bank was reeling from losses that it incurred under its CDS program. As mortgage loans defaulted, the bank as seller of CDS protection was forced to cover losses of its counterparties. These losses, as well as those emanating from the bank’s retained portfolio, were the primary source of capital erosion for the bank. Had the federal government not stepped in when it did, SifiBank was most likely going to fail within a short period of time.
As these losses were being publicized, creditors and other Wall Street counterparties began pulling back from SifiBank. Lines of credit for the bank were at first being renewed at higher rates but over time access for credit dried up. Spreads on ABCP issued by SifiBank widened to such a degree as to be prohibitive for the company in raising short-term financing. Banks no longer wanted to enter into repo agreements with SifiBank and more concerning, the bank began experiencing considerable withdrawal of deposits in the weeks preceding the announcement of financing from the government.8
In order to meet its production targets for its new mortgage