Financial Stability Review – March 2009
The Global Financial Environment
The financial systems of many countries are under more strain than they have been at any time since the 1930s. Confidence in financial institutions generally remains weak and risk aversion is very high. Governments in a number of countries have sought to stem the deterioration in confidence through guarantee arrangements, recapitalisations, and efforts to improve liquidity in markets and de-risk bank balance sheets. These responses have prevented widespread failures of financial institutions, and improved the functioning of short-term money markets, although the confidence which is the cornerstone of a well-functioning financial system is yet to be fully restored.
The current difficulties are impairing the normal functioning of the credit supply process, although business credit growth remained positive in most countries over recent months. While some tightening of credit conditions is to be expected given the deterioration in prospects for the world economy, the current difficulties in the global financial system have significantly increased the risk of a damaging feedback loop taking hold between the financial system and the real economy.
A central feature of the current environment is a marked increase in risk aversion and the price that investors demand for taking on a given risk. This follows many years in which risk aversion and the price of risk were very low. The initial catalyst for this adjustment was the emergence of losses on sub-prime loans in the United States, many of which were packaged into securities and bought by large international banks. Then, the failure of Lehman Brothers in September 2008 saw a further marked rise in risk aversion around the world as banks, businesses and households reassessed the structure of their own balance sheets, and the risks posed by the current degree of leverage. The recent weak economic data has seen this reassessment continue, with the global nature of the problems reinforcing the process.
Looking forward, reducing uncertainty and risk aversion are central to resolving the current problems. Recent announcements in the United States to remove risky assets from bank balance sheets have been helpful in this regard, although it will be some time before it is clear whether there has been a sustained improvement in confidence and the functioning of the financial system.
Profitability and Capital
The difficulties in the global banking system are clearly evident in recent bank profit announcements. In the United States, institutions insured by the Federal Deposit Insurance Corporation (FDIC) incurred a collective loss of US$32 billion in the December quarter, with one in three institutions reporting a loss. For the year as a whole, profits were down by around 90 per cent on the previous year. The losses have been most pronounced among the largest institutions, with the five largest US commercial banks incurring an aggregate loss of US$46 billion over the year to December (Graph 1). In Europe, the aggregate profit of the 10 largest banks is expected to be essentially zero for the full year of 2008, while the five largest banks in the United Kingdom reported a net loss, including extraordinary items, of around £21 billion for the same period. In Japan, the largest banks are also expected to report losses in the December half.
Reflecting the difficult environment, bank share prices in a wide range of countries have fallen significantly over the past eighteen months. In the United States, United Kingdom and Europe, bank share price indices have declined by around 75 per cent since mid 2007, with falls in some European countries exceeding 90 per cent (Graph 2 and Graph 3). On top of the large falls in share prices, 17 of the 50 largest banks rated by Standard and Poor’s have had their ratings downgraded since September 2008, and 20 are on negative outlook. Credit default swap (CDS) premiums for banks also remain elevated and, in some of the major countries, are above their levels following the failure of Lehman Brothers.
One notable aspect of the recent poor profit results for many of the world’s largest banks is the disproportionate share of losses that have been accounted for by write-downs on securities, rather than higher loan provisions. For example, according to Bloomberg data, since mid 2007, approximately 60 per cent of the credit-related losses reported by the top 10 global banks have been accounted for by valuation losses on securities, even though securities accounted for only around 30 per cent of their total assets (Graph 4).
These large losses from securities reflect two interrelated factors. The first is that over the middle part of the current decade, when risk premiums were very low, many large global banks shifted their balance sheets towards holdings of securities, and away from loans. At the time, the increased holdings of securities contributed to the banks’ reported profits, with declining risk premiums leading to mark-to-market accounting gains. Banks also earned significant fees from originating and structuring these securities and from active trading in them.
The second is the recent marked rises in the prices of risk and liquidity, particularly following the failure of Lehman Brothers. When these prices rise, the ‘market’ or ‘fair’ value of financial assets falls, even though the expected cash flows associated with the asset may have not changed. Indeed, over the past year it is difficult to explain movements in the prices of many financial assets simply by reference to changes in the expected underlying cash flows. It is now clear that many large financial institutions simply underestimated how far, and how quickly, the price of risk could change. As a consequence, they significantly underestimated the amount of capital that they needed to hold against a wide variety of assets and the risks that they were running as a result.
The deterioration in the economic environment, including the ratcheting up in risk aversion and uncertainty over the past six months, is evident in the prices of many financial assets, particularly those that are at the higher end of the risk distribution. For example, spreads on lower-rated US commercial mortgage-backed securities, and the price of default protection on sub-investment grade US and European credits are close to their highest recorded levels (Graph 5). These spreads had been increasing steadily after the emergence of the sub-prime problems, but then jumped considerably following the failure of Lehman Brothers, and have risen further this year as the weakness in the global economy has become apparent. A similar pattern is evident in the prices of loans associated with leveraged buyouts (so-called leveraged loans), and securities backed by US sub-prime residential loans (Graph 6). These securities have also been affected by the winding up of many structured investment vehicles (SIVs), which had previously been important sources of demand for them.
The marked cycles in the prices of risk and liquidity – and the immediate effect it has had on financial institutions’ balance sheets – is one of the main reasons why the losses on sub-prime loans in the United States, which should have been able to be absorbed by the global financial system, have been so damaging. As risk premiums rise, asset values fall, banks look less stable, credit conditions tighten and spending by businesses and consumers declines, reinforcing the feedback loop from the financial sector to the real economy. Not surprisingly in the current environment, even healthy banks are looking to restrain balance-sheet growth and, in many cases, reduce the value of their risk-weighted assets.
In addition to losses on securities, loss rates on loans have also picked up noticeably. For US banks, write-offs increased significantly across the loan portfolio in 2008 (Graph 7). Although increases to date have been most pronounced on loans to households, write‑offs have also increased considerably on loans to businesses, particularly in the commercial property sector, as economic and asset price weakness has spread. A similar trend is evident for UK banks, with write-offs for business loans more than doubling in the December quarter 2008.
Another factor weighing on confidence recently, particularly for banks in Europe, is the deterioration in the outlook for the banking systems of ‘emerging Europe’, as many of these countries have large external financing requirements, including some unhedged currency exposures. The spread between emerging Europe sovereign debt and US Treasuries has risen from 2 per cent to 7 per cent since mid 2007, with the bulk of the increase occurring following the collapse of Lehman Brothers (Graph 8). Sentiment has been most affected for those euro area banks with considerable exposures to the region – particularly some large Austrian banks with exposures that collectively amount to around two thirds of Austrian GDP – although the emergence of yet another area of potential difficulty for banking systems has weighed on confidence more broadly.
Working in the other direction, one factor that has recently been helping to support bank profitability is an increase in interest margins. With the intensity of competition having declined, and many banks seeking to restrain growth in their balance sheets, spreads between average borrowing and lending rates have tended to widen. Indeed, over recent weeks a number of large banks in the United States have cited the widening in interest margins as significantly boosting their profitability.
Other areas of the financial system are also under pressure. Several large insurers in the United States and Europe have reported losses in the second half of 2008, reflecting falls in the value of their bond and equity holdings. Share price indices of insurers have fallen by around 70 per cent since mid 2007, and CDS premiums have risen sharply, with US mortgage insurers among the most affected given strains in the US housing market (Graph 9). Hedge funds have experienced record losses of 18 per cent in 2008 and the size of the industry fell by US$525 billion over the second half of 2008 to US$1.4 trillion, with redemption requests from investors adding pressure to sell assets in strained markets.
Given current conditions, many banks around the world have been seeking to raise new capital to either cover losses or to strengthen their capital position. In the initial phase of the crisis, sovereign wealth funds and private investors were the main source of these funds, although more recently governments have become the main contributors (see below). Banks around the world are estimated to have raised around US$900 billion in new capital since mid 2007 – around half of which has been provided by governments – which is broadly comparable to write-downs over this period (Graph 10). Write-downs over this period have been largest in the United States, and for the largest five banks are equivalent to around half of the regulatory capital that they held in mid 2007.
While capital ratios remain comfortably above regulatory minimums for almost all banks, investors remain wary about the possibility of further write-downs, and potential dilution from government equity injections. This wariness, and the earlier losses incurred by those injecting capital into banks, have made private investors very nervous about contributing further capital. The lack of confidence is reflected in sharemarket valuations, with the market value of many large banks in the United States, Europe and the United Kingdom at end February having fallen to around half the book valuation reported in their most recent financial statements (Graph 11).
Efforts to Restore Confidence
The difficulties facing the global financial system have led to unprecedented levels of public-sector support for financial markets and institutions.
In the initial phase of the crisis, these efforts were largely concentrated on improving the liquidity of short-term money markets. As banks became reluctant to lend to one another, other than at very short terms, many central banks significantly expanded the scale of their money-market operations, widening the range of collateral that they accept and undertaking repurchase agreements over longer maturities. A number of central banks have also set up schemes to purchase outright, or assist banks to purchase, assets including asset-backed commercial paper (ABCP), commercial paper and selected short-term highly rated assets.
While these various actions have helped improve the functioning of short-term money markets, spreads on short-term bank paper remain elevated relative to their levels before the emergence of the sub-prime problems (Graph 12). For example, the cost of 3-month borrowing for US banks is currently around 100 basis points over the swap rate, down from over 350 basis points in the wake of the Lehman Brothers collapse, but well above the 10 basis points prevailing in mid 2007. Spreads in Australia remain much lower than those in a number of other major countries, partly reflecting lesser concerns about counterparty risk.
The scale of public-sector support was increased significantly in the wake of the failure of Lehman Brothers. In the immediate aftermath of the failure, confidence in many banks was shaken, so a number of governments increased caps on deposit insurance schemes to provide reassurance to depositors about the safety of bank deposits. The shock to confidence also saw investors become reluctant to buy long-term bank debt. In response, many governments moved to provide guarantees on wholesale funding by financial institutions. These moves followed the action taken by the Irish Government in late September 2008 to provide a guarantee on new and existing debt for Irish-based financial institutions. This decision had a cascading effect, as concerns arose about the ability of financial institutions that did not have access to guarantee arrangements to continue to access funding. In the weeks following the Irish announcement, governments in over a dozen countries, including Australia, followed suit with wholesale funding guarantee schemes, and bank issuance of guaranteed bonds under these schemes has been strong in a number of countries (Graph 13). (Further details on deposit and wholesale guarantee arrangements are discussed in the context of Australian arrangements in Box A: Government Guarantees on Deposits and Wholesale Funding.)
Another key element in the response to the crisis has been the injection of capital into financial institutions. In a number of cases – including the US housing agencies Fannie Mae and Freddie Mac, the insurer AIG and the European banks UBS, Fortis and Dexia – the capital support has been designed to deal with a problem in a specific institution. However, as the difficulties have become more pervasive a number of governments have announced broader schemes under which institutions can apply for support, with relatively standardised terms and conditions. The first of these was the US Troubled Asset Relief Program (TARP), announced in early October 2008. Around US$240 billion of the TARP funds have been used for capital injections, mainly under the Capital Purchase Program, where institutions can apply to receive capital equivalent to between 1 and 3 per cent of their risk-weighted assets, up to a maximum of US$25 billion. In total, 520 institutions have received capital injections through this program. In February 2009, the US authorities announced a broader plan that includes: stress testing of major financial institutions and subsequent capital injections if required; actions to lower mortgage rates and prevent avoidable foreclosures in the mortgage market; and measures to de-risk bank balance sheets, further details of which were announced in late March.
In the United Kingdom, the Government has also set up a program to increase the capital of major banks. To date, Lloyds/HBOS and RBS have received injections under this scheme, although it is open to all UK incorporated banks with a substantial business in the United Kingdom, as well as to building societies. The form of the capital raising for Lloyds/HBOS and RBS was an initial investment of preference shares, and an underwriting of a rights issue. As the rights issues for these institutions were heavily undersubscribed, the UK Government took up large holdings of ordinary equity, which it has subsequently increased by converting the initial preference share investments into ordinary shares. As a result, the UK Government has effective control of these institutions with majority stakes and up to 75 per cent of voting rights. A number of European countries have also set up general schemes to recapitalise their banking systems, typically through the government purchasing some form of convertible notes or hybrid debt securities, rather than purchasing common equity.
Another element in governments’ response has been the development of programs to reduce the risk on banks’ balance sheets by either removing certain types of assets completely or providing insurance against losses on the assets. These programs also allow banks to report higher regulatory capital ratios as they reduce the bank’s risk-weighted assets.
An early example of this approach was associated with the sale of Bear Stearns to JPMorgan in March 2008. This involved the sale of US$30 billion of Bear Stearns’ assets to a special purpose vehicle largely funded by the US Federal Reserve, with the first US$1 billion of losses to be borne by JPMorgan. A broadly similar approach has been followed by the Swiss authorities in the case of UBS, with a pool of assets valued at US$39.1 billion having being sold to a special purpose vehicle, with the first US$4 billion of losses to be borne by UBS. In other cases, assets have remained on the bank’s balance sheet, with the government providing insurance for a fee, typically paid for by the bank issuing some form of equity to the government. In the United Kingdom, for example, the Government has reached an agreement with RBS to guarantee £325 billion of assets for a fee of 2 per cent, and an agreement with Lloyds/HBOS to guarantee £260 billion of assets for a fee of 6 per cent. In both cases, the institution bears an initial loss, and 10 per cent of any remaining loss, and the fee was paid through issuance of a special class of shares. In the United States, broadly similar arrangements have been set up for Citibank and Bank of America.
More recently, the US authorities have announced details of the establishment of public-private investment funds (PPIFs) to facilitate the purchase of so called legacy loans and securities from US financial institutions, involving private investors bidding for the assets to assist with their price discovery. The purchase of the loans will involve a combination of equity financing, provided jointly by the US Treasury and private investors, which can be leveraged up to six times through the issuance of debt guaranteed by the FDIC. For the securities, one element involves the expansion of an existing Federal Reserve program, under which the Fed provides loans for the purchase of newly securitised assets, to cover the purchase of certain existing mortgage-backed securities (MBS) and asset-backed securities. A second element of the securities program involves the PPIFs investing in certain MBS, funded by equal contributions from the US Treasury and private investors as well as the possibility of a loan from the US Treasury equivalent to 50 or 100 per cent of equity capital, subject to certain conditions. The total equity contributions from the US Treasury for the legacy loans and securities programs is expected to be between US$75 billion and US$100 billion and will be sourced from TARP funds.
The various measures discussed above have been effective in preventing widespread runs by bank depositors and bank collapses, and there has been a general improvement in sentiment over recent days. Despite this, there are ongoing concerns about the value of banks’ assets, particularly given the decline in the prices of many securities and the deterioration in the world economy. Reducing uncertainty and risk aversion are central to resolving the current problems, with the sharp drop in confidence and the accompanying increase in the price of risk having a pervasive and debilitating effect on the financial system and the broader global economy. The task of developing and implementing a credible policy response has been complicated by the need to obtain broad political support for major initiatives, especially when they involve governments taking significant financial risks and/or controlling previously private businesses. While debate continues about the best way forward, there is a general consensus that banks’ exposures to risky/troubled assets with highly uncertain future values need to be reduced, either through the sale of these assets or insurance arrangements. Without such action, it is likely that investors will continue to be wary about the future of the affected banks, and management’s effort will be disproportionately devoted to managing these assets. There is also general agreement that troubled banks need to raise new equity. If balance sheets are ‘cleaned up’ through the disposal of risky assets there is some prospect of the private sector injecting the capital, but if this does not occur the public sector will need to do so.
Credit and Debt Markets
The difficulties being experienced in financial systems and the uncertainty about the global economy have seen banks in a range of countries tighten lending standards significantly. In the United States, for example, in the three months to January 2009, almost half of banks reported tighter lending standards for prime residential mortgages, and around two thirds for loans to large and medium businesses, even though standards have been tightening since at least 2007 (Graph 14). Banks have also been increasing risk margins applied to borrowers, in contrast to earlier in the decade when they were reducing these margins (Graph 15). A similar tightening in credit standards is also evident in the United Kingdom and Europe, with the deterioration in the economic outlook, as well as the cost and availability of funds, cited as the major driving forces behind tightening conditions. An IMF survey of banks involved in trade finance suggests that costs have increased and conditions have been tightened on this type of finance, particularly for emerging markets.
Not surprisingly, credit growth has slowed in a range of countries (Graph 16). In the United States, the euro area and the United Kingdom, year-ended growth in housing credit has slowed to low single digits over the past year, with negative monthly growth rates having been recorded recently in some countries. Business credit growth has also slowed in recent months, although it typically remains positive. This follows a period of rapid business credit growth in the early phase of the crisis which partly reflected re-intermediation as conditions in capital markets tightened for many borrowers. The volume of trade credit provided by banks in emerging markets fell in late 2008, according to IMF data, consistent with reports that disruption to trade finance has played a role in the extremely sharp fall in global trade.
The increase in the price of risk and general risk aversion has also dampened fundraising activity in wholesale markets. In the US, for example, issuance of collateralised debt obligations (CDOs) and non-agency MBS has been virtually non-existent as investors remain wary of complex structures or highly leveraged entities (Graph 17). Issuance of corporate bonds has been stronger in early 2009, as a narrowing in spreads from the late 2008 peaks and a sharp fall in the risk-free yield has been met with heavy issuance, predominantly from higher-rated borrowers (Graph 18).
The slowing in the pace of credit growth and, in some markets, debt issuance reflects both supply and demand factors. Banks and investors are clearly more risk averse than they were previously and are seeking to deleverage. They are demanding more in compensation for the risks that they are willing to accept when extending funding. However, just as banks and investors have become more risk averse, so too have households and businesses, and there has also been a marked reduction in the demand for debt given the uncertain environment. The more risk-averse attitudes of lenders and borrowers is evident in a sharp reduction in global leveraged buyout (LBO) activity, which totalled US$129 billion in 2008, down from US$746 billion in 2007, with activity in the December quarter the lowest for the decade (Graph 19).
A notable feature of the current environment is that the difficulties in financial systems have meant that the monetary policy transmission mechanism has become much less effective in some countries. While central banks have lowered policy interest rates significantly, a widening in risk spreads has limited the extent to which reductions have been passed onto many lending rates. In the United States, while the federal funds rate has been reduced by around 5 percentage points since mid 2007, the 1-year mortgage rate is broadly unchanged (Graph 20). At the longer end, spreads between 30-year fixed mortgage rates and government bond rates also widened over the past year, although this has been reversed quite recently. Similarly, in the United Kingdom, rates on new 3-year fixed housing loans have declined by around 160 basis points since late 2007, compared with a fall of around 240 basis points in the equivalent government bond yield, and variable rates have fallen by significantly less than the fall in the policy rate.
With interest rates now at, or close to, zero in a number of major countries, some central banks have begun to augment existing open market operations by purchasing assets outright without conducting offsetting operations to limit the rise in central bank reserves. For example, in January 2009, the Federal Reserve began buying agency-guaranteed MBS outright to bring down mortgage rates. And in March 2009, the Bank of England began purchasing high-quality assets such as government bonds, and allowing the resulting cash to remain in the system, with the aim of boosting broad measures of money and credit and, in due course, the rate of nominal spending. The Swiss National Bank has also recently announced measures to boost liquidity that include purchases of private-sector bonds.
Financial Condition of the Household and Business Sectors
A striking feature of the current crisis has been the large fall in household and business confidence in a wide range of countries. While confidence had already been declining since mid 2007, it took a further step down following the failure of Lehman Brothers and the period of intense financial volatility in late 2008 (Graph 21). As a result, both households and businesses have curtailed spending, adding to the contractionary forces in the global economy (Graph 22). The decline in confidence has also been associated with a reassessment of the structure of balance sheets, with many households and businesses attempting to reduce their leverage as asset prices decline and risk aversion rises. While these measures are sensible from the perspective of an individual household or firm, collectively these actions are serving to further dampen economic growth, reinforcing the damaging feedback loop between the financial sector and the real economy.
An important factor weighing on household and business sector balance sheets has been falls in property prices in a number of countries. Since their peak, house prices have fallen by around 10 to 25 per cent in the United States (depending on the measure used) and by almost 20 per cent in the United Kingdom (Graph 23). There has also been a significant downturn in commercial property prices, particularly in the United Kingdom, where capital values are around 40 per cent below the peak. This, in turn, is reinforcing the adverse credit supply loop, by reducing collateral values against which borrowers can secure their loans.
In this environment of weaker incomes and asset values, the proportions of household and business borrowers having difficulty making debt payments have increased. Though the initial rise in US housing loan arrears mainly reflected sub-prime mortgages – particularly adjustable-rate mortgages as interest rates rose from initial low rates – arrears rates across all mortgages have continued to rise (Graph 24). In the December quarter 2008, around 5 per cent of prime loans were 30 or more days in arrears, while the comparable figure for adjustable rate sub-prime mortgages was nearly 25 per cent. In the United Kingdom, mortgage arrears have also moved higher, with 3.8 per cent of prime securitised loans in arrears by 30 or more days as at January 2009, up by 1.6 percentage points over the year.
Indicators of financial difficulty have also moved higher among corporations. For example, Moody’s global speculative-grade corporate default rate increased sharply over the past year, although at 5.2 per cent in February 2009, it remains below the levels reached in previous recessions (Graph 25). Given the tight financing conditions, indebted firms with refinancing needs are under particular scrutiny, with weakness in sharemarkets and investor sentiment limiting the availability of access to equity finance.