1

History And Lessons From Bank Restructuring: US and Europe

Sergey Rumyantsev, Ph.D., CFA

Outline:

• US: Factors that caused 2007-2008 subprime crisis

• US: Government response and why it worked

• Europe: External vs internal shocks and what worked

• UK: Mergers gone wrong and RE bubble

• Ireland: From most expensive real estate to empty land

• Spain: Too many banks, too few real loans

• Germany: If it looks and feels too complex, it will be misunderstood

• Post-crisis: Much more global and detailed regulation of banks and SIFIs

• Russia: differences and similarities and role of central bank

2

US: History of 2007-2008 Banking Crisis

• Long trend of US housing inflation:

• 15-year upward trends in price appreciation on low rates and accommodative Fed policies

• Was it Fed/Dr. Greenspan to blame?:

• Fed has encouraged developments in securitization markets as Freddie and Fannie would buy AAA

• In early-mid 2000s banks had a lot of incentives of “repackaging risks” and “originate-to-distribute”

models while retaining AAA risk (low RWA under Basel 2)

• Rise and fall of non-prime lending:

• Hungry for fees mortgage bankers fueled non-prime (Alt-A <650 FICO, subprime <600 FICO) lending

• On top of it lending fraud (no income verification, no docs lending) was widespread

• Bankers did not own risk, they were constantly re-selling it

3

US: History of 2007-2008 Banking Crisis (Continued)

• Large US banks got over exposed to complex structured products:

• Massive underwriting volumes with super senior risks retained

• Double leverage in the banking system:

• New abbreviations – CDO, ABS CDO, synthetic CDO, CDO2, CPDO, leveraged super seniors

• Plenty of complex risk management and structuring models, very little common sense

• Effective leverage of structured credit products – ABS CDO: ~200:1, CDO2: ~2000:1

• What can go wrong? Citi CEO Chuck Prince (2007) – “We Are Still Dancing”

Double leverage machine Optimistic underwriting

4

US – Small bump in housing dynamics and a “tsunami” effect on banking sector

• US banks – were getting more and more levered:

• Assets/capital has been getting into 35-40:1 territory

• Most of liabilities were coming from ST funding model and repos

• Small decline in US housing prices caused massive chain reaction that started in 2H 2007:

• 1-2% increase in default rates caused 100% wipe out of certain structured products

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Collapse of largest institutions: leverage and lack of confidence kill

• US regulators let systemic Bear Stearns and Lehman Brothers go and probably regretted that:

• Bear Stearns – most exposed to subprime and DCM: massive exposure to subprime, combined with

lack of stable funding (up to 70-80% in ST funding and repo markets), got 25B emergency credit line

from Fed March 2008 and was sold to JP Morgan for 1.2B (10$ a share, initially 2$) as counterparties

stopped rolling credit

• Lehman collapse – also lack of confidence after capital erosion on subprime losses: larger banks

started shutting down credit line on Lehman causing largest Chapter 11 filing for 600B USD of assets

and Fed managing sale of Lehman core US business to Barclays and Asia/UK core to Nomura. Lehman

senior unsecured claims were trading as low as 7-8 cents during 2008-2009

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US Response to Banking Crisis

Legislation• Emergency Economic Stabilization Act of 2008 (EESA)

• US Treasury got up to 700B USD of funds authorized by US Congress

Banking support

• TARP: Troubled Asset Relief program – pref and equity investments into banks

• Incentives for banks to repay TARP: 5% coupon jumping to 10% in 3 years

• Separate recapitalization of Citi, BofA, AIG (150B total investment in prefs)

Liquidity Support• TALF and PPIP – non recourse leverage given to investors to buy legacy assets

• Both debt and equity investments

• Various credit lines from Fed to support legacy assets and money money funds

Housing Market Support

• HARP – home affordable refinance program, HAMP – home affordable

modification program

• Fannie and Freddie conservatorship (reforms still pending)

Auto Industry Support

• GM/Crysler restructuring

• Ally/ResCap split

• State financing for auto suppliers

Regulation• Operating entity: Office of Financial Stability at US Treasury and FDIC

• Dobb-Frank regulation to govern US banking holding companies, limit risky

operations and create resolution regimes

• US Fed started running detailed annual stress tests

• FDIC deposit insurance limit increased to 250K

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US Banks Recovery: Federal Reserve Tripling Balance Sheet Helped

• TARP – success on quick recovery of financial

assets: most large banks repaid TARP by end of 2009• US Fed – key in financials asset recovery: US Fed has

launched massive shadow banking activities to replace end

buyer for ABS assets

• Net profit for US government: ~17-20B by end of 2014,

only in “red” on auto finance liquidation and Freddie/Fannie

programs

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Case Study: US Treasury TARP for Citi

• Investment: 45B total – November 24 2008 across preference shares and equity warrants

• 20B of hybrid debt

• 7B of hybrid debt for 306B asset guarantee scheme (16B capital relief)

• Warrants for 251M shares at 10.51 USD strike

• Restructuring plan:

• No equity dividends for 3 years

• Creation of “bad bank” Citi Holdings to run off legacy assets, change of management and strategy

• Results:

• TARP repayment: full exit by end of 2013 with 13B profit

• Bad bank run off: 700B over 5 year period, got to break even level 2H 2014

• Significant restructuring of internal governance, annual reviews by Fed, resolution plans

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Europe – Why It Is More Complicated

• European Banks – Too Big, Too Slow to React:

• EU Banks – much larger vs US banks: banks in Europe have grown to be 4-5X size of the economy

• Europe – much more reliance on lending vs capital markets: 80%% of debt financing in Europe has

historically come from banks vs capital markets

• Europe – different causes of crisis: real estate bubbles in Spain and Ireland, PIIGS sovereign crisis,

asset bubble and exposure to US in UK and Germany

• No single regulator to backstop risks: only UK and Germany have enjoyed monetary authority to print

more money, PIIGS countries have needed external support from IMF to restructure banking sectors

• A lot of bureaucracy – EC Competition Commission has to approve all bank state aid cases

10

UK – How Top Banks Mismanaged M&As

• Mega mergers gone wrong:

• Lloyds-HBOS deal: Lloyds got exposed to much worse underwriting standards of HBOS mortgages

• RBS-ABN Amro failed deal: RBS was trying to become one of the largest global banks

• UK banks were exposed to UK and Irish mortgages:

• Following US financial shock, UK RE prices corrected by 10-15%, Irish ones – by 40-50%

• Weak governance at some UK building societies:

• By 2008 there were 59 building societies in UK with 360B GBP assets, some with large exposures to

construction lending

• Northern Rock and Bradford and Bigley got nationalized in 2008 and split in 2009

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UK Response to Banking Crisis

Legislation• Banking Special Provisions Act (February 2008)

• Package (October 2008) to support banking system, up to 500B GBP

Banking support

• Unlike US, mostly investments in common shares – Bank Recapitalization Fund

• RBS – 15B GBP of equity investment, 5B of prefs investment

• Lloyds – 8.5B GBP of equity investment, 8.5B of prefs investment

Liquidity Support

• Bank Liquidity Scheme – up to 200B ST funding support

• Asset Protection Scheme – 2nd loss protection of ABS assets

• 250B guarantee for interbank lending

Regulation• Operating entity: HM Treasury and UKFI (owns stakes in banks)

• UK Special Resolution regime – passed in 2009, wide powers for nationalized

banks – emergency management, split of assets, bridge banks, restrictions on

dividends etc

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Case Study: Resolution of RBS and LLoyds

• RBS Group largest bank in world by assets in 2008 after purchase of ABN

Amro in 2007

• UK Government sold RBS emergency insurance on assets via Asset Protection

Scheme (APS), early 2009

• RBS was 84% owned by UK Government, which paid c £45bn for stake

• Largest UK mortgage lender in 2008

• Following severe liquidity strain, HBOS acquired by Lloyds‐TSB to form

Lloyds Banking Group (LBG), September 2008

• UK Government subsequently recapitalised LBG and sold it emergency

insurance on assets via APS

• Lloyds was 43% owned by UK Government

• After 5 years in restructuring, Lloyds paid first equity dividend in February of 2014, prefs dividends were resumed in 2011

Royal Bank of Scotland

Lloyds Banking Group

Restructuring plans:

• Core/non-core split

• Exit from risky trading

• Balance sheet improvements

• Exit from 100B+ of troubled loans

Lloyds vs RBS

• Lloyds investment was “in the black” by 2013

• UK was close to splitting RBS in 2013 after lack of share price improvement

Outcome:

• Lloyds stake reduced to 20%

• UK is still not in the money on RBS investment

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German Banking Sector: Crisis of Landesbanks

• Mix of commercial banks, savings banks and cooperative banks

• Large number of savings banks being funded by guaranteed debt and not deposits

• Close to 2000 banking entities by 2009

• In 2005-2008 given excess liquidity, German banks have been expanding in CRE

lending with higher margins and in buying US structured products

• Names exposed to CRE lending: Commerzbank, Hypo Real Estate

• Names exposed to US structured products: HSH Nordbank, West LB, Bayern LB

Most convoluted banking sector

Desire to get more yield

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German Response to Banking Crisis

Legislation• Financial Stabilization Act (October 2008)

• 460B package to support banking sector, creation of SofFin (Financial Market

Stabilization Fund)

Banking support

• SofFin made 9-10% preference shares investments in Commerzbank, Hypo RE

and several landesbanks (70B investment capacity, 10B limit per company):

• Commerzbank: 16B silent participation, 1.8B (25%+1) equity stake

• Soffin provided liquidity backstops and 2nd loss guarantee schemesLiquidity Support • Soffin Liquidity Scheme – up to 400B ST funding support

Regulation

• Operating entity: SoFFin and Bafin

• German Bad Bank Act (2009) gave regulators broad powers to deal with troubled

banks

• Restructuring Act (2011) – more additions to regulatory powers

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Case Study – Story of Failed Landesbank West LB

Portigon AG: servicing

operationsEAA (bad bank)

West LB (Top 3 German

Landesbank)

• Story of excessive risk taking:

• Had 280B EUR of assets at the peak

• Too many countries, too many business lined

• 20B+ exposure to US CDOs, over reliance on wholesale funding

• 2009 - first round of restructuring

• EC and Germany agreed to create ~90B EUR bad bank EAA with 3B capital from owners and 3B from

the German state/SofFin

• West LB management has been rather slow in implementing recommendations

• 2011 - second round of restructuring

• In 2010 EC reopened state aid investigation arguing that bank was not following restructuring plan and

that transfer prices for some assets were wrong (most were transferred at par)

• In 2011 EC issued its final opinion that West LB is non-viable and insolvent and should be liquidated:

retail core was sold to Helaba, 40B of servicing assets went to Portigon (no banking license) and bad

assets continue to be managed by EAA (no banking license)

• Impact on investors:

• 100% loss for initial equity investors

• 100% loss for initial subdebt investors• No loss for most senior debt holders (EAA debt got sovereign guarantee)

Retail branches: sold to HELABA

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Spanish Banking Sector: Where Did All The Cajas Go?

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Spanish Banking Sector Restructuring

• 3 Rounds Of Merging Spanish Savings Banks (Cajas):

• Royal Decrees of 2009, 2010, 2011

• From 40+ entities to 5-7 cajas, changing form of ownership and governance

• Bank Stabilization Fund

• FROB (Fund for Orderly Bank Restructuring) – 9B equity available, 40B total buying power, half of

money spent on bailing out Bankia/BFA

• Several rounds of asset stress tests using help of consultants (Oliver Wyman)

• Up to 160B of troubled loans identified, half transferred to a bad bank SAREB

• Pick up in NPLs has been increasing during 2009-2013 given collapse of RE prices by 30-40%

• Most troubled loans are underwater vacation apartments and construction

SAREB: Transfer prices

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Case Study – Not Fully Honest Management of Bankia

BFA (holding company): land loans, funding

exposure

Caja Madrid and 6 other Cajas

• Was formed as a merger of 7 savings banks:

• Half of assets came from Caja Madrid, a lot of land loans

• Lack of single source of underwriting standards

• Round 1 of restructuring

• New entity Bankia goes public while its holding company BFA keeps troubled loans

• BFA promises to investors that Bankia is separate from its obligations

• Round 2 of restructuring

• During EU stress test, it is shown that BFA is insolvent

• Spanish government via FROB injects 20B of prefs and equity into Bankia/BFA and transfers up to 40-

50B of troubled loans to SAREB

• Impact on investors:

• 80% loss for initial equity investors

• 70% loss for initial hybrid debt investors

• 60% loss for initial LT2 debt investors• No loss for most senior debt holders

Bankia (IPO)

Nationalized BFA

Bankia

SAREB: Asset Management Company

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Ireland – Failed “Celtic Tiger”

• Real estate bubbles don’t last forever:

• In 2000-2006 Ireland saw one of the biggest RE increases with Dublin becoming most expensive

European city

• Both top 3 Irish banks (Bank of Ireland, Allied Irish, Anglo Irish) and Irish units of other banks (RBS

Lloyds Danske) have been aggressively competing for mortgage and CRE underwriting business

• Buy-to-let mortgages expanded to as much as 20% of total collateral with weaker underwriting standards

• What is value of land when construction boom stops – not much:

• Anglo Irish specifically got massively exposed to speculative land loans

• On top of it, Anglo Irish management has money a lot of money to related parties and to random places

in the world (e.g. land loans in Ukraine)

• Collapse of Irish banks almost killed Irish economy:

• Banks got too big, 500-600% of GDP

• Ireland has to get IMF/Troika sovereign bail out package, RE prices collapsed by 50% (land by 80-90%),

wages went down by 20-30%, unemployment spiked from 5-6% to 13-14%

• Dublin was a ghost city for 2009-2010

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Irish Response to Banking Crisis

Legislation• Changes to Irish banking act (2009, 2010) to allow restructuring of banks and

moving assets and liabilities and imposing losses on investors

Banking support

Liquidity Support

• September 2008 – broad 1 year liquidity guarantees (~120B used) for credit

institutions, renewed in 2009 2010 and 2011

• IMF 20B loan to Ireland to use for Anglo Irish as a part of IMF package

Regulation

• Operating entity: Irish Central Bank and NAMA (largest bad bank in Europe)

• Irish Resolution Act (2011) – gives government broad powers with troubled banks

- €74 billion of loans from 5 banks transferred for €31.8 billion – average discount of 57%

- 12,000 loans – 10,000 properties – 775 debtor groups

-54% of portfolio in Ireland; 33% in Britain; 9% Other (mainly US, Germany & France); 3% Northern

Ireland & 1% non real estate

- 64% of UK portfolio is London; 67% of Irish portfolio is Dublin

- €15 billion of asset disposals by 2014 with positive PnL

NAMA – National Asset Management Agency:

• Asset clean up at 2 systemic banks BKIR and AIB (3.5B EUR capital injection

each) and recovery plans, full nationalization of Anglo Irish

• Massive burden sharing to sub debt holders (80% haircut) to build more capital

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Europe – Non Core Asset Sales

• Europe – troubled loans and NPLs vs ABS in US:

• Stock of non performing assets has reached ~1.5 Tr

• Mismatches between buyers and sellers: banks would not sell unless they are forced to (forced write

downs, punitive RWA) while buyers want deep discounts – transactions have been slow since 2008

compared to ~150-200B of mostly US money chasing deals

European NPLs:

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Europe – Non Core Asset Sales Picking Up

• It Is Mostly US funds buying from bad banks:

• 2014 – record year for deals: 80.6B EUR of loans changed hands with 77% of investors being US

banks and 41% of sellers being “bad banks”

• Biggest investors have already built servicing/special servicing capabilities away from banks – key to

success in collecting cash flows

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Post-Crisis Improvements in Resolution Regimes

• Key Points:

• Gone Concern Vs Going Concern: regulators have focused on ways to rebuild capital of a bank

without going to insolvency – bail in capital, CoCo, other measures

• OpCo vs Holding Company: US and UK has had more focus on being able to resolve holding

companies while preserving operations of a core bank

• Senior Debt is still untouchable: besides true bankrupcis of Lehman and Icelandic banks where senior

debt lost 70-80% of value, regulators have protected that asset class

Ongoing Concern

• Ability to inject capital

• Bail in debt

• Dividend restrictions

Gone Concern

• Bottom-up restructuring

• Powers to intervene at holdo structure

• US: focus on protecting OpCo

Recovery

• Power to set up bridge bank

• Emergency management

• Resolution plans

• Core vs non core assets

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Overview of Basel 3 Capital Regime

• Summary:

• US UK Swiss regulators have created their own versions of Basel 3 capital regimes

Financial Stability Board

Basel Committee –Bank For

International Settlements

National Regulators: Central

Banks, Treasury Departments

Systemic Banks (SIFIs)

Other Banks

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Post-Crisis Improvements in Bail-In Capital

• Background:

• Pre-crisis Tier 1 capital: in US – preference shares, in Europe – hybrid debt

• In UK during crisis government could not defer a number of securities due to complexity

• Contingent Capital (CoCo) – instrument of choice in Europe:

• Upon a capital level trigger, either a writedown or an equity conversion

• Higher coupons for investors to participate

• Treated as debt for tax reasons, decreases WACC for banks

• Can by itself cause a systemic crisis in the future if a CoCo for a large bank fails (TBD)

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Summary of Banking Crisis Responses

Country Key Risk Factor Key Response Bad Banks

US (the only one

in the money on

bank investments)

Complex securities,

subprime lending

TARP (prefs investments),

massive Fed liquidity back stop

for ABS assets

N/A – on balance

sheet run off of non

core assets

UK M&A deals,

CRE/exposure to

Ireland

Bank partial nationalization,

ABS liquidity scheme, bank

restructuring plans

Northern Rock Asset

Management – merger

of NR an B&B

Germany Risk taking by

Landesbanks, US

CDOs exposure,

CRE

One off complex SPVs for bad

banks with funding guarantee,

liquidation of West LB and run

off of Hypo RE

EAA, FMS, internal

bad banks at CBK and

others

Spain Real estate bubble,

excess capacity at

savings banks

(cajas), fraud at

Bankia

3 rounds of asset clean ups,

reduction of cajas, double

restructuring with burden

sharing of Bankia

SAREB (15 year

horizon)

Ireland Real estate bubble,

fraud at Anglo Irish

Massive restructuring of banks,

write down of equity and sub

debt

IBRC, NAMA (15 year

horizon)

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Lessons from Recent Crises

• IMF Study:

• Double crisis (banking+RE crisis) take several years to recover (Ireland, Spain), triple crisis

(banking+RE+sovereign insolvency) take 5 years+ to recover (Greece, Ukraine)

• Only US has net spent very little, recovering most of the money as financial assets rebounded, RE

collapse in PIIGS won’t allow recovery of initial investments

• On average countries spend 4-5% of GDP on banking crisis (much higher for EM – up to 20-25%)

• Run off is always better than liquidation:

• Sellers always lose (and buyers gain) in fire sales

• Asset prices do mean revert over time

• But troubled/impaired assets can permanently lose value (land in the middle of Ireland)

• Investors better follow cycles of banking develeraging and play along the government:

• Recovery of prefs initially and equity afterwards of US and UK banks has been very profitable

• However investors lost a lot of money betting that a government would not change laws and impose

severe write downs on them (Irish banks, Spanish Bankia)

• Even worse, for failed banks in a number of occasions investors saw 100% loss (HAA, BES, Lehman,

Icelandic banks) on their equity and junior debt investors

• Regulation has become much more complicated and it is risk managers not traders that run the banks

now

• Banks have to run dozens of macro scenarios into internal risk models for stress tests

• Any inconsistency in results is causing massive reaction by regulator

• Legal frameworks are there in US UK Nordics to do anything to a troubled bank

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Russian Banks And Regulation: Potential Extrapolation

• Key issues:

• Rapid growth at 30-40% CCAR of retail unsecured lending: very sensitive to unemployment, poor

recoveries

• FX mismatches at AML: not as bad as former CIS countries, but can be up to 5-10% of liabilities

• Related party lending: no good data, but according to Moodys, on average at 10-12% of loans (5 times

higher vs CEE), likely at 20-30% at small banks (so multiples of capital)

• State lending to unrealistic projects: a number of subsidized loans (e.g. RE in Sochi) that don’t have

sufficient cash flows to support interest payments

• Role of CBR (Central Bank of Russia):

• Much more involved in preemptive actions with non systemic banks (plus has 2008 Directive for SIFIs)

• Has been consulting with Financial Stability Board/BIS much more, moving to Basel 3 and RWA models

• Working on law amendments to more closer to resolution regimes with bridge banks/bail in capital

• True tails for banking sector:

• Geopolitical risks: another massive FX devaluation, SWIFT

• RE prices large correction: Russian RE at ~15-20X multiple vs stocks at ~4-5X multiples looks

overvalued

• Large EBITDA decreases at import-oriented businesses: easily down 30-50% on FX over 2015