United States: Selected Issues

This paper discusses how financial innovation turned U.S. mortgages into an asset class with worldwide investor appeal. It suggests that U.S. financial markets have been skilful in developing tools that have helped households exploit favorable global financing conditions to boost home ownership and acquire housing wealth. It reviews trends in labor supply and demand, electricity sector challenges, oil price developments, and the performance of the U.S. economy. It analyzes U.S. banking developments, with focus on large complex banking groups (LCBGs), and describes the structural change and competition among auto manufacturers and airlines.

Abstract

This paper discusses how financial innovation turned U.S. mortgages into an asset class with worldwide investor appeal. It suggests that U.S. financial markets have been skilful in developing tools that have helped households exploit favorable global financing conditions to boost home ownership and acquire housing wealth. It reviews trends in labor supply and demand, electricity sector challenges, oil price developments, and the performance of the U.S. economy. It analyzes U.S. banking developments, with focus on large complex banking groups (LCBGs), and describes the structural change and competition among auto manufacturers and airlines.

V. U.S. Banking: Financial Innovation and Systemic Risk29

1. The U.S. banking system remains highly innovative. Following computerization and consolidation in the 1990s, banks have become highly adept at isolating and allocating the various risks associated with bonds, mortgage-backed securities (MBS), and other financial products. This has contributed to the securitization of increasingly higher-risk assets, while facilitating the application of bond portfolio management techniques to mortgage books, increasing asset price discrimination, and helping to attract foreign capital. As described in Chapter 1 of this volume, these techniques have also contributed to the growing share of U.S. MBSs in the global bond market (Figure 1).

Figure 1.
Figure 1.

U.S. Asset-Backed Securities as Share of Global Bond Market

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Source: Haver Analytics.

2. As complexity has mounted, so too have surveillance challenges. With banks relying increasingly on hedge funds for liquidity and trading diversity in a broad range of markets, regulators are no longer able to fully track risk on a system-wide basis, but are instead focusing more intensely on a subset of systemically important institutions. These include the “big five” investment banking groups as well as large bank holding companies (BHCs). For the purpose of this paper, the 20 largest BHCs, holding assets of $7.4 trillion (58 percent of GDP) at end-September 2005, are referred to as “large complex banking groups” (LCBGs).

3. This paper analyzes recent U.S. banking developments, with a particular focus on LCBGs. The analysis is based on a review of accounting and equity market data, which are combined in a Black–Scholes–Merton “distance to default” (DD) indicator. This indicator is based on market measures of a firm’s profitability and balance sheet structure. The DD varies positively with returns on assets and capitalization and negatively with the volatility of assets, and its level can be mapped into a proxy measure of probability of insolvency. Thus, any increase in DD indicates improved financial soundness—reflected in a lower probability of insolvency—resulting from higher expected profitability, better capitalization, lower asset volatility, or a combination of these factors.30

A. Innovation in U.S. Banking

4. Depository institutions are the fulcrum of the U.S. financial system, although they only account for a modest share of market assets (Figure 2). In addition to traditional deposit-taking and lending activities, the banking system is engaged in more complex trading businesses and offers a range of services covering most financial activities. For example, while proprietary trading activity has become commonplace at large and midsize banks, these institutions generate significant noninterest income from loan sales, servicing, securitization, ratings advisory, and fund management. Moreover, the broker-dealer subsidiaries of LCBGs, along with independent investment banks, are the leading securitizers of a wide range of assets, including into complex structures at the leading edge of financial engineering.

Figure 2.
Figure 2.

Financial Sector Assets, 2005

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Source: Haver Analytics.

5. Against a backdrop of low interest rates and rapid house price inflation in recent years, housing finance has moved to the center of banking activity and innovation. Large banks have transformed mortgages into a bulk commodity to be originated, securitized, and re-securitized into different risk categories for sale to domestic as well as international investors. Small and midsize banks have joined the cycle of origination and loan sale but, less able to compete against large banks with a national presence, have actively been supplementing their mortgage income with commercial real estate (CRE) lending, including for condominium construction, that requires more intimate knowledge of local conditions.

6. There has been substantial product innovation in the market for housing finance. Households have traditionally been able to capitalize on steep yield curves with adjustable rate mortgages (ARMs) and step up home equity extraction with second mortgages or home equity lines of credit (HELOCs). More recently, they have also been able to purchase otherwise unaffordable homes with nontraditional ARMs carrying interest-only, negative-amortization, or low-documentation features and subsequently refinance back into fixed 15 or 30-year mortgages. Some 80 percent of the refinancing boom in 2002–03 involved traditional mortgages and HELOCs; two years later, spurred by competition between banks and mortgage companies, the market is characterized by a more complex product mix with more difficult-to-understand risks (Box 1).

Mortgage Market Innovation: A Structural Break?

The issue of credit risk in banks’ housing exposures has received limited attention in the recent literature. Reasons include the traditionally low delinquency rates (relative to commercial and industrial loans) and high recovery rates on residential mortgages as well as the geographic diversification often provided by securitized assets.

This may partly reflect continued government involvement. Although now making up less than half of the overall MBS market, MBSs guaranteed by Fannie Mae and Freddie Mac, the two largest housing government-sponsored enterprises (GSEs), continue to account for the bulk of bank-held MBSs.1 Consistently small spreads between agency debt and treasuries indicate a long-standing market belief that default risks of the two types of securities are similar, notwithstanding clear statements by the Treasury—and on every agency bond indenture—that the two GSEs do not enjoy a credit guarantee from the U.S. government.

As the housing GSEs have come under regulatory pressure in recent years, banks and mortgage companies have emerged as the main market innovators. While the GSEs have focused on the securitization of conforming, fixed-rate mortgages, other market participants have gained market share by packaging newer mortgage products into more complex MBSs, including through re-securitization to create MBS-backed collateralized mortgage obligations with separate risk tranches.

The increased prevalence of ARMs may have altered a traditionally weak relationship between interest rates and foreclosures. Attention has focused on the “payment shock” risk posed by ARM resets in an environment of rising interest rates and softening house prices. More specifically, bank regulators have expressed concern that products such as payment-option ARMs that traditionally served the needs of niche borrowers with large but irregular cash flows—the proverbial “Porsche salesman”—may in, 2004–05, have been extended to stretched first-time homebuyers or property investors, with insufficient due diligence and underwriting.

The market response thus far suggests that upcoming ARM resets carry both market risk and credit risk. In a typical pattern, proactive originators contact borrowers as reset dates approach, offering refinancing of ARMs into longer debt-service profiles. To the extent that borrowers are concerned about rising interest rates, this could trigger some increase in prepayment activity.2

1 With $2.6 trillion of guaranteed MBSs and $1.5 trillion of agency debt outstanding, Fannie Mae and Freddie Mac remain the largest underwriters of and investors in the U.S. mortgage market.2 Private mortgage databases suggest stretched homebuyers with nontraditional mortgages are the exception, not the rule. Cagan (2006), for instance, estimates that $1.9 trillion of ARMs were originated in 2004–05, amounting to about 20 percent of 1-4 family mortgages outstanding; that 23 percent of such ARMs carried below-market initial “teaser” interest rates of 4 percent or less; and that 51 percent of the latter were to households with equity shares in their homes of 15 percent or less. Usefully, Cagan also estimates a national median discount of 14–16 percent on foreclosed home disposals during January 2004–June 2005.

B. Exposures and Risks at LCBGs

7. Given their size and scope, a survey of LCBGs should capture the essence of industry trends. A focus on holding companies (as opposed to banking subsidiaries) is expedient for the equity market-based analysis to follow, because the BHC is the dominant listing unit in the banking system. The 20 LCBGs account for about two-thirds of consolidated BHC assets; one-half of net income; three-quarters of BHC securities broker-dealer assets; and virtually all BHC derivatives activity.31

8. The LCBGs form a heterogeneous set. They include 16 U. S. BHCs and four subsidiaries of European banks. All are financial holding companies under the Gramm–Leach–Bliley Act, a status that broadens their authority to diversify functionally under the “umbrella” supervision of the Federal Reserve Board. Their emphasis on nonbank activity differs, however, with assets of their broker-dealer and insurance underwriting subsidiaries varying across LCBGs from 0–30 percent and 0–5 percent of consolidated assets, respectively. The LCBGs’ banking strategies are similarly diverse, ranging from relatively traditional (mortgages and credit cards, funded by retail deposits) to complex (trading and special purpose vehicle financing for large corporate clients, funded in the markets).32

9. As corporate sector savings have grown, credit to households has become the mainstay of LCBG business. Excluding trading assets, exposure to the household sector expanded 3 percentage points, to 36 percent of total assets, in the three years to end-September 2005, while exposure to the corporate sector correspondingly contracted to 18 percent of assets. Given the historically superior credit performance and recovery value of mortgages over commercial and industrial portfolios, the sectoral shift would normally augur well for asset quality. As the housing market is beginning to cool, however, concerns are growing that payment resets on ARMs and nontraditional mortgages could shock many marginal households (Box 2).

LCBG Sensitivity to a Real Estate Shock: A Material Issue?

Although housing and commercial real estate (CRE) markets are expected to cool in a gradual and orderly manner, a more abrupt adjustment with potentially adverse impact on the banking system remains a concern.1 Despite the mitigating and complicating factors already identified, a simple analysis of LCBG balance sheets helps provide an order of magnitude on the potential costs.

Sensitivity analysis on the LCBGs as a group suggests real estate-related credit risk could materially dent profitability, but not capital. The exercise, which focused on retained loan books, setting aside MBS portfolios, sought to isolate the impact of a deterioration in the credit quality of 1–4 family residential and CRE loans while keeping loan loss allowances constant relative to noncurrent loans. Delinquency and net charge off rates for 2006–08 were increased to their highest recorded values since 1990.2 Relative to a benign baseline projection, the stress scenario indicated declines of about 8 percent (1 percentage point) for the average capital adequacy ratio for 2006–08; 42 percent (½ percentage point) for returns on assets (ROA); and 38 percent (5½ percentage points) for returns on equity. In sum, aggregate capital remained above regulatory floors, although aggregate profits fell by a large margin.

uA05fig01

Capital Adequacy Ratio: Sensitivity Analysis

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Sources: Federal Reserve Board; and Fund staff calculations.
uA05fig02

Profitability: Sensitivity Analysis

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Sources: Federal Reserve Board; and Fund staff calculations.
1 CRE loans, in contrast to mortgages, have experienced fairly severe credit problems in the past, and CRE concentrations have reportedly increased at many small and midsize banks in the last five years.2 Delinquency rates on a 90-day basis, including nonaccrual loans, were conservatively marked up to the highest recorded values for the banking system as a whole on a 30-day basis. The baseline assumed that growth rates of total assets and gross loans, relative loan shares, and noncurrent loan ratios and net charge off rates would remain at their 2005 values through 2008.

10. In any event, record financial results may prove difficult to sustain. LCBGs outperformed the 100 largest banks worldwide, in terms of ROA, in 2005 (Figure 3). Real estate-related revenues contributed almost one-third of total gross income, supported by large trading gains at five LCBGs late in the year. Delinquency and net charge off rates fell to all-time lows, although an increasing ratio of loan-loss allowances to noncurrent loans suggested LCBGs were not expecting further improvements in credit quality (Figure 4). If faced with a material slowing of housing activity and related credit demand, and an uptick in foreclosures, LCBGs would be challenged to offset the revenue impact through increased lending to other sectors.

Figure 3.
Figure 3.

U.S. and Global Bank Profitability

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Sources: Bankscope; Federal Reserve Board; and Fund staff calculations.
Figure 4.
Figure 4.

U.S. and Global Bank Asset Quality

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Sources: Bankscope; Federal Reserve Board; and Fund staff calculations.

C. Market-Based Surveillance

11. With regulatory data not keeping pace with innovation, market-based surveillance has become an important complement to bank supervision. Informational lacunae are especially evident in the reporting of hedging and credit risk transfer activity.33 Banking agencies, therefore, maintain continuous supervisory contact with the largest institutions, including through the Large Complex Banking Organization Program and other protocols. Market participants, in turn, tend to build trading strategies around credit opinions from the rating agencies, which are uniquely positioned to assess a wide range of structured transactions. As part of its financial stability function, the Federal Reserve also monitors market-based indicators.34

12. The DD measure used in this paper suggests that LCBG financial soundness in 2004–05 was at its strongest level in a decade. The choice of an equity-based measure over one based on newer credit risk transfer markets facilitates analysis over a longer time frame, with a stronger accent on profit expectations than credit events.35 Calculated in its simplest form, the DD provides insights on soundness trends over time and across firms rather than precise probabilities of failure—particularly since fluctuations can sometimes be the result of shifts in investor attitudes toward risk, and less a consequence of actions by institutions under study. Results for individual LCBGs point to steady improvements in soundness in the period after the large corporate defaults of 2002.

13. An apparent increase in the risk diversification of LCBGs as a group is also observed, underscoring the potential value of system-level surveillance. The “system DD” for the portfolio of LCBGs, embedding all correlations across institutions, is observed to climb faster than the average of individual DDs, implying a reduced likelihood of a shock hitting all firms contemporaneously. The widening difference between the two indicators appears to reverse a ten-year trend, observed through 2003, that had suggested LCBGs were becoming increasingly exposed to common shocks.36 System DDs for the investment banking, insurance, and nonfinancial corporate sectors are also observed to improve.

14. The findings suggest no material differences in soundness among LCBGs based on their appetite for real estate exposure or emphasis on noninterest income (Figure 5). Separating LCBGs into two subsets, above and below the unweighted 2003–05 average ratio of real estate exposure to total assets, reveals a minor downtick in soundness at the former group in 2005, although the two subsets’ average DDs remained at similar levels. This appears to indicate that markets remained relatively sanguine about risk-return tradeoffs related to the real estate sector. A similar exercise based on the ratio of noninterest income to total gross income was also inconclusive, notwithstanding the narrowing of term premiums.

Figure 5.
Figure 5.

Distance to Default Indicators for the U.S. Financial System

Citation: IMF Staff Country Reports 2006, 278; 10.5089/9781451839654.002.A005

Sources: Datastream; Haver Analytics; and Fund staff calculations.

D. Regulation and Oversight

15. The foregoing analysis, while indicative of a banking system in good health, underscores the surveillance challenges spawned by innovation. After years of benign conditions, new market segments could be tested in the period ahead, especially if there is a “tail event” related to global imbalances. However, accounting data shed little light on growing risk transfer activity, while market prices cannot be assumed to perfectly reflect underlying risks. In practice, U.S. regulators have met the challenge by focusing on a few systemic institutions, with an emphasis on continuous supervisory contact, internal controls, counterparty risk management, and measures to ensure rapid clearing in critical market segments. Led by the Federal Reserve, they also monitor a host of market signals.

16. Functional divisions remain in evidence. With consolidation across business lines slowing, umbrella supervision has not taken on all the operational intensity anticipated under the Gramm–Leach–Bliley Act. This relates in part to the fact that synergies between banking and insurance businesses have proven elusive, as demonstrated by Citigroup divesting its insurance arm in 2005 in favor of an “open architecture” model that did not limit customers to proprietary insurance products. Similarly, leading investment banks have shown themselves reluctant to submit to umbrella oversight by the Federal Reserve, generally opting to acquire industrial loan companies over commercial banking subsidiaries. In most respects, U.S. financial supervision, therefore, remains highly decentralized.

17. Nevertheless, the regulatory system continues to adapt. Bank supervision is becoming more quantitative and risk-focused, with market studies playing an important supporting role. Implementation of Basel II should help improve the “granularity” of supervisory data, providing more transparency on the largest banks’ internal estimates of probabilities of default, losses given default, portfolio correlations, and value at risk. Moreover, housing GSE reform tops the Administration’s agenda, followed potentially by greater federal involvement in insurance regulation.

E. Conclusion

18. Financial soundness of LCBGs, as well as investment banks and insurers, is found to have improved in 2003–05. Distance-to-default measures are at multi-year highs, while weakening comovements of LCBG risk profiles point to diversification gains at a system level. Dividing LCBGs into real estate-focused and other, more diversified subsets, or by the share of noninterest income in total gross income, reveals no meaningful differences.

References

  • Cagan, C.L., 2006, “Mortgage Payment Reset: The Rumor and the Reality,” First America Real Estate Solutions. Available on the web at http://www.loanperformance.com/infocenter/whitepaper/FARES_resets_whitepaper_021406.pdf.

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  • De Nicoló, G., P. Hayward and A.V. Bhatia, 2004, “U.S. Large Complex Banking Groups: Business Strategies, Risks, and Surveillance Issues,” in United States—Selected Issues, IMF Country Report 04/228 (Washington: International Monetary Fund).

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  • Houston, J.F., and K.J. Stiroh, 2006, “Three Decades of Financial Sector Risk,” Federal Reserve Bank of New York Staff Report No. 248 (New York).

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  • Nelson, W., and R. Perli, 2005, “Selected Indicators of Financial Stability,” paper presented at the Irving Fisher Committee Workshop on Data Requirements for Analyzing the Stability and Vulnerability of Mature Financial System (Ottawa: Bank of Canada).

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29

Prepared by Ashok Vir Bhatia (MFD). Special thanks to Gianni De Nicoló (RES) for guidance and Marianne El-Khoury (MFD) for research assistance.

30

For methodology, see De Nicoló and others (2004). DDs are calculated through end-2005, and so do not capture the market turbulence in mid-2006.

31

At end-September 2005, the system consisted of 7,527 commercial banks and 2,288 BHCs. Some LCBGs own several hundred bank (and nonbank) subsidiaries. Data for the LCBGs cover only those institutions that were in existence at end-September 2005, with market data restricted to the 16 U.S.-listed LCBGs.

32

At end-September 2005, core deposits varied from 3–65 percent of liabilities and household sector exposure (including investments in MBSs) from 2–68 percent of assets, with a rank correlation coefficient of 0.44.

33

The regulatory data do not, for instance, separate derivatives dealing positions from proprietary hedges, or clarify whether interest and exchange rate contracts represent net long or short positions, or identify holdings of collateralized debt and mortgage obligations by tranche.

34

Nelson and Perli (2005) describe various indicators used by Federal Reserve staff, including risk-neutral probabilities of default based on credit default swap spreads and actual default probabilities of default based on Moody’s KMV’s “expected default frequencies”, which map calculated DDs to observed firm-level default data.

35

Indeed, “DD” may be a misnomer, given that it represents distance to insolvency rather than default.

36

In other words, banks were diversifying at the firm level while taking on similar exposures at the group level. Houston and Stiroh (2006), also basing their analysis on equity valuations, present evidence of a contemporaneous increase in systemic financial sector risk and decrease in idiosyncratic risk during 1995–2002.

United States: Selected Issues
Author: International Monetary Fund