“the year in review”/media/others/events/2011/capital... · “the year in review ... jpm ms us...

“The Year in Review” 17th Annual Capital Markets Conference

Federal Reserve Bank of Chicago

November 7, 2011

Kurt Wilhelm

Director Financial Markets Group

Office of the Comptroller of the Currency

(202) 874-4660

All quotes courtesy of Lawrence Peter "Yogi" Berra

2

What a Difference a Year Makes!

• Last year, although there were lingering problems from the financial crisis, we focused on the healing that had occurred in financial markets during 2010

• This year, those lingering problems have intensified, and some new problems/risks have emerged – Sovereign credit risk

– Absence of loan demand

– Weak economic growth in developed countries

– Foreclosure practices in the US

– Liability for reps and warrants

– Revenue pressures

– Stubbornly high unemployment and weak consumer confidence

• So, have we turned the corner, or is it “déjà vu all over again?”

Office of the Comptroller of the Currency

Parallels to the Financial Crisis

• Rising bank CDS spreads

• Low price/book ratios for banks

• Bank solvency concerns (Europe)

• Expanding central bank balance sheets

• Very low interest rates

• Broker/dealer failures

• Dollar funding difficulties

• CVA/DVA “noise” in trading results

• Depressed real estate markets

"Yeah, but we're making great time!" -- In reply to "Hey Yogi, I think we're lost."

0

200

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1400 1/2

/2007

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5-Y

EA

R C

DS

LE

VE

L

US BANKS 5-YEAR CDS 1/2007-PRESENT

BAC

C

GS

JPM

MS

US bank CDS spreads have increased sharply,

notwithstanding much higher capital and stabilizing earnings.

Is this the “memory trade?”

0.000

100.000

200.000

300.000

400.000

500.000

600.000

5-Y

EA

R C

DS

LE

VE

LS

EUROPEAN BANKS 5-YEAR CDS

10/2007 - PRESENT

Barclays

BNP

Credit Suisse

Deutsche

UniCredit

European bank CDS spreads have exceeded levels from

the crisis in 2008/2009. Euro banks are at the epicenter of

current global financial concerns.

-40.00%

-35.00%

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

1/4/2011 2/4/2011 3/4/2011 4/4/2011 5/4/2011 6/4/2011 7/4/2011 8/4/2011 9/4/2011 10/4/2011

YT

D R

ET

UR

NS

EQUITY INDICES YTD RETURNS

S&P

KBW Bank Index

FTSE 100

DAX

Nikkei

Hang Seng Even after a sharp rebound after the Greek debt resolution (?), US

bank stocks have performed far worse than the overall market. US

equity markets, however, have outperformed most global peers.

0

0.5

1

1.5

2

2.5

3

3.5 D

ate

2/7

/2007

3/1

5/2

007

4/2

0/2

007

5/2

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007

7/3

/2007

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007

10/1

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11/2

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007

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008

4/1

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008

10/1

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11/2

4/2

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12/3

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/2009

3/1

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4/1

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5/2

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8/5

/2009

9/1

0/2

009

10/1

6/2

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11/2

3/2

009

12/2

9/2

009

2/3

/2010

3/1

1/2

010

4/1

6/2

010

5/2

4/2

010

6/2

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010

8/4

/2010

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/2010

10/1

5/2

010

11/2

2/2

010

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/2011

3/1

0/2

011

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/2011

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/2011

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011

PR

ICE

TO

BO

OK

RA

TIO

US BANKS PRICE TO BOOK RATIOS

1/1/2007 to Present

BAC

C

GS

JPM

MS

Very low price/book ratios are an uncomfortable parallel

to the crisis in 2008/2009.

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0.5

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ate

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/2007

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/2009

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11/2

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/2010

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010

4/2

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/2010

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/2010

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010

9/2

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010

12/7

/2010

1/1

3/2

011

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1/2

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011

5/6

/2011

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1/2

011

8/2

9/2

011

10/5

/2011

Pri

ce t

o B

oo

k R

ati

o

EUROPEAN BANKS PRICE TO BOOK RATIOS 1/1/2007 to Present

BARCLAYS

BNP

CS

DB

UNICREDIT

Major Differences from the Crisis

• US banks in much better shape

– Earnings recovering

– Record levels of bank capital and liquidity

– Improving asset quality

• Euro-centric vs. US-centric

• Push for central clearing of derivatives to reduce

counterparty credit risk of derivatives

• Much stronger leveraged loan prices

"When you come to a fork in the road, take it."

10 Source: Reports of Condition and Income

Equity Capital to Total Assets

6%

7%

8%

9%

10%

11%

12%

Q1 1

996

Q3 1

996

Q1 1

997

Q3 1

997

Q1 1

998

Q3 1

998

Q1 1

999

Q3 1

999

Q1 2

000

Q3 2

000

Q1 2

001

Q3 2

001

Q1 2

002

Q3 2

002

Q1 2

003

Q3 2

003

Q1 2

004

Q3 2

004

Q1 2

005

Q3 2

005

Q1 2

006

Q3 2

006

Q1 2

007

Q3 2

007

Q1 2

008

Q3 2

008

Q1 2

009

Q3 2

009

Q1 2

010

Q3 2

010

Q1 2

011

National Banks TA < $1B National Banks $1B < TA < $10B National Banks TA > $10B

Condition of the Banking System

11

-2

0

2

4

6

8

10

12

14

16

18

73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11*

12

Profitability still weak National banks and federal thrifts

Source: Integrated Banking Information System (OCC)

12 12

Return on equity

Percent

System

Assets under

$1 billion

* Data as of June 30, 2011 (annualized); all other data as of year-end. Thrift data not available (not included in chart) prior to 1984.

Recessions

2Q 1Q 2Q

2010 2011 2011

National Banks 7.1% 8.7% 7.8%

assets <$1 billion 3.9% 5.4% 6.0%

Federal Thrifts 5.7% 5.0% 6.7%

assets <$1 billion -0.2% 4.0% 5.5%

$ billions

1Q:10 2Q:10 1Q:11 2Q:11 1Q:10 2Q:10 1Q:11 2Q:11

Revenues

Net interest income 78.4 76.5 74.1 73.5 3.16 3.20 3.19 3.23

Noninterest income 46.5 44.5 43.5 43.2 1.35 1.41 1.37 1.34

Realized Sec. G/L 1.1 1.7 -0.5 0.1 .01 .03 .02 .05

Expenses

Provisioning 39.0 29.0 14.3 13.4 0.60 0.66 0.43 0.41

Noninterest expense 66.7 68.5 71.9 73.4 3.31 3.53 3.40 3.33

Income taxes 5.9 7.9 9.4 10.0 0.16 0.12 0.19 0.24

Net income 14.2 17.0 21.4 19.9* 0.52 0.35 0.55 0.64

13


System Assets <$1 billion

Data are merger-adjusted and held constant for institutions in continuous operation from 1Q:06 to 2Q:11. * BAC 2Q:11 settlement costs mostly reflected in non-bank mortgage subsidiary of holding company.

Revenue and expense trends remain drag on system earnings; quarterly provisions stabilizing National banks and federal thrifts

*NOTE: BAC combined OCC charters reported 2Q:11 net income of $3.5 billion, but Y9C HC showed a net loss of $8.8 billion

15

20

25

30

35

40

45

50

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11*

Noninterest income

% of net operating revenue

Erosion of noninterest income has contributed to pressure on earnings at big and small lenders National banks and federal thrifts

Non-specialty with

assets <$1 billion


*2011 data as of June. Net operating revenue = net interest income + noninterest income

14

Assets >$1 billion

Dodd-Frank provisions, such as restrictions on fees and the Volcker Rule, will

create significant headwinds against growth in non-interest income. Trading revenues

have been especially strong in 2009, 2010 and the first half of 2011.

Asset Quality

15

Asset Quality Continues to Improve

• Delinquencies and charge-offs continue to decline, but

remain elevated for some loan classes

• Improving credit quality driving lower provision expense

• SNC exam showed continued improvement in classified

and criticized levels

“If you don't know where you are going, you will wind up somewhere else."

Commercial loan performance

National banks. C&I, CRE, loans to depositories, government, agricultural, and all other commercial loans and leases.

Source: Consolidated Reports of Condition and Income

5.9%

2.0%

4.8%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

$0

$500

$1,000

$1,500

$2,000

$2,500

4Q01 2Q02 4Q02 2Q03 4Q03 2Q04 4Q04 2Q05 4Q05 2Q06 4Q06 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09 2Q10 4Q10 2Q11

$ Billions Loans (Bn$) 30+ DPD Rolling 4Q Net Losses NPLs

0

2

4

6

8

10

12

14

06 07 08 09 10 11

18

Noncurrent loans, Percent

18

Noncurrents continue to improve; mortgage loans and small lenders still lagging National banks and federal thrifts


18

Data are merger-adjusted and held constant for institutions in continuous operation from 1Q:06 to 2Q:11.

RES RE

C&I

Consumer

Nonres

RE

Assets >$1 billion Assets <$1 billion

Construction Peak 2Q:11

Assets > $1 B 18.5% (1Q:10) 15.5%

Assets < $1 B 12.7% (3Q:10) 11.8%

0

2

4

6

8

10

12

14

06 07 08 09 10 11

0

2

4

6

8

10

122Q:09

2Q:10

2Q:11

19 19 19 19

Net charge-off rates, percent annualized

Total Construct Nonres mortg

C & I Installment 1-4 fam HELOC Credit card

System charge-off rates down from year-ago

levels but still high; RES RE decline lags National banks and federal thrifts

Post-2007 quarterly peak


Net charge-offs as a percent of loans in respective category. Not all detail loan categories are shown.

Long-term avg

Historical peak

3Q:92

Current share of loans*: 2 18 10 12 9 24 9

20

2011 SNC Summary

Criticized and classified commitments and percentages continue

to decline but are still at historically high levels.

0%

5%

10%

15%

20%

25%

$0

$100

$200

$300

$400

$500

$600

$700

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

$ B

illi

on

s

Special Mention Classified Percent Criticized

Commercial Real Estate

21

CRE Improving but Challenges Remain

• Delinquencies and losses improving

• Construction & development remain problematic for

some banks

• Concentrations down, but remain worrisome for some

small banks

• Slower economic growth likely means slower

improvement in vacancy rates

“You can observe a lot just by watching.”

0

2

4

6

8

10

12

14

16

18

20

22

2009 2010 2011* 2009 2010 2011*

23

Sources: Reports of Condition and Income Note: 2011* data as of 2011Q2. Commercial mortgage includes multi-family mortgages.

0

1

2

3

4

5

6

2009 2010 2011* 2009 2010 2011*

National banks over $1 billion

Commercial mortgage noncurrent rate (%)

National banks under $1 billion

Construction noncurrent rate (%)

National banks over $1 billion

National banks under $1 billion

CRE Delinquencies Declining, but Remain High

24

-1

0

1

2

3

4

5

91 93 95 97 99 01 03 05 07 09 11*


Assets >$10 billion

Assets <$1 billion

* 2011 data as of June 30, 2011 (year-to-date annualized): all other data as of year-end. Commercial real estate includes nonresidential, multifamily and construction.

Assets $1-$10 billion

Net charge-offs, percent

CRE Charge-off Rates Continue to Decline

137%

146%

48%

25%

75%

125%

175%

225%

275%

< $1 Bn

$1 - $10 Bn

> $10 Bn


CRE Concentrations Remain Elevated for

National Banks with Assets < $10B

5.0

7.5

10.0

12.5

15.0

17.5

20.0

01 02 03 04 05 06 07 08 09 10 11 12F

Down-shift in economic forecast implies slower improvement in CRE vacancy rates

Forecast

Source: Property & Portfolio Research; 2011Q2 original baseline and sluggish recovery forecast

Office

Warehouse

Retail

Apartment

National vacancy rates, %

Residential Mortgage Risk

27

Residential RE Slow to Recover

• Residential mortgages lag behind other loan

types in credit improvement

• Record-high levels of foreclosure still weigh on

the market

• Mortgage resolution costs continue to build – Contingent liabilities for mortgage settlements a big unknown; could be

one year of earnings

• GSE put-backs

• Robo-signing

• Reps/warrants on private label deals

"We made too many wrong mistakes.”

0

1

2

3

4

5

6

7

8

9

10

06 07 08 09 10 11

29

Noncurrent loans (%)

29

Noncurrents continue to improve, mortgage loans still lagging

29

RES RE

C&I

Consumer

Commercial RE

Sources: IBIS (Call Report) Note: Data are merger adjusted and population is held constant.

National banks and federal thrifts

Distressed properties still loom over housing market

1-4 family mortgage loans (# millions, SA)

0

1

2

3

4

5

6

7

06 07 08 09 10 11

30+ days delinquent, but not in foreclosure

In foreclosure

Source: Mortgage Bankers Association

Interest Rate & Liquidity Risks

31

32

Sources: Bloomberg

Treasury yields at historic lows

Interest

yield (%) 10 to 2 year

UST Spread

Median 0.81

Peak 3.18

Current 1.77

Treasury yield curve estimates, coupon equivalent par-yields.

Updated as of October 31, 2011.

0

2

4

6

8

10

12

14

16

18

UST 2 Year

UST 10 Year

Sovereign 10 Year Yields Interest

yield (%)

0

2

4

6

8

10

12

14

Germany

France

Japan

UK

Sources: Bloomberg

Updated as of October 31, 2011.

0

2

4

6

8

10

12

14

16

Jan

2010

Apr

2010

Jul

2010

Oct

2010

Jan

2011

Apr

2011

Jul

2011

50%

60%

70%

80%

90%

85 90 95 00 05 08 11

Deposits Share of liabilities

4Q:08

Deposits

Yr-yr % change

34 34

Large commercial banks

Source: Federal Reserve weekly H.8 data (domestically chartered institutions)

34

Small commercial

banks

Weekly data as of Wednesdays. Large domestically chartered commercial banks are defined as the top 25 domestically chartered commercial banks, ranked by domestic assets in most recently available Call Report. All others are placed in sample for small domestically chartered commercial banks. Data are adjusted to remove the estimated effects of mergers and panel shifts between these two groups.

Weekly data through Aug 31ST, 2011

Large banks have seen further surge in deposits since June Commercial banks

0

5

10

15

20

25

30

35

90 93 96 99 02 05 08 11

0

5

10

15

20

25

30

35

84 87 90 93 96 99 02 05 08 11

35

Cash and U.S. govt. securities, % of assets

35

Liquid asset share is already at historically high levels at largest banks and thrifts National bank and federal thrifts

<$1 billion


>$10 billion

35

$1-10 billion

National banks Federal thrifts

NOTE: cash data for thrifts not comparable prior to 1990

Data are for combined charters where holding company present. Mixed holding company underlying charters are assigned to either bank or thrift group based on majority of assets.

0

1

2

3

4

5

6

06 07 08 09 10 11 Latest*

0

1

2

3

4

5

6

06 07 08 09 10 11

36

US Treasury yields

Percent

36

Decline in safe asset yields and flatter yield curve further pressure margins National banks and federal thrifts

5-year Treasury


2-year Treasury

Average funding cost

% of interest-bearing liabilities

36

* UST yields as of 9/14/2011. Bank/thrift data are merger-adjusted and held constant

for institutions in continuous operation from 1Q:06 to 2Q:11.

Banks/thrifts with

assets <$1 billion

Banks/thrifts with

assets >$1 billion

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Q1 2008

Q2 2008

Q3 2008

Q4 2008

Q1 2009

Q2 2009

Q3 2009

Q4 2009

Q1 2010

Q2 2010

Q3 2010

Q4 2010

Q1 2011

Q2 2011

U.S. Treasury Securities U.S. Government Agency Securities Municipal Securities MBS Securities (Agency) MBS Securities (PLMBS) Asset-Backed Securities Other Debt Securities Investments in MF & OTH Equity Securities

Source: Reports of Condition and Income

Excess Liquidity Feeds Growth in

Investment Securities Centered in MBS

European Sovereign Debt Crisis

38

• U.S. banks and BHCs report cross-border exposures

via form FFIEC 009, which feeds the widely-cited BIS cross-border banking statistics •FFIEC 009 data show that “Guarantees extended” is the major component of country exposure • CDS protection sold is the dominant component of guarantees extended • “Foreign claims” includes loans, securities, repo activity, etc. • Peripheral exposures are a very small part of total country exposures

“Half the lies they tell about me aren’t true.”

• Credit exposure from bank submissions is

less than 10% of CE from the 009 data

• Major differences are treatment of credit

derivatives, repurchase agreements and

securities trading

• Our measure of bank risk considers

hedging, CVA and short positions in securities

•Some banks are net “short” in various

countries

•Peripheral exposure manageable with Italy

and Spain a modest concern

Regulatory Reform

41

Dodd-Frank Act – Key Provisions for OCC

• Volcker Rule

• OTC Margin Rules

• Systemically Important Financial Institutions

• Securitization

• CFPB

• Orderly liquidation authority

• Heightened prudential standards

• Financial Stability Oversight Commission

• Removing Use of Credit Ratings in Regulations

Office of the Comptroller of the Currency 42 “It gets late early out there.”

Volcker Rule

• Bans proprietary trading

• Statute provides regulators significant flexibility

• Banks have already shut down “pure prop trading” desks – Separate unit

– No client contact

– Covered by “the street”

– Price takers, not price makers

• Many exemptions – weakens scope of the rule

• Key area of focus is degree to which prop trading activities are buried within permitted market making function

43 Office of the Comptroller of the Currency

"It was impossible to get a conversation going; everybody was talking too much."

Swap Margin Rules

• US prudential supervisors proposed swap

margin rules that fundamentally change current

business practice for dealers

– Initial margin required, segregated at independent

third parties

• Potentially significant liquidity impact

– Proposed application creates competitiveness issues

due to extraterritoriality concerns

"A nickel isn't worth a dime today."

Emerging Risks

CDS Effectiveness

• Most major banks use credit default swaps to hedge

their “tall tree” credit exposures

• Greek “voluntary” debt exchange will not constitute a

credit event, so no CDS payout

• If politicians can invalidate CDS protection, what is the

value of CDS?

• Are bank exposures correctly stated?

"Nobody goes there anymore; it's too crowded."

Transfers from AFS to HTM

• A number of banks have made large transfers from AFS portfolios to HTM

– Basel capital rules will require OTI to be part of regulatory capital

• Absence of loan demand has led to large purchases of negatively convex MBS, at the lowest yields ever

• Rates have been low for a long time

• Central bank policy has encouraged maturity extensions

• A contrarian might say we’re due for an unpleasant surprise

• Interest rate risk, usually a lower order risk for banks, is increasing sharply

“If you don’t know where you’re going, you might end up some place else.”

Alternative Termination Events

Valuation Adjustment (“ATEVA”)

• Also known as Replacement Valuation Adjustment, or “RVA”

• Banks are attempting to model RVA as an adjustment to the derivative MTM

•This is in addition to CVA and DVA

• CVA and DVA account for default probabilities

• RVA accounts for the impact of rating downgrades

•RVA arises from “Alternative Termination Events” (ATE) clause in ISDA-governed

confirmations

• Typically requested by counterparty as protection against a deterioration in the bank’s credit rating

• Allows counterparty to terminate a trade against a bank if the bank’s credit rating falls below a pre-defined

threshold

• Bank would be responsible for any replacement costs incurred by the counterparty upon the decision to

unwind

• Typically, the replacement costs would be the MTM plus transactions costs

•Transactions costs = bid/offer

•ATE clauses have always existed, but heightened awareness of counterparty risks are leading

banks to attempt to measure its value

"I didn't really say everything I said."

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