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Central Banker - Spring 2008

Central Banker - Spring 2008

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Published by: Federal Reserve Bank of St. Louis on Aug 13, 2010
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Spring 2008
News and Views for Eighth District Bankers
By Michelle Neely 
ter many years o strong prots and ew asset quality problems, EighthDistrict banks now ace a decidedly dierent banking environment as the economy slows and credit markets tighten. This more challengingbackdrop is refected in recent Call Report (Reports o Condition and Incomeor Insured Commercial Banks) measures o protability and asset quality,which have deteriorated over the past year. (See table on Page 4.)Return on average assets (ROA) at District banks ell in the ourthquarter and was down 17 basis points rom its level one year ago. ROAwas brought down by a alling net interest margin (NIM) and a risingloan loss provision (LLP) ratio.While the earnings trends are basically the same at U.S. peer banks(banks with assets o less than $15 billion), they remained more protable
District Banks Face Challenging Environment
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Greatly Strengthened BankingSystem Aided Economy
Fed Invites Banks To Explore Innovation
Payments Study:Checks Down, Not Out
Fed’s CommunicationStrategy: Loud and Clear?
Out for Comment
Subprime Crisis: Is There a Way Out?
continued on Page 4 
continued on Page 3By Yuliya Demyanyk
he recent turmoil in the sub-prime mortgage marketreverberated beyond theimmediacy o that collapsedmarket, creating dicul-ties or borrowers, lendersand securitizers o bothsubprime and primemortgages. Borrowers,the media and Congressare asking: What canbe done? Unortunately,that’s a question that doesnot yet have an answer.Economic research indi-cates that the 2007 crisis wasbrewing or six consecutive years beore it actually occurred.
 Between 2001 and 2007, the quality o subprime securitized mortgages deteriorated,and the susceptibility o the subprime mortgagemarket to economic shocks grew. A housing mar-ket slowdown—a big economic shock—stoppedmasking the true risky nature o subprime loansand triggered the crisis. Moreover, the crisis wasnot driven by rate resets and was notconned only to adjustable-ratemortgages (ARMs). Fixed-ratemortgages contributed to thecrisis, as well.With the subprimemortgage market disap-pearing, another ominousword has started takingthe place o subprimein the popular media:oreclosure. The EighthDistrict, like the rest o thenation, is acing a massivewave o subprime mortgagedelinquencies and oreclosures.In Illinois, or example, almost60,000 households entered oreclo-sure between Sept. 30, 2006, and Sept.30, 2007. In Missouri, about 27,000 oreclo-sures were initiated during the same time period.
Greatly Strengthened Banking SystemAided Economy Since Early 1990s
By Bill Poole, president of the Federal Reserve Bank of St. Louis
This is the last Feditorial by Bill Poole, who retires from the Fed March 31.
etween the end o the brie 1990-91 reces-sion and the ourth quarter o 2007, a spano 67 quarters, the U.S. economy experi-enced only three quarters o decline in real grossdomestic product (GDP). The down quarters wereewer than 5 percent o the total. During the prior 44 years, 19 percent o the quarters (33 out o 176)saw a decline in real GDP. No wonder we call theperiod since 1991 the Great Moderation.The general agreement is that during the GreatModeration, improved inventory managementamong businesses and better Fed monetary policyprobably played some role. Some observers believewe also have been lucky because we haven’t acedeconomic shocks like those o the 1970s, includingoil embargoes and grain harvest ailures.My view is that good luck fows rom good policy.The U.S. economy
aced serious nancial andeconomic shocks in recent years, but despite themhas been more stable than in the past. Consider some o the shocks: emerging-market debt crises in1994 (Mexico) and 1997-98 (Asia); nancial marketturbulence when short-term interest rates rose sharply(1994-95) and when the large hedge und Long-TermCapital Management imploded (1998); and, o course,the terrorist attacks o Sept. 11. The bursting o thehigh-tech stock-market bubble (2000-02) causedripple eects throughout the economy and nancialmarkets. Since late 2001, the oil price has quintupledto nearly $100 per barrel. Other commodity pricesalso have risen strongly in recent years. The dollar hasbeen volatile. And, today, we are acing a potentiallyhistoric correction in the housing market at the sametime that credit markets are experiencing unusualstrains rom deaults on subprime mortgages.A notable aspect o the U.S. economy’s improvedperormance since the early 1990s, despite manyshocks, is a greatly strengthened banking system.As the nation’s central bank, we are keenly aware o the importance o strong depository institutions inwhich the public justiably can place its condence.It was not always so. Failures o banks and thritsaveraged 255 per year between 1982 and 1992—anaverage o more than 21 every
Many o thebanks and thrits that survived the 1980s and early1990s were under stress; the economic recovery romthe 1990-91 recession was hampered by a creditcrunch—reduced credit availability or marginal andeven some strong borrowers.The bank ailures themselves weeded out many o the unsound bankers and thrit managers who oper-ated during the 1980s. Those who remained under-stood that higher ratios o bank capital to assets wouldbe necessary to survive and prosper in the uture.New legislation and bank regulations reinorcedthis newound nancial discipline. Bank ailuresduring 1997-2007 averaged only our per year.Bank protability has been consistently strong sincethe early 1990s, encouraging hundreds o newbanks to begin operations. Bank-lending growthhas comortably exceeded and, thereore, supportedGDP growth or most o the past 15 years.There is no reason to expect that we will be anymore or less lucky than those who came beore.We should expect to ace our share o economicand nancial challenges. A strong, well-capitalizedbanking system subject to well-designed prudentialsupervision increases the economy’s resilience. Lowinfation rom sound monetary policy and soundbanking practices will go a long way in creatingthe good luck the economy needs.
Data on bank and thrit ailures are available at www2.dic.gov/hsob/SelectRpt.asp?EntryTyp=30.
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Fostering innovation in community development among banks and otherentities is the goal o the St. Louis Fed’s Exploring Innovation Week, April 14-18.The event stems rom last May’s Exploring Innovation conerence, whichconcentrated mainly on community development nance. The Bank’s Com-munity Development department is planning various activities throughout theDistrict, including speeches, resource airs and workshops on topics such asinnovation in housing nance and new ways to promote entrepreneurship.For more inormation, call these Fed sta:
Matthew Ashby, 314-444-8891
Amy Simpkins, 501-324-8268
Faith Weekly, 502-568-9216
Kathy Moore Cowan, 901-579-4103Visit www.exploringinnovation.org or more inormation.
Fed Invites Banks To Explore Innovation in Community Development
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Foreclosures have devastating personal con-sequences, but they are necessary. Withoutoreclosures—or more precisely, without thethreat o oreclosures—it would be impossible toenorce timely monthlymortgage pay-ments.Also,withoutoreclosure asan option, themortgage inter-est rate would bemuch higher. Bor-rowers would knowthat there is no pun-ishment or not makingpayments. Lenders wouldsee this situation asan elevated risk o mortgage lendingand, to be compensated,would raise the mortgage interest rate.
Finding Solutions
Foreclosures are costly. However, renego-tiations o mortgage contracts are also costly.Securitization makes renegotiations betweena lender (or a servicer) and a borrower almostimpossible. The Bush administration has takensteps to ease renegotiations by proposing theAmerican Securitization Forum (ASF) rame-work to reeze mortgage rates or ve years or anumber o borrowers with subprime securitized2/28 and 3/27 hybrid ARMs.
The ASF proj-ects that approximately 1.2 million borrowerswould qualiy or the ast track loan modica-tions, but some private orecasters expect as ewas one-th o that number to benet.The government’s plan, however, doesn’t quiteget to the heart o the matter. Among securi-tized subprime ARMs originated in 2005 and2006, almost 20 percent were already seriouslydelinquent (past due more than 60 days) justone year ater origination—one to two yearsbeore the resets would have occurred. Theseloans will not qualiy or the ASF modicationsbecause they are already seriously delinquent.Most importantly, modications will not solvethe problems because they were not caused byresetting rates.The government’s plan helps illustrate how thedepth o the current crisis is yet to be realized.Still, policymakers are analyzing and searchingor an ultimate solution to the persisting sub-prime mess.To ease the problems with outstanding sub-prime loans, a dramatic restructuring o thesubprime mortgage market—especially the secu-ritized portion—is needed. As an example o asizable intervention, theederal government mayneed to provide a newtype o loan guarantee— similar to an FHA-type,but applicable to subprimeloans. This would letborrowers with subprimeloans (re)build equityin their homes. As amore radical proposal, aprogram similar to theone run by the HomeOwners’ Loan Corp.(HOLC) during theGreat Depressionmay help stabilize themarket. The HOLC renanced about 1 millionmortgages that were in deault. The program didnot require public nancing other than its initialcapitalization. Such a stabilization program—onethat would rst wipe out subprime debt and thenrecapitalize existing loans—would most likelybe more expensive today than in the 1930s and1940s because we are in very dierent economiccircumstances.These potential solutions would take time towork and are costly. In the meantime, modica-tions on a loan-by-loan basis, timely inormationto borrowers and mortgage counseling may helpmany borrowers postpone or avoid oreclosure.I lenders choose to write o some debt, it iscritical that money continues to move—in other words, lenders need to keep issuing new loans tobe able to absorb any current recapitalization inthe uture.The bottom line is that the mortgage marketmust not reeze up. To prevent the occurrenceo such a crisis in the uture, more nancialeducation or existing and new borrowers isneeded.
Yuliya Demyanyk is an economist at the Federal Reserve Bank o St. Louis.
 Yuliya Demyanyk and Otto Van Hemert, 2007, “Under-standing the Subprime Mortgage Crisis,” available at http://papers.ssrn.com/sol3/papers.cm?abstract_id=1020396.
See www.americansecuritization.com/uploadedFiles/Final-ASFStatementonStreamlinedServicingProcedures.pd.
continued rom Page 1

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