Guest Post: Hard Evidence: Bailed-Out Banks Take More Risk

Tyler Durden's picture

Submitted by Finance Addict

Hard Evidence: Bailed-Out Banks Take More Risk

Politicians, Treasury Secretaries, etc. would have you believe that “moral hazard” is something we should only worry about in the abstract, in the future, when they’ve moved on to another job. But now a study confirms with hard facts: moral hazard–it lives.

Researchers have asked for some time whether and how bailouts might affect banks’ risk-taking. Would they run wild, aware of the high likelihood of being bailed out again if they ran into trouble? Or would they ease off precisely because they’d now be assured of lower financing costs and long-term survival, and therefore would want to avoid doing anything that might cause regulators to take that valuable banking license away? More daring or more discipline?

Each of these camps had its underpinnings yet the question was a difficult one to study. Why? Because, generally speaking, the developed Western countries didn’t really do bank bail-outs. [Insert smirk here.]

But then came 2008 and its bailout-palooza. And so, thanks to hundreds of billions of taxpayer dollars and an alphabet-soup of bank welfare programs, this question can now benefit from the availability of real-life, empirical data. (Cloud, silver lining and all that.)


Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. You may recall that this became the centerpiece of TARP once Hank Paulson decided that the money would be better spent directly buying into the banks as opposed to overpaying them for dodgy asset-backed bonds. (Mind you, other parts of TARP were spent overpaying for dodgy asset-backed bonds.)

The CPP lasted a little more than a year and invested $205 billion of taxpayer funds into various qualifying institutions. Not every bank that filled out the 2-page application was successful in gaining access. Others were approved but ultimately decided not to take the funds (probably because of the attached restrictions on pay and on paying out dividends.) In the end, 707 financial institutions received the funds.

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand.

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find?

For mortgages the bailed-out banks increased their risk–

“after CPP capital infusions, program participants tilted their credit origination toward higher-risk loans by tightening credit standards for the relatively safer borrowers and slightly loosening them for riskier borrowers.”

–while at the same time ensuring that they didn’t trip off any alarms

“This pattern would be consistent with a strategy aimed at originating high-yield assets, while improving bank capitalization ratios, since the key capitalization ratios do not distinguish between prime and subprime mortgages.”

Likewise, for corporate loans

“the fraction of CPP recipients in loans to borrowers with lower credit ratings has increased after CPP compared to nonrecipients.”

Finally, not only did the CPP recipients buy more investment securities than non-bailout recipients, but also riskier ones at that!

“[T]he total weight of investment securities in bank assets increased by 5.3% after CPP relative to non-recipient banks. More importantly, the increase in the allocation to investment securities at CPP participants was primarily driven by higher allocations to riskier securities, which increased at CPP banks by 6.2% after CPP relative to nonrecipients.”

Looking specifically at CPP recipients vs. those who applied but were rejected from the program, the authors found that the average yield on the bailed-out banks portfolios increased by 9.4%!

“Overall, the analysis of banks’ investment portfolios suggests that CPP participants actively increased their risk exposure after being approved for federal capital. In particular, CPP recipients invested capital in riskier asset classes, tilted portfolios to higher-yielding securities, and engaged in more speculative trading, compared to nonrecipient banks with similar financial characteristics.”

Moving from this granular level to a bank-wide basis, the authors found that the CPP banks increased asset risk (using ROA & earnings volatility as proxies) while decreasing their leverage (perhaps because they knew that regulators would be keeping an eye on this metric in addition to the capitalization ratio.)

What does all this mean and how should this shape actions in the future?

The bail-out itself increased our chances of having the bail the banks out all over again. Moral hazard is no longer in the realm of the abstract. Further, my guess is that the bailed-out banks took on more risk so that they could earn enough to speed repayment of the aid and therefore escape the onerous strings attached. So perhaps the limits on executive compensations, dividends, etc. in a perverse way increased our chances of having to bail the banks out all over again.

Finally, as the data on the mortgages show, banks are very good at gaming the system to make the figures work in their favor. How on earth do we get around this? Capital requirements like those contemplated for SiFis now seem to me grossly inadequate. Perhaps the answer is a Tobin tax that would force banks to pre-fund their eventual bailouts. And I say eventual because I don’t believe for a second that Dodd-Frank will do anything to enable wind-downs–when the next crisis comes the TBTFs will likely be bailed out. And we can start the whole messy process all over again.

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PAPA ROACH's picture

That's it, I am starting a fucking bank!!

trav7777's picture

somebody actually expected contrition or shame from these motherfuckers?  WTF?  how the fuck did they ACT during the event itself???  Snotty, petulant, self-absorbed.

Until and unless these fucks start GOING TO JAIL, don't expect shit out of them.  They will take the money as their entitlement and lever it the fuck even more.

jdelano's picture

NO GO FOR L-PAP?!  WOW.  Central Banking Cartel losing control?!!!

cat-foodcafe's picture

They are all buying each other's garbage to keep the prices from collapsing.  All balance sheets are a joke at this point.  This is CDS-2 in action.  If you can't use your original CDS insurance, then just get some cash from Ben and buy the trash.

swissbene's picture

reminds me of modest mouse song 'bankrupt on selling':

so all of the businessers in their unlimited hell

where they sell and they buy and they buy and they sell

all their trash to each other but they're sick of it all

and they're bankrupt on selling

So Close's picture

When reality takes hold this will be true.

HelluvaEngineer's picture

Not today.  G-pap is about to resign again on TV.  Put on your BTFD rally hat.

disabledvet's picture

Watch you talkin 'bout Willis?

TheMerryPrankster's picture

Different strokes 4 different folks...

I now know why Goldman became a bank in the blink of an eye.

Clorox Cowboy's picture

The only solution has always been to break up big banks into many small banks, then put a cap (so un-American I realize) on how big, in % of total deposits, any institution can become.  Don't tell Romney, though...he'd have you brought up on murder charges for killing a person!

TheMerryPrankster's picture

You could limit banking by region or by state as it was when we had a stable economy.

DogSlime's picture

So perhaps the limits on executive compensations, dividends, etc. in a perverse way increased our chances of having to bail the banks out all over again.


Only if we're stupid enough to let the banks think that we will bail them out again.

Our leaders need to have the balls to stand up and say that the 2008 bailouts would be the last time that would ever happen...

...but our leaders are spineless and corrupt, so the elite know - KNOW!! that there's no end to the amount of hardship the little guy can be made to suffer at the altar of TBTF.

God help us all :(

IrritableBowels's picture

Glad I stayed in TVIX overnight. 

School's out due to inclimate weather....BEAR DAY

YesWeKahn's picture

Should let them fail the first place. A verbal education never works for a speeding driver, you have to fine them.

Crash N. Burn's picture

"Overall, the analysis of banks’ investment portfolios suggests that CPP participants actively increased their risk exposure after being approved for federal capital."

Well duh! If you walked into a casino and were presented 2 games. Game 1 is 2 to1 odds, game 2 is 20 to 1. If its your money you'd pick game 1 (better chance of winning). Banksters always pick game 2 because you pay for the losses. Posted this video in the blackrock thread explaining how limited liability and tax incentives created these volitiliy seeking 40 to 1 leveraged too big to fail parasites.

DormRoom's picture

The Moral Hazard Chain:  Savings & Loan Crisis > LongTerm Capital Management crisis > Asian Crisis > Real Estate Crisis > Sovereign Debt crisis.


You follow the node in the financial network.. Each crisis was absorbed by bigger nodes, until it reached Central Banks,  the IMF implodes, and the  institutions of the Bretton Wood system (IMF, World Bank, WTO flexible, exchange rates) are gone.


Once these pan-national institution fail, Western hegemony is over.


TheMerryPrankster's picture

all 3rd world citizens know power resides in the banks and in the armies. If the big bank fails (iMF etc) the armies remain.

YesWeKahn's picture

This time, I will be on the street and protest any tax payer robery.

topcallingtroll's picture

They took on more risk because leverage ratios were being watched and to try to repay sooner to get out from onerous scrutiny.

This is another good example of why regulations are ineffective.

Market discipline (allowing failure to fail) is the best approach to making sure banks are morw careful.

El Gordo's picture

So long as the TBTF's can continue to swap dead horses for dead cows, no sweat.  A rolling loan gathers no loss.

slaughterer's picture

Look, it's a bird, it's a plane, it's the EU rumour-du-jour!  Coming to an exchange near you!

Kickaha's picture

What are traders to do when there remains no wealth to be exchanged?

Obviously, you trade risk, instead.  There is plenty of that available these days.  You can just as readily skim some profits from those trades as you did when there was wealth to trade.

"Liquidity" aids this process.  Since fiat liquidity is worthless, being completely unbacked by any real wealth and given to you by the government via ZIRP, exchanging it for risk is a fair trade for both sides.

Picture a bunch of prop desk guys standing in an empty olympic size swimming pool, holding a cup of risk.  As they fill their cup by dealing in new securities designed to transfer risk, they get nervous and dump the risk into the pool.  The cup is then empty, and they breathe a sigh of relief.  Everybody else is doing the same.  This process repeats itself over and over agan, and after a while, they all look around and find that they are all up to their necks in risk.  That is where we are today.

But if somebody else can be found to bail out the pool and take some of that risk, its back to business as usual, since their is no wealth to trade, only risk.

SheepDog-One's picture

A Shiticane is swirling right off coast...big, greasy, dirty Cat 5 Shiticane.

monopoly's picture

Any one that buys a bank for more than a 2 hour trade is in a delusional state of mind. That makes 0 sense. No, I do not short them but never, ever trade them. Broken, lying, insolvent squids, all of them. And when I think of Mozillo I always get sick.

And look at our miners. DOW down 260 and most are green, we will not see Robot today. Maybe we break 1,800 later???

Josh Randall's picture

RobotBucketShopTrader will be in later with his analysis after the Trading day is over, so he can find out whom the winners were and then pretend they were his...stay tuned...

Seasmoke's picture

of course they do.......and why wouldnt they ?

xavi1951's picture

Bring back Glass-Steagall of 1932.  End the games.

SheepDog-One's picture

Problem with that is theyre WAY past the point of no return...change 1 law and all is fixed? the system MUST collapse....they designed it that way.

xavi1951's picture

I know what you are saying.  However, "designed" to collapse?  What I was implying was (after the crash) reinstate GS and lets see if it works now, like it did up until the repeal in 1999.  It would kill the squids.

SheepDog-One's picture

Something is going to snap here big time, like an overstressed crane cable....POP!...then its On like Donkey Kong. 

Food riots, gas station murder and mayhem, bank wars in the parking lots as people are shut out behind 2 inch thick bulletproof glass (Ive been doing installations myself localy) soon, REAL soon.

swissbene's picture

yeah it does not feel right.  full moon tomorrow.


on the bp glass: are you saying first hand knowledge of recent bank installations.  not clear if your own installations are separate.  if you do not mind clarifying it seems like a useful signal.

fajensen's picture

Some of "our boys" coming back from Kosovo should be able to stir up some RPG's at a reasonable price ... 

Calculated_Risk's picture

It's all fun and games when it's not YOUR money!

SheepDog-One's picture

I like the story on MF Global paying out their bonuses a couple hours before bankruptcy...burn the fucker to the ground...the whole damn thing!

tony bonn's picture

so science is catching up with common sense....nice work if you can get it...i suppose that these astute researchers will study the effects of prunes upon defecation and announce that there is a positive correlation....

TheMerryPrankster's picture

So you're sayin they know their shit?

bankonzhongguo's picture

I don't see a down side to being a bank or increasing risk.  In fact the only survival strategy is to become bigger and more irresponsible in order to get those bailouts and political protection.

Has any of these TBTF banks been hurt in all these years?  No. They prosper on the misery they cause.  They do it because they find joy in apprehending the World.

What happened to the whole 'Greek bond haircut' concept.  Gone.  Overnight, with the G-pap smoke and mirrors show.

You would be out on the street if you made bad decisions on risk.  Until one of these banks gets nationalized, its rank and file employees put in bread lines, the executives and directors publicly linked and identified and cut down like pigs in the street, the sovereign bonds surrendered back to the issuing countries and all the "debt" cancelled - nothing will change.

The odds of all that happening?  Less than zero.

Its going to be an interesting 2012.

SheepDog-One's picture

If you make it to 2012. Remember this what youre seeing is the planting of demolition charges, theyre almost done....Id suggest moving away from the blast zone because the count down has already started.

vegas's picture

Privatize gains, socialize risk. WTF is so hard to understand?

slewie the pi-rat's picture

"moral" banksters?  [insert guffaw here]

Let Them Fail, then Put Them In Jail   [BiCheZ]

if they turned everything to shit, do not acquit!

Shizzmoney's picture

Yet Representatives in Congress tell us to "DONT BLAME THE BANKS"

No wonder this country is one of the worst in the world in math skills.

bahaar's picture

Just as a monkey gives birth to a monkey and an oak tree gives birth to an oak tree...austerity gives birth to austerity and bail-out gives birth to bail-out...Duh.

Grand Supercycle's picture

DOW chart reveals very overextended price action and another Wile E Coyote scenario...