Organizational Stripping and Reassembly is Also Financial Engineering: Stockholder Value Can be Crea

1
Organizational Stripping and Reassembly is Also
Financial Engineering Stockholder Value Can be
Created by Overcoming Regulatory Burdens and
Charter LimitationsSIVs exemplify the
Re-Engineering of a Firms Corporate Structure
and/or Its Contracting Technology
Week 07-0910
2
TYPICAL STRUCTURE OF AN SIV
ASSETS
AAA tranche
Junior tranche
Z tranche
Hedges
3
Exercise

• According to Wikipedia, Structured Investment
  Vehicles (SIVs) are usually sponsored by either
  an investment company or a bank. SIVs describe
  themselves as credit arbitrage funds that make
  profits from the difference between short-term
  borrowing rates on commercial paper and long-term
  returns on corporate and mortgage-backed debt.
• SIVs show at least three tiers of liabilities a
  AAA-rated senior collateralized commercial-paper
  tranche a low-rated or unrated junior tranche
  and an equity or Z tranche. Typically, SIV
  assets are medium-term asset-backed securities
  whose maturity runs between 4 and 5 years.
  Assume that in February 2007 the ratio between
  the market value of The Eagle SIVs assets (A)
  and the value of its Z tranche (N) is 10 and the
  cost of equity is 15 percent. Suppose that the
  SIVs assets are 3.5-year bullet notes whose
  value is 100 million and whose yield is 5.5
  percent and that its liabilities consist of
  junior and senior tranches of single-payment,
  asset-backed commercial paper that mature in 6
  months.

4
Exercise

• Find the value of L/N, and the duration and pvbp
  of the SIVs equity tranche.
• L/N 9
• DN 10(3.5) 9(1/2)
• 35 4.5 30.5 years
• pvbp(N) -(30.5/1.15) (10m) (.0001)
  -26,521.73

5
Exercise

• (b) Is it reasonable to describe this firms
  strategy as arbitraging the yield curve? Please
  explain why or why not.
• No, it is not. Eagle is highly exposed to
  interest-rate risk and possibly to default risk
  as well. Leverage produces high returns on this
  strategy when interest rates are stable or
  falling. But when asset values decline, leverage
  works adversely and equity can be quickly
  exhausted.

6
Exercise

• Suppose, to hedge its exposure to interest-rate
  risk, Eagles managers use a single interest-rate
  swap whose pvbp in February 2007 is equal in
  value but opposite in sign to the pvbp of its
  equity position. Suppose further that 7 percent
  of Eagles assets deserve to be written off as
  uncollectable and that the interest rate on
  Eagles assets had increased by 50 basis points
  by the time Eagle had to roll over its
  liabilities in August 2007. Explain whether and
  how the SIVs losses on its assets might have
  blown through the hedge, ruined the ratings of
  its senior debt, and put pressure on its sponsor
  not to walk away.
• The assets are now 3-year bullet notes promising
  (.93)x120.61 million in 3 years. At the new
  yields, Eagles assets are worth only
• 112.17 mil./(1.06)-cubed 94.18 mil.
• If it were not for the hedge, the equity hedge
  would have lost more than half of its value. But
  the hedge is far from perfect. It did not cover
  default risk and such a large movement in asset
  yields makes probable differences in convexity
  between the swap and equity positions very
  important. Whenever insolvency exists or
  threatens, its sponsor would feel pressure to
  support the fund both for reputational reasons in
  a repeat business and because implicit or
  explicit recourse arrangements might force the
  assets and the losses imbedded in the Z position
  back onto the sponsors balance sheet.

7
MEGACEPTS AND MEGATHEMES

• 1. Differences in Ownership Structures alter
  owners responsibility for losses corporations,
  partnerships, sole proprietorships, holding
  companies.
• 2. Importance of Choosing the Right Charter
  Charter is a legal document authorizing specific
  rights and functions.
• a. Stock vs. Mutual vs. Partnership Form
• b. Alternative Charter Issuers State (which
  state?) vs. Federal vs. Foreign (which
  country?)
• c. Charter type Com. Bank vs. thrift vs.
  industrial loan co. vs. credit union vs.
  securities firm vs. Insurance Co., etc.
• 3. Regulators Compete for Jurisdiction This
  explains why U.S. fin. system is so messy. Leads
  to Loopholes and Regulatory Migration in response
  to differences in net regulatory benefits.
• 4. Managerial searches for Value-Creating Teamups
  and Consolidations Are Always in the Background.

8
Why Do FSFs Let Themselves Be Regulated?

• 1. Regulatory services can produce benefits for
  society and private benefits for regulatees.
• 2. But who watches the watchdogs? Layers of
  conflict of interest exist for regulators These
  result in either partial or total regulatory
  capture.
• 3. Etymology REGULA (latin for rules)
  Distinction between rulemaking and enforcement.
  Example of Montana enforcement of 55 mph limit.
  
• a. Different rewards accrue to rule-breakers
  and to those who conform.
• b. Enforcement uses both carrots and sticks.
• 4. Metaphor FSF safety regulations share
  entailments with traffic safety.
• a. stop signs (e.g., CD orders)
• b. speed limits (caps on activities)
• c. one-way street restrictions (exclusionary
  rules)
• d. radar guns vs. radar detectors (resistance
  to transparency)
• e. traffic courts (due-process guarantees)
• f. Risk-rated insurance premiums
• 5. Different Incentives for Private vs.
  Government Regulators Self-Regulatory
  Organizations.
• 6. Role of Regulatory Culture.

9
Definition of Financial Regulation

• Purposeful efforts to monitor, discipline, and
  coordinate the behavior of individual firms in
  the financial-services industry to generate
  social and private value by promoting specific
  macroeconomic and microeconomic goals.
• Microeconomically, the socially approved purposes
  are to increase FSF-customer confidence and
  convenience. A socially unpopular purpose is to
  insulate banks from competition to some degree.
• Overtly, regulators seek financial-stability
  missions, but covertly also seek jurisdiction and
  prestige.
• Internationally, regulators help their regulatees
  compete more effectively against differently
  regulated foreign and domestic firms.

10
Regulatory Competition

• Regulators compete whenever their jurisdictions
  overlap or when they proffer chartering
  relationships that differently chartered FSFs
  may choose among. In negotiating a contract
  with a government regulation supplier, exchanges
  of value take place as repeat business in markets
  for political and bureaucratic services that are
  imperfectly competitive and dysfunctional in the
  discipline they generate.
• Why and how dysfunctional? -- Regulatory agencies
  resist their exit even when exit might be
  efficient. Top regulators are made to pay a
  price if they weaken their clientele often they
  become cheerleaders and seek post-government
  careers in the regulated industry.
• Promontory is a shining example of
  loophole-exploiting postgovernment career
  opportunities. Top managers are an ex-Comptroller
  of the Currency and an ex-Fed Governor.

11
Six Elements Define a Regulatory Culture and Vary
Across Jurisdictions

• -- Legal Authority and Reporting Obligations
• - Formulation and Promulgation of Specific Rules
• -- Technology Used to Monitor for Violations and
  Compliance
• -- Penalties for Proven and Material Violations
• -- Duties of Client Consultation and
  Administrative Due Process, with Assigned Burdens
  of Proof (to Guarantee Fairness)
• - Right to Invoke Outside Judicial Review
  Appeals Procedures (to bond the fairness
  guarantee)

12
Avoiding vs. Evading Rules

• Legalistic elements imbedded in a countrys
  regulatory culture both empower and limit
  avoidance.
• We may illustrate this by drawing an analogy to
  filling out ones tax return optimally. Avoidance
  activities and their control are restrained by
  TAX LAW (which specifies rules and penalties) TAX
  AUDITS (monitoring), INTEREST AND OTHER PENALTIES
  (imposed by auditors), ADMINISTRATIVE APPEAL
  RIGHTS (within the IRS), TAX COURT (which exists
  to handle first stages of outside appeals).
• Evasion is illegal avoidance of burdens of rules.
  Distinction between avoidance and evasion is
  jesuitical. It turns on whether the letter of the
  law is obeyed while its spirit is broken and on
  the size and likelihood of penalties imposed on
  violators.

13
THE HOLDING COMPANY (HC) AS AN AVOIDANCE
PLATFORM

• Definition of an HC A corporation that owns
  enough of at least one other corporation to
  control it. May even be a shell corporation
  that does no other business. A shell is a hard
  outer case or covering. A shell corporation
  serves only to layer or mask a corporations
  ownership.
• 1. Every HC must have at least one subsidiary
  corporation (sub), but it may have many.
• 2. Queries What is a holding-company
  subsidiary? an affiliate? a consolidated income
  statement or balance sheet? (Be sure that you can
  show the difference on an Organization Chart.)
• 3. Metaphoric use is made of language of the
  human family parents, progeny, siblings. CARTOON
  scolding of a subs board members by CEO.
• 4. What is meant by upstreaming and
  downstreaming funds within a HC? What would
  sidestreaming describe?

14
What is a bank holding company (BHC)?

• - A corporation that owns a bank as the
  quoted terms are defined in the BHC Act of 1956,
  as subsequently amended. BHCs are usually named
  after their leading bank sub. e.g., Banc One
  differed from Bank One.
• - Subject to Evolving Affiliation and Ownership
  Restrictions. BHC and SL HC (SLHC) regulations
  differently restrict the affiliations that are
  allowed within the HC. Statutes also constrain
  what type of corporations may own or sponsor
  various types of chartered FSFs.
• - Provided a circumventive platform through
  which banking industry could test the limits of
  geographic, capital, product-line, and ownership
  restrictions piecemeal on many fronts.

15
Financial-Engineering Origin of BHC Form

• Initially used mainly to disguise ownership or to
  save taxes.
• Became even more important as a way for bank
  owners to transform an FSFs offices and
  divisions into separate corporations with
  separate charters.
• This kind of transformation can favorably affect
  FSF profit generators and profit killers.

16
It is Instructive to Compare a BHC With Each of
the Following

• 1. A bank with nonbank subsidiaries. BHC is
  usually not itself a bank. (A national bank may
  not itself even be a BHC, but some states do
  permit the banks that they charter to become a
  BHC.
• 2. A financial-services mall in which a
  commercial bank, brokerage firm, insurance
  company, SL, leasing-company, and sales-finance
  company have offices located around a central
  parking lot. Sources of difference
• - common vs. diverse ownership? Idea of
  minority interests.
• - presumption of back-office links?
• - extent of common marketing and employee
  interchange?
• - Do components have to be located in a single
  geographic neighborhood?
• 3. A Japanese or European financial
  conglomerate in which individual firms own each
  other (cross-shareholding with no parent
  corporation).
• 4. A European universal bank.

17
What is a One-Bank BHC (OBHC)?

• 1. How might an OBHC not be a single-subsidiary
  BHC?
• 2. How many different kinds of affiliates can an
  OBHC have? Many kinds. BHC Act largely allows the
  Federal Reserve Board to determine this. A
  secular expansion of laundry list driven by
  Regulatory Competition led to Gramm-Leach-Blilely
  Act of 1999.
• 3. Why were OBHCs more common before 1970 than
  afterwards?

18
What is a Nonbank BHC Subsidiary?

• Any sub that is not a bank by the definitions of
  the BHC Act e.g., a monoline credit-card bank.
• 1. How does it differ from a subsidiary of a
  bank?
• 2. Illustration of where subs metaphorically
  hang on the following chart

BHC Parent Corp.
Domestic Foreign NonBank Nonsecurities Subs
Bank Sub 1
Bank Sub 2
Subs operating subs - service corporation -
mortgage banking sub
Foreign Banks or Foreign Securities Subs
19
Multibank Holding Company (MHBHC) With a Lead
Bank vs. Multi-Office Banking

• A branch office is a direct and integral
  extension of the corporation of which it is a
  part organization would have one charter and a
  consolidated balance sheet.
• A multibank holding company differs in several
  dimensions from a bank that puts branch offices
  in exactly the same locations and premises as the
  MBHC puts its subs.
• Which of the following items in the sub might be
  separated from or consolidated into the HC?
• a. in management structure separate officers
  boards
• b. in balance sheet sub net worth passes
  through via stock
• c. in income statements key role played by
  dividends from bank(s)
• d. in deposit-insurance coverage (per account
  name branches foreign subs)
• e. in regulatory relationships
• 1) parent regulated by Fed
• 2) bank sub regulated by chartering authority
• 3) special treatment of state-chartered member
  banks
• 4) source-of-strength doctrine (slide 19).
• f. in transferability of ownership branches
  cannot offer stock, but can be sold as
  units.
• g. in managerial authority or independence FRB
  rules limit when an official may work for
  two different banks
• h. in taxation (especially for foreign subs)

20
Legislative Chronology of Changes in Federal
Reserve Responsibilities in BHC Regulation and
Reregulation

• 1. BHC Act of 1956 OBHC exemption (Douglas
  Amendment)
• 2. BHC Amendments of 1970 Closed OBHC loophole
  and established BHC bank definition
• 3. CEBA of 1987 Amended 1970 amendments.
  Importantly Revised BHC bank definition
• 4. FIRREA of 1989 Instituted cross-guarantees
  among affiliated banks.
• 5. FDICIA of 1991 Strengthened regulators
  rights to demand that capital be injected from
  parent BHC.
• 6. GLBA of 1999 Authorized reciprocal entry of
  banks, securities firms, and inscos into one
  anothers signature businesses.
• 7. Law-Making Role of the Courts Key rules are
  always challenged and litigated. Courts sometimes
  resist and sometimes legitimize
  cross-jurisdictional forays by regulatees.
• .

21
In the Past, BHC Subsidiaries Served to
Circumvent Limitations On

• 1. Where a bank might locate a branch office
  (say, across Massachusetts counties or across
  state lines)? Leapfrog Loophole 30-mile moves of
  headquarters after a merger represented a
  loophole for national banks and later for state
  banks in a few states.
• 2. What activities a bank may undertake? ANS.
  Parent can deliver bank-restricted financial
  services from a nonbank sub that it operates as
  an affiliate of the bank.
• 3. Restrictions on bank mergers? (How does an HC
  acquisition differ legally from a merger? ANS.
  Purchase of controlling position in stock vs.
  complete consolidation of both firms accounts).

22
DOUBLE-LEVERAGING

• 1. Capital requirements initially focused only on
  how much capital a bank had to hold to support
  its risk-taking.
• 2. The following balance sheets illustrate the
  concept of consolidated leverage
• Bank
• Assets 100 Deposits 80
• Owners Equity 20
• OBHC (parent)
• Assets (Bank Stock) 20 BHC Debt 19
• BHC Stock 1
• - The banks leverage A/E is only 5 to 1, but
  the consolidated leverage of the bank and
  its parent is 100 to 1. Try to construct the
  consolidated balance sheet. What terms cancel
  out?
• 3. What market and regulatory reactions serve to
  limit such double-leveraging?
• 1) Market requirement for sizeable
  interest-rate premiums on BHC debt when BHC
  leverage is high. Most BHCs have lower credit
  ratings than their lead banks.
• 2) FR regulation of consolidated entity Since
  1987, Fed has sought to enforce its twofold
  source-of-strength doctrine (1) that a BHC
  parent should infuse additional capital into
  any failing bank sub and (2) that a BHC could not
  selectively liquidate its weakest bank subs
  FRBs assertion insisted that affiliated banks
  cross-guarantee one another was eventually
  passed into law.

23
Instructive History Lesson How BHC Loopholes
Destroyed Longstanding Restrictions on Bank
Activities and Geographic Locations

• IBBEA of 1994 and GLBA of 1999 reduced need for
  circumvention
• Passage of this legislation resembled a pair of
  storms taking down a forest of hollowed-out
  trees Expansion of de jure powers followed prior
  de facto hollowing out of limits
• 1. Charter shifting state vs national
  charters thrift vs. bank charters mutual
  vs. stockholder form.
• 2. Insurance powers small-town exemption
  credit life annuities South Dakota
  loophole
• 3. Securities Powers Starting in 1987, not
  principally engaged loophole for Section
  20 securities affiliates, was widened by an
  expanding definition of principally
• 4. Leapfrog loophole for national-bank branches
• 5. OBHC and Unitary SL loopholes
• 6. Non-bank bank debanking
• 7. Nonbranch-office geographic extension e.g.,
  Loan- Production Offices
• 8. Shuffling bad loans across subs ahead of
  scheduled examiner visits (Butcher
  Banks)

24
MMEMONIC METAPHORS USEFUL IN UNDERSTANDING CASES

• Medieval City Walls Fences with Gates and
  Leapfrog Opportunities
• Laundry List
• Fig-Leaf Outsourcing
• Upstreaming and Downstreaming funds
• Spinning activities out of the bank
• Salami-slicing
• Speed limits De Jure vs. De Facto
• Grandfathering of privileges Underlying
  metaphor recalls exemption from literacy tests
  for voters that were introduced to exempt
  illiterate white people in the South. These rules
  allowed people to vote if their Grandfather
  could.

25
Why Change Control of a Bank or BHC?

• Benefits that might be pursued Substitute
  Forms of Dealmaking
• Correct Inefficiencies Joint Ventures
  Outsourcing
• Enhance Market Power Cartel Agreements
• Pursue Loophole Benefits Lobbying Building
  Clout Offering Bribes

26
ALTERNATIVE CONTRACTING STRUCTURES FOR
CONSOLIDATION

• Mergers (e.g., fold target into an existing bank
  sub) vs. Direct Acquisitions of Stock
• -- voluntary vs. supervisory
• -- hostile vs. friendly
• ? Terms
• -- pay by cash vs. swap of stock vs.
  mixed

27
Stanford Weills Assembly of Citigroup
28
Why is Consolidation Happening Now and Why at
Such a Rapid Pace?

• 1. Twofold push from (1) Too-big-to-fail and
  too-big-to-discipline adequately policy
  frameworks and (2) release of pressure against
  consolidations that past regulatory policies had
  damned up
• 2. Twofold pull from industrys prospects for a
  different and richer (1) national and global
  competitive environment and (2) technological
  future.

29
Industry Conditions of 1940s through 1970s are
Helping to Shape Current Events

• Regulation protected commercial banks from
  competition
• Geographic entry barriers (McFadden Act, state
  laws).
• Product-line entry barriers (Glass-Steagall Act,
  limited thrift powers).
• De novo entry slowed by FRBs application of
  convenience and needs tests.
• Deposit-rate ceilings (Regulation Q, but
  money-market mutual funds).
• Relatively stable population of between 13,000
  and 14,000 banks
• Most banks operating well below efficient scale.
• Bank mergers and new entry tightly regulated.

(with thanks to Robert DeYoung of FDIC)
30
Industry Conditions 1940s through 1970s

• Very stable demand for banking services,
  primarily due to the lack of substitute products
  and services.
• Physical bank offices were the main portal to a
  paper-based payments system.
• Banks were the primary source of investment
  products for households (savings accounts, time
  deposits, CDs).
• Banks were the primary source of business
  finance. Only the largest firms could access
  capital markets.
• Banks and thrifts were the main sources of
  consumer finance (auto loans, mortgages).

(with thanks to Robert DeYoung of FDIC)
31
Industry Conditions 1940s through 1970s

• Through the 1960s, little technological change or
  innovation
• Pre-computer, pre-internet, pre-cell phone.
• Pre-mutual fund, pre-money-market fund, pre-NOW
  account.
• Pre-junk bond, pre-NASDAQ.
• Banks held information advantages about most
  firms.
• Relatively stable market interest rates
• Bank financial performance was profitable and
  predictable
• 3-6-3 banking
• Failure unlikely Most large losses traced to
  fraud rather than to exposures to credit or
  interest-rate risk.

(with thanks to Robert DeYoung of FDIC)
32
Deregulation

• Deregulation was an endogenous response to
  economic conditions (volatile rates) and
  technological progress.
• Riegle-Neal Act (IBBEA of 1994) and prior state
  laws allowed geographic entry.
• Over 9,000 commercial bank mergers between 1980
  and 2001.
• 1980 14,078 community banks, with 33.4 of
  industry assets.
• 2001 7,631 community banks, with 16.0 of
  industry assets.
• 1986 28 of industry assets in ten largest
  BHCs.
• 2001 76 of industry assets in ten largest
  BHCs.
• Gramm-Leach-Bliley Act of 1994 and prior
  regulatory rulings directly exposed banking
  markets to nonbank competitors.
• Thrifts, credit unions, brokerages, insurance
  companies, investment banks.
• Repeal of Reg. Q authorized explicit price
  competition for deposits.

(with thanks to Robert DeYoung of FDIC)
33
Information and Financial Technology

• Payments
• Credit cards reduced consumer bank deposit
  balances.
• ATMs, Internet, debit cards reduced consumer
  reliance on paper-based payments and physical
  bank location.
• Hard information (credit scoring) transforms
  consumer credit into a commodity product.
• Mortgages in bank share of household debt in
  1983 11.6
• Mortgages in bank share of household debt in
  2001 38.0
• Mutual funds, online brokerage, and 401K plans
  reduce banks share of household investments.
• Household assets held in depositories in 1983
  22.7
• Household assets held in depositories in 2001
  10.3
• Businesses forgo bank loans for direct finance
  (high-yield bonds, commercial paper, IPOs).

(with thanks to Robert DeYoung of FDIC)
34
Increased FSF Competition

• Nonbank competition for investment products.
• Nonbank competition for business finance.
• Nonbank competition for consumer finance.
• Intensified competition required banks to become
  more efficient
• 27 FTEs per office in 1970............... 23 FTEs
  per office in 2001.
• 586,000 payments per office in 1987.............
  1,001,000 in 2001.

(with thanks to Robert DeYoung of FDIC)
35
A Strategic Map of the Banking Industry
hard INFORMATION
soft
high COSTS low
small SCALE large
Relationship banking Low-volume, high
value-added Personal service Interest income
Transactions banking High-volume, low
value-added Commodity products Fee income
standardized PRODUCTS
personalized
(with thanks to Robert DeYoung of FDIC)
36
Growing less alike Loans as of assets.
1991 100
(with thanks to Robert DeYoung of FDIC)
37
Different production technologies for large and
small banks

• Patterns of survival are consistent with cost
  studies of traditional banks, performed during
  the 1970s and 1980s.
• Substantial scale efficiencies up to about 500
  million.
• Studies using more recent data that sample larger
  sizes than existed before suggest that the
  largest banks have not yet reached efficient
  scale!
• Hughes, Lang, Mester, and Moon (2001).
• Rossi (1998) for mortgage banks (transactions
  banks).
• DeYoung (2005) for Internet banks (transactions
  banks).

(with thanks to Robert DeYoung of FDIC)
38
Market extension mergers

• Quickest way to exploit the scale economies
  available to transactions banks.
• Concentration in local markets is unaffected,
  but
• the business plan of acquired bank changes.
• competitive rivalry in the local market changes.
• External entry improves local bank efficiency
  (DeYoung, Hasan, and Kirchhoff 1998 Evanoff and
  Ors 2005).
• Outside entrants with brand images gain local
  market share more quickly (Berger and Dick 2004).
  
• De novo re-entry response of small banks when
  managerial jobs are extinguished by outside entry
  via acquisitions by large banks (Berger, et al
  1999, Keeton 2001)

(with thanks to Robert DeYoung of FDIC)
39
Sources of increased non-interest income

• Production or delivery of non-traditional banking
  services (insurance, brokerage, mutual funds,
  etc.).
• Production of traditional banking services
• New methods (e.g., electronic payments and
  banking).
• Expand existing products (e.g., back-up credit
  lines).
• New pricing schemes for traditional banking
  services
• Vertical unbundling of loan production (e.g.,
  origination, securitization, servicing) generates
  fees.
• Unbundled deposit pricing (concept?) generates
  fees.

(with thanks to Robert DeYoung of FDIC)
40
Advertising and Image Creation

• Large banks spend twice as much per dollar of
  output on advertising, relative to small banks.
• Little research on advertising at banks, but what
  exists suggests that depositories use advertising
  strategically.
• DeYoung and Ors (2005) examined advertising by
  thrifts
• For differentiable deposit products (e.g.,
  checking accounts), data suggests that thrifts
  use advertising of elements of implicit interest
  to reduce elasticity of demand.
• For commodity deposit products (e.g., CDs), data
  suggests that thrifts use advertising to
  communicate information.

(with thanks to Robert DeYoung of FDIC)
41
Creating Customer Switching Costs

• Transactions banks encourage customers to use
  direct deposit and direct payment services.
• (Have you tried to change banks recently?)
• Transactions banks differentiate themselves by
  packing the map with multiple, convenient
  delivery channels.
• Bank branches doubled, and ATMs tripled, since
  1990.
• Internet banking obviates geographic location.
• Convenience masquerades as personal service.
• Depositors appear willing to pay higher fees at
  convenient banks.
• FRB annual surveys support this.

(with thanks to Robert DeYoung of FDIC)
42
Precluding Entry

• The explosion in bank branches has been largely a
  strategic phenomenon
• Packing the map (product differentiation)
• Waving the flag (image differentiation)
• Toeholds and packing the map (preclude entry)
• Chicago provides an excellent example.

(with thanks to Robert DeYoung of FDIC)
43
Transactions banking and risk mitigation

• Pure size creates diversification opportunities
• Geographic
• Product lines
• Loan securitization separates and redistributes
  risks
• So does hedging in financial markets
• Interest rate derivatives
• Credit derivatives

(with thanks to Robert DeYoung of FDIC)
44
U.S. banking system is flush with capital
(with thanks to Robert DeYoung of FDIC)
45
Multiple drivers of increased capital

• Record earnings
• Fortunate macroeconomic conditions
• Freeing up of longtime regulatory constraints
• Innovation and Strategic Focus
• Globalization of large institutions
• Pressures to operate efficiently
• More banks publicly traded
• Market for corporate control
• Strong competition from nonbanks
• Improved regulation and supervision
• Basel I standards
• FDICIA and the specter of Prompt Corrective Action

(with thanks to Robert DeYoung of FDIC)
46
Minicases for Classroom Discussion

• 1. Wachovia-Golden West Deal
• a. how big?
• b. what kind of fit?
• -- geographically?
• -- product-line revenues and costs?
• -- charter issues?
• -- corporate culture?
• 2. Bank divestures of proprietary mutual funds
  and their purchase by large asset-management
  firms e.g., Amsouth Bancorp sold to Pioneer
  Investment Mgt. (July 2005)
• - comparative advantages in gathering assets
  vs. managing them
• - small size of most bank fund families.

47
More Minicases

• 3. Citigroups Decision (July 2006) to fold
  164B in assets at its San Francisco and Virginia
  Federal Saving Banks into its main National Bank
  charter.
• 4. Demutualizations Two-Step Conversions
• (a) of credit unions to mutual thrifts and
  thence to stockholder form
• (b) of mutual thrifts into federal mutual
  holding companies wholly owning a
  subsidiary stockholder bank followed by
  partial or full conversion of the mutual
  HC to stockholder ownership.

48

• Example People's of Conn. Takes Second Step
  From American BankerThursday, September 21,
  2006 By Laurie Kulikowski
• Ending months of market speculation, People's
  Bank of Bridgeport, Conn., said it plans to
  become a fully public company -- a move analysts
  said could raise as much as 3.4 billion.
  People's said Wednesday that it plans to convert
  to a public-stock savings and loan company. It
  took its first step toward doing so 18 years ago
  when it created People's Mutual Holdings, the
  mutual holding company that now owns 58 of the
  11 billion-asset banks shares Peoples stock
  rose by 6.9 Wednesday.

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• Cont.
• Under the second step of its conversion,
  People's said, it would retire the majority of
  its shares held by the mutual holding company
  and sell them as common stock under the company's
  new name, People's Holdings. The bank also said
  it would exchange the 42 of its shares that are
  already publicly traded with shares of the new
  company The bank, which converted to a mutual
  holding structure in 1988, said it plans to
  conduct an appraisal of the new holding company
  and determine the exchange ratio at a later date.
  It did not provide an estimate on the value of
  the offering, though analysts said the proceeds
  could range from 2 billion to 3.4 billion. In
  June 2005, Hudson City Bancorp Inc. of Paramus,
  N.J., completed the largest second-step offering
  by a banking company. It sold 53 of its
  ownership stake to raise 3.93 billion.
• For months analysts had questioned People's
  executives on whether a second-step offering was
  in the worksIn March it said it was interested
  in acquiring companies outside Connecticut that
  would make it look more like a commercial bank.
  In May it announced that it was switching from a
  state charter to a federal one, and that over the
  next three years it would open 15 Westchester
  County, N.Y., branches -- its first outside the
  state. The charter conversion was completed in
  August.
• On Sept. 6, People's disclosed that it had
  recently sold the remaining 835 million of
  securities on its balance sheet as part of a
  restructuring plan. It said it would use the
  proceeds to pay down short-term borrowings and
  reinvest the rest in federal funds and other
  short-term securities.
• Jared Shaw, an analyst at Keefe, Bruyette
  Woods Inc., who estimated that the offering could
  raise up to 3.4 billion, said People's "needed
  to get their ducks in a row internally" before
  going public.
• "For the last three years they've been keeping
  busy with improving fundamentals at the bank," he
  said. "The first priority was improving earnings.
  The second was improving its balance sheet. ...
  Now that they've hit all those they feel they
  have cleaned up enough in-house" to do the
  offering. He rates People's stock "outperform.