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(originally published by Booz & Company)


Aftermath of Bank Bailouts: More Risk

Although banks don’t have to divulge applicants’ credit scores or the interest rate for every mortgage, they must report the interest rate spread on loans with an APR that is at least 300 basis points above the Treasury yield. Previous research has demonstrated that a rate spread this large serves as a close proxy for subprime mortgages. The authors used borrowers’ loan-to-income ratio as another proxy for mortgage risk.

The analysis looked at three aspects of bank operations: retail lending (mortgages), corporate lending (large syndicated loans), and investment in financial assets. To examine corporate lending, the authors used the DealScan database, which covers large corporate loans that stem from several banks in a syndicate. According to the database, between 2006 and 2009, 179 qualified banks in the study originated $3.5 trillion in corporate credit.

In the first step of their analysis, the authors focused on the mortgage market and found that after receiving federal funds, banks that had received bailouts shifted their credit issuance toward riskier mortgages, whereas those denied federal funds decreased their portfolio of subprime loans. The share of CPP recipients issuing risky loans increased from 91.2 percent before the bailout to 96.7 percent afterward. In addition, the approval rates among bailed-out banks for the least risky mortgage applications fell from 74 percent to 63 percent, while approval of the most risky loans rose from 48 percent to 53 percent.

The findings were similar for large corporate loans. After getting government funds, banks increased their share of credit issuance to the riskiest corporate borrowers, as measured by their credit ratings and bond yields, and cut back on their loans to safer companies.

“Altogether, our findings for both retail and corporate loans suggest that the bailout was associated with a shift in credit rationing rather than the volume of credit, leading to a marked increase in the riskiness of originated credit by government-supported institutions,” the authors write.

The risk-taking trend also extended to the investments made by government-supported banks. After receiving federal capital, banks boosted their investments in risky securities, such as equities scooped up in an attempt to profit from short-term price movements, mortgage-backed securities, and long-term corporate debt. In the average portfolio of a bailed-out bank, the combined value of these assets increased by 10 percent, in place of safer assets such as Treasury bonds, short-term paper investments, and cash.

After controlling for bank fundamentals and changes in security valuations, the authors found that non-recipients were much less likely to make risky investments. Because high-yield bonds have lower credit ratings and are widely regarded as more likely to default, the researchers used asset yield as a market measure of risk. For bailed-out banks, the average interest yield on investment portfolios shot up by 9.4 percent after getting government aid compared with banks that received no federal funds.

And there is a real economic consequence for bailed-out banks, say the authors, who measured the level of systemic risk through an analysis of firms’ earnings volatility, leverage, stock return volatility, and market beta — a measure of the risk contained in a security or portfolio vis-à-vis the overall market. Compared with applicants that did not receive federal funds, recipient firms increased their exposure to systemic risk after getting government money, the authors found, with their beta measure increasing substantially, from 0.8 to 1.01. In contrast, non-participating banks experienced no changes in systemic risk over the same period.

Overall, the authors write, their analysis “indicates a robust increase in risk taking in both lending and investment activities by bailed financial institutions, as compared to fundamentally similar banks, which were denied federal assistance.”

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