The Global Response to the Financial Crisis: Can We Avoid a Repeat?

Robert C. PozenChairmanMFS Investment Management®

The views expressed in this presentation are those of the speaker and are subject to change at any time. 14173.1

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“Never let a serious crisis go to waste.”

— Niccolo Machiavelli, 15th century philosopher

— Rahm Emanuel, current White House Chief of Staff

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Major financial crises — World War II to 1995-97

• 22 major banking crises in advanced industrial societies

• Including Europe, Turkey, Russia, Japan, Canada, U.S., Australia, and New Zealand

Source: Carmen M. Reinhart and Kenneth Rogoff, “This Time is Different: Eight Centuriesof Financial Folly”, 2009

1945 to 1995

38

139

1945 to 1971 1973 to 1997

Source: Michael Bordo and Barry Eichegreen, “Crisis Now and Then: What Lessons from the Last Era of Financial Globalization?”, National Bureau of Economic Research Working Paper No. 8716.

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U.S. exports and imports

2000200120022003200420052006200720082009*

$1,0711,005

9771,0201,1591,2811,4521,6461,8361,411

U.S. international trade in goods and services ($B)

$1,4501,3701,3991,5151,7691,9972,2122,3462,5171,752

Exports Imports

*Through 11/30/09. ** As of 9/30/09.Sources: U.S. Census Bureau; National Bureau of Economic Research

4.2%3.94.34.75.35.96.05.24.93.0**

Current Account Deficit(% of GDP)

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Continuing negative savings by U.S.(Personal and government)

Sources: Federal Reserve Bank of St. Louis; Congressional Budget Office; Brookings Institution

U.S. Personal Saving Rate

U.S. Budget Deficits

External debt at end of fiscal year (FY) 2008 $5.8 trillion

Budget deficit in FY 2009 $1.4 trillion

External debt at end of FY 2009 $7.2 trillion

Projected budget deficits in FY 2010 – 2018 $9.0 trillion

Projected external debt at end of FY 2018 $16.2 trillion

+

+

=

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Can the Fed be an effective inflation fighter?

Maximum and Actual Exposure of Federal Reserve to the Financial Bailout ($B)

As of March 25, 2009 MaximumExposure

ActualExposure

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U.S. Treasury — Bailing out institutions

• Recapitalized too many banks without clear rationale

• AMEX and State Farm allowed to become bank holding companies

• Recapitalize troubled banks with preferred stock (+15% warrants)

Problem Solution

• New statute to justify rationalefor every bailout of each institution

• Provide liquidity support, not capital, to non-banks

• Preferred stock with warrants to purchase 100% of preferred

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FDIC — Government guarantees

• Short-term liquidity crisis after Lehman’s failure

• Deposit insurance increasedto $250,000 (through 2013)

• Guarantee 100% of debt of banks, thrifts, and their holding companies

Problem Solution

• Fed did good job in allowing swaps of Treasuries for illiquid securities

• Stay at $100,000, whichcovers 98% of depositors

• Limit FDIC guarantee to 90%of debt of banks and thrifts(not their holding companies)

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Government actions: Executive compensation for financial institutions

• Legislative limit for assisted institutions– Bonus no more than 1/3 of base– Example: Wells Fargo CEO

• Special Master for six TARP institutions– Approve compensation specifics of top-25 – Approve compensation structure of next 75

• Federal Reserve – for all 8,200 banks– Proposal to ensure appropriate incentive compensation– Will reject arrangements with “excessive risks”

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Improving boards of mega-banks

• Existing mega-bank board model – Large boards: 12 to 18 members– Lack of industry expertise– Meet 6 times per year

• Board of “Super-Directors”– Smaller number of directors: 5 to 7– All directors with relevant experience– Devote 2 to 3 days per month

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Mortgages — Securitization process

• Brokers sold mortgages without retaining any risk of loss

• Securitization vehicles:Multilayered and opaque

• Credit rating agencies haveconflicts of interest

Problem Solution

• Sellers of loans should retain atleast 5% risk of loss

• Simpler vehicles with moreongoing disclosures

• SEC-appointed representativeto choose credit rating agency

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Banks — Capital requirements

• Basle I reduced capital requirements for mortgages, MBS

• Basle II based on internal risk models of banks

• Loan loss reserves limited to probable losses

Problem Solution

• Should have distinguished between more and less risky mortgages

• 12 to 16 categories of risk capital plus subordinated debt

• Allow contingent loanloss reserves plus disclosure

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Key Canadian virtues

• Require 20% down payments for most home mortgages and no tax deduction for interest paid on home mortgages

• Set higher amount and quality of capital for banks• Did not buy products without understanding them• Combination of commercial banking and securities

underwriting: Not a problem for Canadian banks

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Close gaps in U.S. financial regulation

• Customized financial derivatives exempt from most regulation

• Hedge funds, aggressive short sellers, grew rapidly

• Global insurers regulatedby 50 states

• Inadequate regulatory focuson systemic risks

Problem Solution

• More standardized contracts; through one clearing corp

• Require managers of hedge funds to register as investment advisers

• Federal charter for a fewglobal life insurers

• Council of regulators, with Fed,to monitor systemic risk

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Proposed restructuring of financial agencies

• Merge all four banking agenciesinto one new agency

• Create new agency to regulate all retail financial products

• No merger of CFTC with SEC because of Senate conflict

Current Proposal Better Approach

• Merge Office of Thrift Supervision into Comptroller

• Limit new agency oversight to home mortgages, nonbank lenders

• Merge with joint sub-committee from Agriculture and Banking

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Five key recommendations

• Stop bailing out so many institutions• Adopt a totally different board model• Revamp loan securitization process• Increase and redesign capital requirements• Close gaps in federal regulation

The Global Response to the Financial Crisis: Can We Avoid a Repeat?

Thank you.

The views expressed in this presentation are those of the speaker and are subject to change at any time.