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Banks weakened by gaming their capital requirements

Kling

Kling

Securitized banking, which is economist Gary Gorton’s term for securitization financed by repos, has been around a long time. Why did it balloon and then collapse between 2001 and 2008?

In the seven steps that RepoWatch has identified as the answer to that question, three were changes in how much capital, or equity, regulators said commercial and investment banks had to have to securitize.

These changes drove such developments as credit default swaps, collateralized debt obligations, off-the-books entities and the burst in repo lending. Each change in the rules, and each innovation to dodge them, made it more profitable for financial institutions to be securitized bankers.

Several studies by Federal Reserve and academic economists conclude that banks drove securitization in the past decade not to offload risk, as they claimed, but instead to be able to do much more business, and make a lot more money, with a lot less capital.

Economist Arnold Kling, a scholar at the Mercatus Center at George Washington University, explores the capital changes, among others,  in “Not what they had in mind,” A history of policies that produced the financial crisis of 2008,” published in September 2009.

From his report:

The most important regulatory failure contributing to the financial crisis was in the arena of safety and soundness. Bank capital regulations were the  primary culprit. … In fact, it will be seen below that the risk-based bank capital regulations had perverse effects. The regulations created an incentive for banks to take highly levered positions in securities backed by risky mortgage loans.

The financial tactics that ultimately were at the heart of the financial crisis emerged in order to achieve regulatory capital arbitrage—gaming the system in order to minimize capital while retaining risk. These tactics included securitization, off-balance-sheet financing, the use of credit derivatives such as credit default swaps, and the reliance on ratings of credit agencies.

The capital requirements were part of a regime known as the Basel Accords. The problems with
the Basel regulations, and especially with the use of credit rating agencies, were anticipated by many economists. In particular, the Shadow Regulatory Committee, a group of economists offering independent opinion on bank regulation, issued timely and accurate criticisms of the approach that regulators were taking toward capital regulation.

By incorporating Nationally Recognized Statistical Rating Organization (NRSRO) ratings into formal capital requirements, bank regulators effectively outsourced critical oversight functions to the credit rating agencies. However, as it turned out, the credit rating agencies did not serve well the regulators’ purpose. Instead, they rated mortgage-backed securities too generously, under assumptions about house prices that were too optimistic. …

The late 1990s saw the emergence of collateralized debt obligations (CDOs). These enabled mortgage securities to be deemed low risk for capital purposes, even though they were not guaranteed by Freddie Mac or Fannie Mae. These so-called “private label” securities now became eligible for regulatory capital arbitrage.

The financial engineers carved CDOs into tranches, with junior tranches bearing the risk of the first loans to default, insulating senior tranches from all but the most unlikely default scenarios. Once regulators endorsed the use of credit rating agency evaluations, CDO tranches could earn high ratings, which meant low capital requirements. At that point, private-label securitization really took off.

Capital requirements could be reduced further by moving CDOs off a bank’s balance sheet into
a structured investment vehicle (SIV). As long as the bank only offered a short-term line of credit (less than one year) to the SIV, the assets of the SIV did not have to be included in the calculation of capital requirements.

The phenomenon of regulatory capital arbitrage was well understood by the Federal Reserve Board.
Although papers in academic journals written by Federal Reserve Board employees routinely carry a disclaimer that they do not represent the opinions of the board or its staff, a paper published in 2000 by Fed researcher David Jones provides clear evidence that the Fed knew that regulatory arbitrage relative to capital requirements was taking place. Moreover, the tone of the paper was generally sympathetic to the phenomenon. …

What is striking about the paper is the degree to which the regulator shows understanding and support for the banks’ use of securitization and off-balance-sheet entities to reduce capital requirements. Because we know what happened subsequently (the paper was published in 2000), reading the Jones paper is like watching a movie in which we see how a jailer becomes sympathetic to the plight of a prisoner, while we know that eventually the prisoner is going to escape and go on a vicious crime spree….

The 2002 rule thus had several deleterious effects (RepoWatch note: This is the Recourse Rule, decided November 29, 2001, and implemented January 1, 2002). First, it created opportunities for banks to lower their ratio of capital to assets through structured financing. Second, it created the incentive for rating agencies to provide overly optimistic assessment of the risk in mortgage pools. Finally, the change in the competitive environment adversely affected Freddie Mac and Fannie Mae, which saw their market shares plummet in 2004 and 2005. The government-sponsored enterprises (GSEs) responded by lowering their own credit standards in order to maintain a presence in the market and to meet their affordable housing goals.

Thus, the 2002 rule unleashed the final stages of the mortgage boom: the expansion in private label securities and subprime lending.

The drive to hold mortgage assets backed by as little capital as possible proceeded well beyond the initial structured finance mechanisms sketched in the table above. Other tactics for minimizing regulatory capital included:

• bundling and re-bundling mortgage-backed securities (Wall Street terminology included “CDO” for “collateralized debt obligation” and “CDO-squared” for a CDO collateralized by CDOs);
• “renting” AIG’s triple-A rating by obtaining credit default swaps from that insurance company;
• putting mortgage-backed securities into off-balance-sheet entities called special purpose
vehicles (SPVs) and structured investment vehicles (SIVs). …

Step by step, innovation by innovation, the process of regulatory arbitrage became more efficient. …

In hindsight, many observers have faulted the rise of the “shadow banking system,” meaning the various investment banks and off-balance-sheet entities that became involved in mortgage finance. However, at the time, most regulators were pleased with the way that mortgage credit risk was allocated by these transactions. For example, the annual report of the International Monetary Fund in 2006 stated that financial innovation “has helped to make the banking and overall financial system more resilient.”

At the time, in the view of many regulators, securitization and credit derivatives helped to disperse risk in ways that made the financial market safer.

See Kling’s paper for much more detail and some proposed solutions.

 

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