Tuesday, April 14, 2009

Banking, Opacity and Financial Securities, Part II

In several prior posts, I've sought to identify the cause of, and solution to, the current financial crisis. Recently, I've focused on banking regulation and mortgage securities. The Goldman Sachs "Effective Regulation: Avoiding Another Meltdown" paper I cited earlier addresses the point (at 19-20):
The fundamental problem of securitization -- one that was missed by regulators and bankers alike until the crisis actually hit -- was that the combination of inadequate ratings oversight and the inclusion of poor-quality underlying assets (such as sub-prime mortgages) allowed for a reduction in the global capital cushion without actually reducing the level of risk. What had made sense on the level of individual institutions ultimately had extremely dangerous consequences when played out on a global scale -- as we are now seeing in vivid detail.
The Goldman Sachs paper includes (at 21-26) an analysis of securitization under the Basel I and Basel II international bank regulatory agreements. This chart (which is taken from Exhibit 17) is specific only to Basel I:


source: Goldman Sachs, page 22

What does the chart show? Felix Salmon explains:
On the left hand side is the amount of capital that a bank would need to have if it had $100 of mortgages on its balance sheet: 5%, or $5. Once it securitizes those mortgages and they become RMBS, however, the capital needed drops to $4.10.

Of the $4.10, 40 cents is comprised of capital provisions against the triple-B tranche of the RMBS. But if the bank then repackages that triple-B tranche into a CDO, that capital requirement drops still further, to 35.5 cents.
The Goldman Sachs paper says (at 26) that "Pillar I" of Basel II makes it worse:
Applying Basel II standards to our examples would further reduce capital levels both within individual banks and across the global financial system. As Exhibit 18 shows, direct mortgage loans would incur a $3.80 capital charge; securitization into our "typical" RMBS would reduce this further to $3.30 (compared to $5.00 and $4.10 under Basel I). Repackaging RMBS into CDOs would also yield lower capital requirements than under Basel I ($6.00 on a standalone basis and $6.80 for a CDO, compared to $8.00 and $7.10 under Basel I). Assuming the same facts as before, selling off the equity tranche would allow banks to reduce the capital cushion to just $1.30 for the RMBS and $1.80 for the CDO (vs. $2.10 for both the RMBS and the CDO under Basel I).
[NOfP note: so far as I know, the Goldman Sachs paper does not examine Basel II Pillar II requirements that banks independently determine whether the Pillar I capital is sufficient, see third comment on Salmon's post.]

Felix Salmon continues:
In all these cases, the total amount of risk in the bank is unchanged -- we’re assuming the bank is just repackaging, here, and not actually selling anything. But just by dint of structuring and repackaging, if you turn a loan into an RMBS and then a CDO, you manage to reduce your capital requirements -- and thereby increase your return on equity -- substantially.

Goldman has four principles it would like to see implemented so as to avoid a repetition of the current disaster; they all make perfect sense. The first is for regulators to spend a significant amount of time looking at the system as a whole, rather than just the individual institutions within it: one big cause of the current crisis was that while the system could cope with any one institution’s assets going bad, no one realized how high correlations were, and that if one institution’s assets went bad, hundreds of other institutions’ assets would all be going bad as well, all at the same time, with systemically-devastating consequences.

The second principle is simple, and tries to prevent the regulatory arbitrage in the chart above:
Securitized loans should, in aggregate, face the same capital requirements as the underlying loans would if they were held on bank balance sheets.
The third and fourth principles are essentially the converse of the second: if you treat securities like loans, then you should treat loans like securities. That means marking them to market at origination, both in commercial banks and at investment banks.

None of this would be sufficient to prevent another crisis, but it’s a good start.
Questions:
  1. Is this what MaxedOutMama is saying?


  2. Despite Salmon's closing caveat, would Goldman Sachs's four principles have lessened the current crunch had they been operative this decade? (Changes to the Basel agreements to address CDOs and similar securities have been mooted.) Or were they already in place--in the form of Pillar II (see Basel framework pages 219-24), which should have encouraged banks to be more conservative with capital requirements covering securitized mortgages?


  3. Might Goldman Sachs's four principles be the centeral element of what I've sought (with no responses to date), "the minimum prohibitions necessary to impose on commercial banks to stop the financial system from [collapsing again]?"

9 comments:

OBloodyHell said...

> The first is for regulators to spend a significant amount of time looking at the system as a whole, rather than just the individual institutions within it:

And here we see the flaw inherent in the system, that these grade-AAA Prime federal "oversight" idiots didn't consider this necessary ALL ALONG.

This notion is so f***ing DUH it's downright pitiful.

As someone who tests software for a living, I can absolutely guarantee you that any component-level testing which is not also connected to all-up system testing WILL fail to be adequate. You cannot rely on component-only testing to identify errors or problems. You MUST also create tests for the whole, all-up system to verify if it functions properly or not at that level. Unexpected and un-planned for interactions will ALWAYS occur. This rule comes from the same source as "The Law of Unintended Consequences".

In short, there are always interactive effects in ANY complex system which have to be looked for. This is one reason why the AGW models can't be trusted -- they assume linear local model behavior can be tossed into a complex dynamic feedback system and still have relevance, to say nothing of accuracy.

bobn said...

Goldman Sachs is pretty much the absolute last place I'd go for advice on financial regulation. Their corruption is absolute, and the fact that you even mention them in this context is highly revealing.

Hank Paulson and GS were one of the prime movers in lobbying for the increase in I-Bank leverage in 2004, which has to be considered a large contributor to the current crisis.

Additionally, they are the biggest recipient of taxpayer funds through the conduit of AIG - a deal put together when Hank Paulson was Treas. Sec'y and GS CEO Lloyd Blankfein was inexplicably present in negotiations.

But today's news is the topper: How to Puff Up Earnings, Goldman Sachs Style.

bobn said...

"Carl Frank

* Gender: Male
* Industry: Telecommunications
* Occupation: Attorney"

I guess the old saying is so true: where you stand depends on where you sit.

Carl said...

bobn:

A "troll" is someone who attacks the source or the author of ideas they don't like, rather than a substance. Don't do it again.

bobn said...

Oh, somebody got their feelings hurt! It's OK for you to accuse me of holding specific views because I'm allegedly "smoking something", but if I point out that your deregulationism just might have something to do with your paycheck, oh, that just won't do!

And attacking Goldman Sachs after their role in this catastrophe does not make me a troll - it says I'm awake! You should try it some time. Quoting the thieving scumbags at Goldman Sachs on financial system regulations - ARE YOU KIDDING?

Carl said...

First off, your second comment impugned my integrity based on three very general data points from my profile. Don't do that again. I won't bore you with the hard-scrabble story of where I started out and how I got where I am, but don't presume, then mock, what you don't know. So your second comment was insulting and thus unpersuasive.

Second, while it is acceptable to point out the potential bias of a particular source--I did it in responding to your babble about Vincent Bugliosi -- it is utterly unpersuasive to rely solely on castigating the motivation of a source without taking on the facts and logic too. Your first comment, therefore, wasn't insulting--it was silly and trivial. This is despite the fact that--had you actually read my post and the Goldman Sachs article--you'd realize it's closer to your posture on reforming banking regulation than the laissez-faire position you've (wrongly) tagged me with in the past.

The bottom line is that your two comments were not the high level debate of which you sometimes are capable. If you repeat the first mistake, this forum may no longer be appropriate for you. If you repeat the second, you'll convince no one.

bobn said...

Your "smoking something" remark was directed at the very idea that Iraq agreeing to allow full non-scheduled inspections just prior to us going to war should have had any effect on us going to war with them. Since you've based your whole Iraq stand on "preemption", not imminence, the hole was and is obvious.

I apologize for saying that your opinion was based on your paycheck. I can believe that you honestly believe what you say.

I just can't, however, take seriously even the idea of a financial regulation paper from Goldman Sachs. I can't even begin to read such a thing. It's too much like NAMBLA issuing a paper regarding punishment and treatment of sex offenders. And yes, I group Goldman Sachs with NAMBLA without reservation, based on the harm they have done to the entire world, and the depravity needed to do that harm with so little regard for consequences.

If you are for separation of commerce and state, Goldman Sachs is the very worst company you could ally yourself with.

Having said that, I'll try for a higher level of discourse.

OBloodyHell said...

Coming to THIS party late, but:

> the very idea that Iraq agreeing to allow full non-scheduled inspections just prior to us going to war should have had any effect on us going to war with them. Since you've based your whole Iraq stand on "preemption", not imminence, the hole was and is obvious.

bobn, the idea that someone out there can wave a gun in peoples' faces, fire it down into the ground a number of times thus scaring the neighbors, tell the neighbors to f*** off when they complain, tell the police to f*** off when they come by, and THEN, when the police show up with an arrest warrant from the D.A., suddenly go, "Hey, ok, I'll stop!!" and have the police walk away -- does that strike YOU as reasonable?

The expense of coming to the virtual brink of war -- and then having Saddam at the absolute last second saying "oh, ok, I'll let them in" -- most particularly when he's said exactly this sort of thing in the past and reneged sooner or later -- says: just finish it, remove him from power.

The man also had the chance to leave -- to retire to Switzerland or wherever with billions and billions of ill-gotten loot, and to continue living just short of the life of a king and despot. He chose no. End of story. He got what he deserved, and probably a whole lot less.

OBloodyHell said...

> If you are for separation of commerce and state, Goldman Sachs is the very worst company you could ally yourself with.

Bob, by the way, this is an ad hominem argument, basically. While it is appropriate to doubt the reliability of the source, and express such doubts, one still needs a full argument in this case. They may have a vested interest in the result, but that does not mean they are not correct. It's not their job to be detached, unlike, say, the media on political matters.