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]?"