Wednesday, December 3, 2014
On page 226 of his “The shifts and the shocks” Martin Wolf writes:
“The essence of Basel I was risk weighting of assets… Ironically and dangerously these weights treated government debt as riskless and put triple-A-rated-mortgage-securities into the next least risky category… Basel II, initially published in 2004, was an extension of Basel I… In the event, the crisis occurred before Basel II had been fully implemented.”
That is not so! And to present it in this way, impedes the understanding of what happened… it makes it much more difficult to connect the dots.
Basel I had risk weighting but that was in relation to claims on sovereign, claims on non-central-government and public-sector entities (PSEs), loans secured with residential property and banks within or outside OECD.
Basel II introduced the use of credit ratings, Basel I had none of it:
I, then an Executive Director of the World Bank, protested this and in a letter published by the Financial Times in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”
And it was Basel II that allowed any private sector bank asset backed by an AAA to AA rating to have a risk weight of only 20 percent. That, since the basic capital requirement was 8 percent, signified banks needed to hold only 1.6 percent in capital against these assets. In other words it was Basel II that authorized banks to leverage 62.5 times to 1 in the presence of an AAA to AA rating.
And Basel II approved in June 2004 was immediately implemented in Europe. In the US it was accepted even before its approval by the SEC and made applicable for those investment banks they were supervising.
And that opened a ferocious appetite for AAA’s in any which form they came, whether as the securities collateralized with mortgages awarded to the subprime sector, or by being able to add an AAA rated company to the guarantees, most notoriously AIG.
Also in order to understand the profits for those developing these AAA rated securities, it is illustrative to consider the following deal:
If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.00
Martin Wolf, over a very short period which started when the banks were assured that Basel II was to be approved and many saw this as a buying opportunity for later resale to Basel II covered banks… and that ended sort of early 2007…there was a monstrous demand for these AAA rated securities… and that, and nothing else, detonated the crisis.
Martin Wolf, consider that 62.5 to 1 bank leverage was allowed only because an AAA rating was present! It is clear that our world fell into the hands of real regulatory morons.
And that is not even considering the worst of it, namely that favoring so much the AAA rated they odiously discriminated against the fair access to bank credit of all those not AAA rated.
And so it is our duty to see that such things never happen again… not to wittingly or unwittingly helping regulators not to be held accountable for what they did….
If the solution to planet earth’s environmental problems falls into the hands of something like the experts of the BCBS, then we are all toast!
PS. Basel I has only 30 pages and though Basel II grew into 347 pages, one should have the right to think that someone writing about the “interactions between changes in the global economy and the financial system” had read these fundamental documents.
PS. Around 2008 I studied and complied with all the exams needed to be a licensed real estate and mortgage broker in the State of Maryland, USA; and that I did so that I could analyze from a closer distance what had happened. And everything I found there only confirms what I have here argued. I heard of: “Give us the worst mortgages you have to package, because when we get a good rating for the security, those are the most profitable ones”.