Saturday, December 12, 2015

I have not seen “The Big Short” but I am sure it comes up short explaining what happened. If not, I will apologize.

This is the film "The Big Short"

And this is my short explanation of the subprime crisis.

In June 2004 the Basel Committee, with Basel II, decided that any bank that held securities rated AAA to AA (or lent to investors guaranteed with such securities) needed to hold only a meager 1.6 percent in capital (equity) against these. That meant banks could leverage their equity (and the support they received from society) with the expected risk adjusted profit margin of these securities, a mindboggling 62.5 times to 1.

For instance, if banks thought they could earn a reasonable 1 percent expected risk adjusted return on such securities, then they would be expecting to earn a 62.5 percent yearly return on their equity.

Basel II regulations applied to the European banks and, due to a decision taken by the Security Exchange Commission in April 2004, also to American investment banks.

This mother of all incentives set up the mother of all demands for AAA to AA rated securities collateralized with mortgages to the subprime sector.

And it was really not the “good” mortgages that the intermediaries were most after in order to package. The worse they were, meaning the higher interest rates they carried, the larger their profits.

Let me explain the deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with a little help from your friends the credit rating agencies, you could convince risk-adverse Fred the banker 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 that mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.000

I am almost sure that “The Big Short” is based on the growing overabundance of these lousy mortgages packaged in highly rated securities... but not on the cause for their overabundance.

I heard in the film trailer "The banks' got greedy"... but in fact there was and is no rational market in the world, that has the strength to say NO! to the kind of temptations offered by the regulators.

And this is tragic. If the truth does not come out, and there is plentiful of interests in the truth not coming out, for instance among all bank regulators, then we have missed a very good opportunity to learn that we should not leave the regulations of our banks in the hand of a small mutual admiration club of experts.

For a starter, current regulators have not yet even defined the purpose of our banks before regulating these. Is that not criminally stupid?