Blame Basel II

Robert Waldmann

gives advice to libertarians, free market fanatics and Republicans on how to blame the financial crisis on government regulation.

Quite frankly, their efforts so far have been pathetic — Let’s pretend that Fannie Mae and Freddie Mac lead the way in sub-prime mortgages which were orginally defined as mortgages that they wouldn’t touch. Let’s blame the Community Reinvestment Act which does not apply to non bank mortgage lenders and even though the default rate for CRA covered mortgages is lower than the over all average. The “Barack Obama is an atheist Moslem born outside the USA” people have better arguments.

So, being moved to pity, I have some advice. Look up Basel II on Wikipedia. Then click till you get to Standardized Approach (Credit Risk) and you will find a candidate for the source of the trouble.

There are capital requirements by type of debtor and then as a function of ratings from AAA down to “below B-“.

Now my knowledge is vague recollections of things I read here and there plus the Wikipedia. I don’t know to what extent ratings by rating agencies count for actual regulations under the Basel II framework. They can’t have the force of law and, I would guess, that national regulators can over-rule them and issue corrected ratings. However, I would also guess that they are very reluctant to do so.

One page back at Standardized Approach

You will read

The Basel Accord proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative is to measure credit risk in a standardised manner, supported by external credit assessments. The other alternative is based on internal ratings.

The approach supported by external credit assessment is known as standardized approach (credit risk).

So the standardized approach is an option.

Now in my earlier post on the credit ratings game, many commenters said of course the agencies are frauds. That was not the puzzle. The puzzle is why were they so credible for so long. The ratings were taken very very seriously. In fact actual defaults were well predicted by lagged ratings. Now not so much. For years there have been systematic differences in the price of different intstruments with the same rating. Also highly rated instruments have defaulted. What changed ?

I’d look into the Lucas critique — when policy makers assume that an empirical relationship is a natural law and attempt to exploit it, it disappears. In particular the usefulness to private agents of the ratings caused regulators to decide to use them too (and destroy them) via Basel II.

Regulations change things. Now ratings such as AAA are no longer mere communicative acts whose value depends entirely on whether investors believe the. Now those three letters appear in a proposed regulatory framework. A bank that doesn’t believe an instrument is worthy of an AAA rating can still choose to hold that instrument in order to keep its requried capital low. Any instrument that clears the AAA bar with room to spare has wasted safeness which is not being used leveraging up as much as possible.

Now that innaccurate ratings are useful to the private sector in its never ending quest to suck more money out of the public sector in expected bailouts, the former opponents in the ratings game become team mates. Issuing firms, the agencies and investing banks subject to Basel II all want high ratings — just for different reasons. This can explain why ratings agencies gave AAA ratings to the most senior tranches of re-pooled and re-tranched mezzanine tranches of CDOs, why S&P had a MBS risk assessment program which would not simulate outcomes for any negative change in the average US house price index. This explains how new assets which didn’t exist last recession could be rated AAA etc etc etc.

With a mix of players some regulated by Basel II and some not, the return on the most risky bonds of a given rating is lower than it would be (the price is higher) than without Basel II. However, it is still higher than the return of safer bonds, because not all concern about risk is avoidance of capital requirements.

This explains who held the “Super Senior Tranche.” US investment banks (not subject to Basel II) kept tranches senior to AAA rated tranches on their books. Here I think both the Basel II regulated and non Basel II regulated banks can gain higher returns until the crash comes by making just barely AAA rated securities for Basel II regulated banks (so they can hold as little capital as possible for the risk and return they get) and have non Basel II regulated banks hold the wasted safety (and low returns) of the better than barely AAA tranches.

Now I’ve read explanations of the value of unconvincing ratings. They are based on principal agent issues and rules imposed by principles on the managers of pension funds and endowments. Helping an agent cheat his or her principal is a way to make money which leads to crises and waste. I don’t see anything especially problematic if the principal is an official lender of last resort or deposit insurer.

But then I’m not a libertarian am I.

If you want to blame public sector agents — google Basel II.