Below is a guest contribution by reader Michael Dokupil. Michael points out that ratings agencies and banks are incented to support a market in so-called toxic assets rated triple-A because of a strange regulatory arbitrage. Basel II rules allow a bank to keep much less capital on hand to support AAA assets than is necessary to support lower-quality paper. As a result, banks operating under Basel II rules can leverage up and earn more in interest, with the ratings agencies earning more fees as a result.
I am not sure I agree with Michael’s conclusion that the regulators are to blame for interfering with the free market and this allowed bogus AAA-ratings to sneak through the market’s microscope undetected. Another simpler explanation is the desire to increase returns among fixed-income investors caused them to pile into poor quality assets. Nevertheless, Michael’s points about regulatory arbitrage are definitely worthy of discussion.
By now, we all know that ratings agencies erroneously rated securities AAA. And this fact comes as no surprise when we consider that Standard & Poor’s, Moody’s, and Fitch only get paid on a structured finance transaction if the deal closes. So, these agencies have every incentive to rate the securities as highly as possible to get the deal done.
In a free market “no rules” economy, an erroneous rating wouldn’t matter. Investors would see through the ratings and understand that Wall Street and the ratings agencies were pulling a fast one. But, we don’t have anything approaching a pure free market. We live in a world full of regulation, and in this case, the regulations amplified the ratings errors.
The vast majority of the world’s banks and insurance companies had to overvalue AAA securities, either under Basel II or the NAIC. Basel II rules allow a bank to leverage itself 175 times into AAA securities and still be “well capitalized.” Because regulators asserted that AAA-rated securities were virtually risk-free, banks could both increase their profitability and improve their regulatory capital ratios by owning more of them. Banks all over the world thus had a voracious appetite for anything rated AAA, and Wall Street supplied over 65,000 AAA-rated structured-finance securities.
In 2006, the typical financial institution faced a choice between owning $100M of AAA securities yielding 6%, $30M of single-A securities yielding 6.2%, or $10M of BB securities yielding 8.4%. Naturally, they chose to make $6M per year on the AAAs rather than $840,000 on the BBs. We now know that while the banks were decreasing their regulatory risk profile by owning massive amounts of AAAs, they were actually taking on catastrophic risk.
Banks felt compelled to play this game to remain competitive. As Chuck Prince, the CEO of Citigroup, put it in July 2007, “As long as the music plays, we dance.”
Prices went up because credit was too cheap. The regulators made credit cheap by telling banks and insurance companies that AAA-rated securities were virtually riskless, which in turn compelled the banks to gorge on structured-finance AAAs.
How can we be sure that this regulatory arbitrage drove the demand for AAA securities, which ultimately supplied the subprime mortgages and other “toxic assets”? First, two credit unions, US Central and WesCorp, with a combined $57 billion in assets failed while investing exclusively in AAA and AA structured finance securities. While it is theoretically possible that they agnostically looked at the investment universe and determined that a portfolio constructed of 93% AAA securities and 7% AA securities represented the optimal investment portfolio, a much more plausible explanation is that their regulators enticed them through capital requirements into buying these securities.
Second, Collateralized Debt Obligations purchased over 80% of the non-AAA securities in residential-mortgage-backed securitizations. Through regulatory alchemy, these CDOs turned 85% of those non-AAA tranches into AAAs. And then, repeating this same non-economic process, “mezzanine” tranches of these CDOs were again transformed into AAA securities and purchased by other CDOs, or CDOs-squared. Does this feel like the free market at work?
Third, many seemingly unrelated markets simultaneously experienced bubbles. The US, the UK, Spain, and Australia all had housing bubbles at the same time. These countries have not had synchronized housing markets in hundreds of years. Likewise, residential and commercial markets in the US never move in the same cycles. The commercial market collapsed in the early 1990s without so much as a hiccup in the residential market. Plus, auto loans, credit cards, and private equity experienced simultaneous bubbles. The only thing these markets have in common is that they were all fed by the securitization beast, created by regulatory arbitrage.
Regulators caused the entire credit crisis by coercing banks and insurance companies to stuff themselves to the gills with toxic assets that no one ever thought were superior investment products. But, to remain competitive, banks and insurance companies had to own these falsely rated AAA securities that their governmental masters told them were virtually riskless. Alas, the regulators erred, and we all now suffer for their sins.
Edward here. I am reminded in reading Michael’s post that Steve Waldman often writes about these issues. He had a very good post in late 2006, “CPDOs, Model Risk Spread, and Banks under Basel II” well before the CDO bust occurred about a financial innovation called the CPDO, or "Constant Proportion Debt Obligation."
The post outlined similar problems with investors reaching for yield by buying AAA paper which we now know subsequently was not AAA at all. If someone tells you these problems were not evident until the bust occurred, here is your counterfactual.
19 comments
Comments are closed.
“By now, we all know that ratings agencies erroneously rated securities AAA”
The words “erroneously rated” rates the writer as having NO credibility.
Goodhart’s Law, baby. Regulators were warned way back when that reliance on ratings agencies was probably flawed, res ipsa loquitur.
That said, few people can believe how completely underwriting standards collapsed in the latter years of the credit bubble, and I’d still rank this as a more important causal factor behind the crisis than the regulatory reliance on ratings agencies. But Goodhart’s Law is right up there as well.
Great idea. If we just blame the regulators, nobody will think to look for the fraud perpetrated by the banksters.
I think he’s generally correct about the nature of the problem, but misses the source. The regulatory requirements may have pushed the banks to increase their holdings in AAA paper, but the largest buyers have always been the pension plans and mutual funds, particularly the money market funds.
The various overseers of pooled investment vehicles came to the collective conclusion that, since retirements were at stake, it would make sense to limit holdings to only the “safest” of investments–AAA-rated products. The problem is that there simply isn’t enough AAA-rated paper to fund every retirement plan, bond fund, money market fund, and profit sharing plan in the country.
The banks knew that, which is why they came up with the whole alchemy of securitization in the first place. The extraordinary demand for AAA-rated paper could be met by taking lower-grade products, and bundling them and tranching them out, resulting in more AAA paper for the buyers who wouldn’t take anything less. The end result was a massive dilution in the quality of AAA ratings.
The solution is straightforward, but entirely unintuitive: loosen the restrictions on what pensions plans, money market funds, banks, etc. can hold. Realistically, there is no bottomless supply of perfectly safe, moderate-yield instruments–Treasuries are the closest thing, but they don’t have high enough yields. So the various overseers of pooled investment vehicles are going to have to live with a certain level of risk, which means diversifying their holdings, not just by sector, but also by risk profile.
I agree with Tao Jonesing, and by the way what a great moniker. Obama and others have criticized financially illiterate homeowners for not understanding the terms of their loans. But we are supposed to give a pass to financially sophisticated bankers because they were hoodwinked by fancy talking regulators? Something is very wrong with this picture.
The real question here is why the regulators did that. To please the financial industry. No one should believe the old tale, the devil made them do it.
No more self-serving argument has been made since Nero insisted that the Christians enjoyed being thrown to the lions because it permitted them to become martyrs.
“Because regulators asserted that AAA-rated securities were virtually risk-free, banks could both increase their profitability and improve their regulatory capital ratios by owning more of them.”
WRONG, it was the rating agencies that asserted AAA rated securities were virtually risk free. No regulator made a rating agency like Finch or Moodys slap a AAA rating on a pig of an investment.
Bleh, that last post was meant to be in reply to the blog entry and not to Downsouths post.
Regulators need simplified formulas to calculate credit risk. That is inescapable. They can’t understand complex internal models, or they would rely on those they regulate, which is worse. Efforts to have the regulators understand credit in the absence of the rating agencies has failed — consider the NAIC SVO.
So, they need third party evaluations of credit risk, and so they rely on the rating agencies for that. Perhaps they could use some quants in their place, but that would create model dependency. (And hedge funds could take advantage of that.
There are lots of critics of the current system, but no one proposing something genuinely better that achieves all the good of the existing system, and lessens the difficulties.
http://alephblog.com/2009/09/22/in-defense-of-the-rating-agencies-iv/
“There are lots of critics of the current system, but no one proposing something genuinely better that achieves all the good of the existing system”
Didn’t the current system create an $8 trillion housing bubble? Didn’t it meltdown last year destroying tens of trillions in wealth? Didn’t it need trillions in bailouts that could have been used much more productively elsewhere in the economy? Is this “all the good” of which you were speaking?
Hugh,
Yep. I think you’ve zeroed in on the weak link in David’s argument.
I’m with Mr. Dokupil to the extent I believe that demand for USD AAA paper had much to do with the crisis. I suspect it was this demand which drove US underwriting standards into the Minskian Ponzi zone (not only mortgages but also cov-lite commercial loans and much more), while inflating the real estate bubble in the US.
Mr. Dokupil seems to think that because regulators were regulating, investors and society have suffered.
Regulators had faith that market forces would discipline the ratings agencies. Regulators had faith that market forces would discipline the shadow banking system. Regulators had faith that market forces would discern and allocate risk appropriately.
To the extent regulators failed, they failed by abandoning the lessons of history and allowing faith to guide them.
(off to wash my hands now… I hate feeding trolls… can’t resist sometimes… DownSouth said it all, really….)
Market forces came home to bed-down, but the market did not like the effect, so they extended it into the future hahahahahahahahahaha_cough_haha.
Skippy….ROFL free market ideology whilst the monies are rolling in, till it bites back, then its time for fascism, because nationalizing any thing is too much like socialism aka communism lite…oooh man…Mommy Bernie can you kiss it and make it better…WHAT an enema, but I have a fracture…your weird mommy, see link re: The Enama Of The State:
http://www1.au.shopping.com/xPO-Enema-Of-The-State
Skippy…run away!
During the Bush years, regulators depended upon the free market to self regulate and it failed to do so. Blaming this crisis on regulators is laughable at best, contemptable at worst. Regulators failed not from the lack of ability to enforce laws, but from the lack of the willingness to enforce those laws.
Bank regulators under the Bush administration were the cocksuckers that denied that they had the authority to enforce laws, and under the Bush administration actually did their best to undermine laws designed to control the banking industry. The Bush OTC did its best to roadblock any legislation that was designed to bring into order the use of toxic mortgage products.
There was a time when the OTC actually gave a shit about the soundness of our banking system. That was a time before the Bush administration. That was a time before the republicans actually controlled congress. Blaming regulation or regulators for this catastrophe is completely laughable.
I don’t mean to downplay the role that regulation had in creating the huge demand for AAA paper, and in turn structured finance. But I don’t buy the solution offered here.
“In a free market “no rules” economy, an erroneous rating wouldn’t matter. Investors would see through the ratings and understand that Wall Street and the ratings agencies were pulling a fast one.
…
The vast majority of the world’s banks and insurance companies had to overvalue AAA securities, either under Basel II or the NAIC. Basel II rules allow a bank to leverage itself 175 times into AAA securities and still be “well capitalized.””
By this logic, even in a regulated economy, bank shareholders – who obviously have no regulation of “credit qualtiy”, should have seen through Wall Street and the rating agencies and punished those banks that overleveraged on AAA securities. On the contrary, they rewarded them.
“In a free market “no rules” economy, an erroneous rating wouldn’t matter. Investors would see through the ratings and understand that Wall Street and the ratings agencies were pulling a fast one.”
Really? So how did eeeevul government regulation stop people from doing this on their own?
@ Michael Dokupil – Yes the rules were/are wrong. But no bank was compelled to game the rules to the max. Their mistakes were their own.
@ Tao Jonesing – It was not fraud, it was stupidity. Why don’t people get this?
@ Periperal Visionary – Actually, it’s not too hard to meet the demand for AAA paper with good, safe stuff. The problem was, people didn’t want the good, safe stuff. They wanted high yield, and AAA, at the same time. Two into one don’t go.
I’d feel better about this blog if the emphasis shifted toward asserting that the Regulators were complicit as opposed to largely or solely responsible. It is indisputable that they did not do their job. In that it is important to recognize that by not doing their job they joined in the fraud that was being perpetrated.
Behind every bond offering there is an indenture contract that describes and defines what it is that the bonds are financing and what the bond holders rights are. A pension fund that did not look at the indenture didn’t do its fiduciary duty. If the beneficiaries received any indication that the trustees were acting in their best interest, that circumstance may be a felony if not an actionable tort.
The biggest fraud in this whole mess is that so many gave credence to the canard of the efficient market hypothesis.
Pikestaff’s last point is at the nexus of the acceptance of the high risk paper that fraudulently carried a rating of AAA. A greater fool bot AAA with a big coupon. Saying that the tranche was AAA despite the fact that it had a big coupon is as big a red flag as I can imagine. I don’t need a regulator to tell me that something is wrong with that proposition. I need a regulator who will prosecute the fraud.