10

Basel—Faulty

The other part of the appeal of mortgage-backed securities came from a change in regulation. American and European regulators began requiring compliance with many of the features of Basel II, the name for the regulatory changes that were expected around 2008 but adopted in practice before that date.1

Beginning in 2002, for example, commercial banks were allowed to leverage AAA- and AA-rated securities 60–1.2 A-rated securities could be leveraged 25–1, BBB 12–1, and BB 8–1. A 60–1 leverage ratio means investing $1.60 of your own money for every $100 you invest. You borrow the rest. Of course, that means that if those securities lost value, a mere 2 percent reduction in the value of the asset would not cover what you owed, and you risked insolvency or bankruptcy.

These changes seemed reasonable from the outside. They required banks to hold more capital for riskier investments but less capital for the safest classes—AAA and AA. I can find no contemporaneous press coverage of these changes. It seems no one was paying any attention in the media, and rightfully so: capital requirements are boring. But I suspect the commercial banks and investment banks were paying a great deal of attention as these regulations were discussed and negotiated in the Basel process.

These changes created a demand for AAA- and AA-rated opportunities. For the commercial banks and the investment banks, such opportunities were like conforming loans were to Fannie and Freddie: highly profitable, but limited in number. But the investment community found a way to get around the restraint. The tranching system of CDOs was a way to create AAA-rated investments out of loans that were highly risky. This financial alchemy was particularly attractive because of the regulatory change.3

Many observers have blamed the ratings agencies for significantly contributing to the crisis because they gave AAA ratings to the tranches of mortgage-backed securities that were created out of toxic assets and that eventually poisoned even the senior tranches. Much is made of the fact that the issuers of these securities paid for the ratings, which compromised the integrity of the agencies.

The problem with these explanations is that most investors knew that the issuers were paying the agencies. They also knew that these assets were extremely complex and that the agencies may have lacked the expertise needed to analyze the assets correctly. They took the ratings with many grains of salt. The commercial banks bought the assets, not because they trusted the agencies, but because they could leverage them under the new regulations. The investment banks bought the assets because they were highly profitable and easy to borrow against.

The lower capital requirements for AAA- and AA-rated securities helped fuel the demand for subprime mortgage-backed securities and helped create the crisis. But just because your car can go 120 miles per hour doesn’t mean you’ll choose to go that fast. Why would a firm want to take advantage of this deregulation and put itself at risk of bankruptcy? And how would a firm be able to take advantage of this looser capital requirement? Why would anyone lend them the money?

Lenders lent the money because they could expect to be rescued, and for the most part they were. Firms borrowed the money because borrowing gave the executives in the firm glorious individual payoffs. The AAA-rated super senior tranches did not pay particularly well even while the music was playing. As one hedge fund manager told me, “I could never understand why there was such a demand for the senior tranches—the return was lousy.” But with enough leverage, say 60–1, they looked a lot better. A hedge fund couldn’t play that game; an investment bank could.

At one level, this story is just a natural response to incentives. Because AAA-rated investments were “safer,” there was an incentive to create them. There was an incentive to figure out a way to price them. There was an incentive to figure out a way to expand them (using subprime loans and lots of alchemy), and there was an incentive to expand them further (synthetic CDOs). But none of these incentives make sense without leverage, and the leverage makes no sense without the prospect of creditor rescue.

The most plausible alternative explanation is some variation on irrational exuberance, coupled perhaps with rational exuberance—players trying to profit from the rise in housing prices even while knowing it may not last. But as I have shown, the key players weren’t reckless with their own money. They made sure to invest it elsewhere. When it was their own money, they picked up quarters rather than nickels in markets that were relatively free from steamrollers. And they made sure that regulations that might have restrained their ability to exploit the system (looser capital requirements) were relaxed, so they could effectively use taxpayer money instead of their own to fund the risky investments.

Could Wall Street have gotten into this game even without implicit guarantees to creditors? The creditors did say no to Bear Stearns eventually—to its hedge fund in 2007 and to the firm as a whole in 2008. Was that because they worried that the government wouldn’t come to their rescue? After all, the borrowing and lending were very short term, suggesting a wariness of the future. Or was the short-term nature of the borrowing just an additional way to hold down costs? Yet it does so in a risky way. Given the systematic rescue of creditors in recent decades, it is hard to believe that the strong possibility of rescue did not play a role in the increasing amounts of leverage and risk.

NOTES

  1.  For more information on Basel II, see Board of Governors of the Federal Reserve System, “Basel Regulatory Framework,” http://www.federalreserve.gov/GeneralInfo/basel2.

  2.  See Marty Rosenblatt, “U.S. Banking Agencies Approve Final Rule on Recourse and Residuals,” Speaking of Securitization 6, no. 4 (December 5, 2001), http://www.securitization.net/pdf/dt_recourse_120501.pdf.

  3.  Some say a change in capital requirements in 2004 that allowed the broker-dealer part of investment banks to become more leveraged “caused” the crisis. See Stephen Labaton, “Agency’s ’04 Rule Let Banks Pile Up New Debt,” New York Times, October 2, 2008. It may have contributed, but as far as I can tell from the press and conversations with insiders, the holding companies of the investment banks were essentially on their own with respect to how much capital they chose to hold, and that was more important. The investment banks were also affected by the 2005 European regulations that encouraged the use of VaR. Despite numerous off-the-record conversations with insiders, I’ve struggled to figure out exactly how these regulations changed the incentives facing investment banks. What is clear is how unclear the regulatory world of investment banks is to those of us on the outside.