RISK IS THE MOTOR THAT DRIVES THE MACHINE...:

Capitalism without Romance (Jeffrey Friedman, December 5, 2009 , American)

The heart of the matter is that most mortgages written during the housing boom were pooled into enormous mortgage-backed securities (MBS). Fannie and Freddie securitized mortgages, but so did investment banks, such as Bear Stearns and Lehman Brothers. Shares of these MBS were then sold, as bonds, to investors around the world—but primarily to the world’s commercial (lending) banks. When subprime mortgage defaults began to spike in the summer of 2007, the value of all MBS began to be doubted. By September of 2008, doubt had turned to rout. Nobody wanted to buy the MBS inventory held by Lehman Brothers, since nobody knew how far home prices would drop, and therefore how low the value of MBS might go.

Federally mandated mark-to-market accounting translates temporary market sentiment into actual numbers on a bank’s balance sheet, so when the market for MBS dried up, Lehman Brothers went bankrupt—on paper. Mark-to-market accounting applies to commercial banks as well, however, and after Lehman failed, commercial banks worried that their own MBS holdings, and those of their counterparties, might bankrupt them, too, at least on paper. So they freezed lending. Hence the Great Recession.

Thus, any explanation of the financial crisis has to tell us why so many mortgage-backed bonds wound up in the hands of the world’s commercial banks.

For American banks, the answer seems to be an obscure regulation called the Recourse Rule. The Rule was enacted by the Fed, the FDIC, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001. It was an amendment to the international Basel Accords governing banks’ capital reserves—and all over the world, these regulations appear to have caused the crisis.

A bank’s capital reserves represent funds that aren’t lent out or invested. This means that they are unprofitable, but they also might come in handy should a bank’s loans or investments turn sour. By reducing their reserves—and thus increasing their leverage—banks can, at least in principle, increase their profitability. But under the Recourse Rule, American commercial banks were required to hold 80 percent more capital against commercial loans, 80 percent more capital against corporate bonds, and 60 percent more capital against individual mortgages than they had to hold against asset-backed securities, including mortgage-backed securities rated AA or AAA. The Rule thus created a 60-80 percent incentive to buy highly rated MBS for any bank that wanted to reduce its capital reserves.

Now, the purpose of capital reserves is to cushion against unexpected trouble. So banks that increased their leverage by reducing their capital reserves were, in principle, exposing themselves to trouble. But that didn’t turn out to be the problem. At the beginning of 2008, the aggregate capital cushions of American commercial banks were 30 percent higher than required by bank-capital regulations. The problem was not the depth of the cushions or, conversely, the height of the banks’ leverage. It was the composition of this leverage, which is to say, its overconcentration in mortgage-backed bonds.

...provided that you can know what that risk truly is.

Posted by Orrin Judd at December 5, 2009 11:53 AM