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.