Why the banks *held* toxic securities

John Gapper of the FT is proving himself to be eponymous (or rather the reverse -- whatever you call someone who's named for what he does). As the financial crisis has enfolded, he's emerged as a master at pinpointing the gaps in regulatory regimes that the banks have exploited.

Today he provides a primer in how the banks evaded capital requirements, why they loaded up on mortgage-backed securities, and how they rendered the 1988 Basel Accord (Basel I), which set capital adequacy standards for global banks, obsolete. Basel I, he recounts, set the minimum ratio of capital to assets at a conservative 8%, "but some investment banks entered this downturn with capital-to-asset ratios of 30 times or more." How did they pull that off? Gapper:

On assets, Basel introduced the notion of risk weighting, which essentially meant that some kinds of loans – for example, highly rated corporate bonds and, yes, residential mortgages – were considered less risky than others, so less capital needed to be held against them.

It was not a bad idea in principle but it set off two decades of financial engineering by banks to classify as many of their assets as possible as low-risk weighted in order to swell their balance sheets and so make a higher return on capital.

One of the puzzles of the financial crisis is why banks were caught with huge amounts of securitised mortgage debt when the point of securitisation – turning assets into securities – is to be able to sell loans.

Viewed through the Basel lens, however, the hoarding of securities made sense. By transforming 50 per cent risk-weighted mortgage loans into triple A securities, and with the help of rating agencies, banks reduced the amount of capital that they needed to hold against these assets.

That explains why the banks were not just packaging and selling toxic mortgage-backed securities for luscious fees, but holding these securities. And that was only step one in the metastasizing of leverage enabled by illusory risk management. Gapper again:

A bit of insurance wizardry took the regulatory arbitrage further. Banks could cut their capital charge to near zero by laying off the credit risk of mortgage securities to AIG through credit default swaps. Hey presto, billions of dollars of assets absorbing virtually no capital!

As the debt securities were illusory wealth, the CDS's proved to be illusory insurance. That's because they were not regulated as insurance -- CDS issuers were not under the jurisdiction of state insurance regulators, and so were not required to hold reserves to pay "claims," as payouts on credit defaults would be called if CDS's were true insurance. Quite a double-reverse the banks pulled off to get themselves past regulators and downfield into leverageland.

It has often been observed that as surely as bacteria adapt to antibiotics, human beings and the institutions they create will find the gaps in regulatory regimes. That's no reason to despair of regulation, though, any more than we abandon antibiotics. Regulatory reform must be ongoing as conditions change. And the best defense against corrupted regulatory reform is effective lobbying reform. Which in turn generates its own cycle of creative evasions. This cycle itself cannot be evaded.