December 24, 2016
Sir, again, December 24, we read on your front page about banks being hit with penalties for the subprime mess, and still not a word about the responsibility of regulators creating the temptations they should have known that, sooner or later, some would not resist.
Here are four factors that explain the subprime mess, or at least 99.99% of it.
Securitization: The profits for those involved in securitization are a function of the betterment in risk perceptions and the duration of the underlying debts being securitized. The worse we put in the sausage – and the better it looks - the higher the profits. Packaging a $300.000, 11%, 30 year mortgage, and selling it off for US$ 510.000 yielding 6% produces and immediate profit of $210.000 to be shared among those involved in the process.
Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies. The systemic risk with using credit ratings so much should have been anticipated by regulators.
Borrowers: As always there were many financially uneducated borrowers with needs and big dreams that were easy prey for strongly motivated salesmen, of the sort that can sell a lousy time-share to a very sophisticated banker.
Capital requirements for banks: Basel II, June 2004, brought down the risk weight for residential mortgages from 50% to 35%. Additionally, it set a risk weight of only 20% for whatever was rated AAA to AA. The latter, given a basic 8%, translated into an effective 1.6% capital requirement, which meant bank equity could be leveraged 62.5 times to 1.
So, clearly the temptations became too much to resist for many of those involved.
The banks, like the Europeans, thinking that if they could make a 1% net margin they could obtain returns on equity of over 60% per year, went nuts demanding more and more of these securities; and the mortgage producers and packagers were more than happy to oblige, signing up lousier and lousier mortgages and increasing the pressure on credit rating agencies.
Of course it had to end bad... and it did… in sort of less than 3 years.
Financial Times, is this a version of the real truth that is not to be named?
PS. “DoJ penalties hit $58bn. If banks leverage 12 to 1, that means $696bn in credit capacity. Why do they not collect these fines in bank shares?