Without the endorsement by regulators, banks would never have leveraged their equity 60 times to 1 with any asset.

Sir, Gary Silverman writes: “exempting the derivatives known as credit default swaps from more rigorous federal regulation…[was] one of the biggest mistake leading to the financial crisis”, “Why it is wrong to forget Lehman’s fall” September 20.

That is not so. Again, for the umpteenth time, I will explain prime cause of the financial crisis, namely the capital requirements for banks, and this by using the examples of Lehman Brothers, AIG and Greece.

The regulators in June 2004, with Basel II, decided that against AAA rated private sector assets, and against any sovereign rated as Greece was until November 2009, banks needed to hold only 1.6 percent in capital, meaning banks could leverage their equity with those assets over 60 times to 1. In comparison, when holding “risky” assets like loans to entrepreneurs and SMEs, banks were only allowed to leverage 12 times to 1. 

On April 28, 2004 the SEC decided that what was good for the Basel Committee was good enough for them, and so allowed Lehman to leverage over 60 times to 1 with AAA rated securities guaranteed with mortgages to the subprime sector… Since Europe were allowing their banks to do the same… the demand for these AAA securities became so huge that it overpowered all the quality controls in their manufacturing and packaging process… and Bang!

If AAA rated AIG guaranteed an asset, banks could also dramatically reduce the capital they needed to hold against that assets, and this overwhelmed AIG’s capacity to resist selling “very profitable” loan default guarantees… and Bang!

And Greece was of coursed offered loans in such amounts, and in such generous terms, so that its governments could not resist the temptations… and Bang!

As can be seen the above has nothing to do with deregulation, or with exempting anything from rigorous federal regulation, and all to do with imposing extremely bad and distorting regulations. On their own, and without the direct endorsement of regulators, banks would never ever have dreamt of leveraging their equity 60 times or more, with any asset… no matter how safe it looked.

If we are not going to spell out the real reasons why Lehman Brothers fell, then we better all forget Lehman’s fall.

PS. Here are 7 questions US Congressmen and Governors should ask bank regulators.

@PerKurowski

If only our bank regulators in the Basel Committee / FSB grew up to wear long pants and assumed their responsibilities.

Sir, Gillian Tett holds that: “Credit derivatives deserve a revival — if financiers grow up” May 22. I agree… but that is far from being enough.

Though Ms. Tett rightly advices that these derivatives need to be a genuine tool in risk management, and not just a technique for regulatory arbitrage… she keeps mum on the fact that the only reason for which they are used to arbitrage, is the availability of regulations that can be too easily arbitraged, or are too tempting to arbitrage, like the current credit-risk-weighted capital (equity) requirements for banks.

In short for risk-management instrument to be useful you have to remove the distortions made possible and provided by regulations… and for that to occur it is even more important that regulators grow up. 

We can all wonder how immature regulators have to be to be looking at the risks of bank’s assets and not on how banks manage those assets… and we can all wonder how immature they have to be regulating banks without even defining their purpose... and we can all wonder how infantile they can be thinking themselves able to regulate with some formulas… that no one of them can explain.

@PerKurowski

CDS were bought more for their capacity to reduce equity requirements for banks, than as insurance against defaults.

Sir, I refer to Joe Rennison’s report “Wall St looks to revive niche CDS” May 20.

It states: “single-name credit default swaps, a derivative contract that tracks the risk of default by a company that sells bonds. Regulators sought to clamp down on the market after the crisis because it was widely blamed for helping to inflate the credit bubble”.

That is not telling it like it really was!

According to Basel II, if a bank wanted to hold a bond that for instance was rated BBB+, it needed to hold 8 percent in equity… meaning it could leverage about 12 to 1.

But, if it bought a CDS for that bond from an AAA rated company, like from AAA rated AIG, then it needed to hold only 1.6 percent in equity and could therefore leverage about 60 to 1.

And that is what really drove the incredible artificial demand for these CDS that helped to inflate the credit bubble.

If CDS are to work, as they should, they need to be traded on their own merits of how they provide insurance against defaults, and not because of regulatory distortions.

Do not let failed regulators get away with their own favorite version of history!

@PerKurowski

AIG, instead of suing those who bailed them out, should sue those who got them in problem, namely the bank regulators.

Sir, Tom Braithwaite reports that “AIG considers suing US over bailout terms” January 9, something that sounds indeed a bit surrealistic.

Basel II’s 8 percent basic capital requirement for banks allowed a 12.5 times to 1 leverage of bank equity. But it could be reduced to a minimal 1.6 percent, pushing up the allowed leverage to 62.5 to 1, if the bank exposure could be construed as guaranteed by something possessing an AAA rating.

Therefore, had bank regulators not turned the AAA-rating of AIG into an amazing magical capital requirement for banks shrinking machine; something which created an insatiable demand for AIG's credit default swaps, absolutely nothing bad would have happened, as even the whole 2007-08 financial crisis would have been avoided.

Therefore, if the AIG board absolutely must sue someone, because it feels that is the only way it can discharge its responsibilities, according to current traditions, then instead of suing those who bailed them out, they should sue those who got them in problem, the bank regulators.... and perhaps even the US tax-payers would join them in order to turn it all into a class action.

Let us pray it stays with a headache

Sir, after reading Gillian Tett’s “A headache is in store when the credit party fizzles out” May 19, it is clear we should all go down on our knees and pray for that she is right, in that it is only a headache that is in store for us.

As for myself I have serious doubts that the consequence of this blissful-ignorance-bubble resulting from our hide-and-not-seek the risks with derivatives, is unfortunately going to be much more painful than that. When that day comes though, before putting the sole blame on the poor bankers earning their luxurious daily keep, I suggest we look much closer at the responsibility of our financial regulators.