May 09, 2009

Unfortunately Tett misses what turned a snowball into an avalanche

Sir another great chapter by Gillian Tett though again she misses the most fundamental point. If it had only been the loss in the market value of the “super-seniors” that had to be covered with new equity, that could have been manageable, but the fact was that as the risk ratings of the whole exposure to super-seniors were down-graded then like rubbing salt on the wounds they had to find additional equity to cover for higher capital requirements.

Assume that Citibank had one of those super-seniors rated AAA and that according to paragraph 615 of the Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version of June 2006 carried a risk weight of only 7%.

This meant that a $1430 investment was going to show up as only $100 in risk-weighted assets, which in fact believe it or not, signified an authorized leverage of (1430/8) of 179 to 1, and therefore required only $8 in equity (8% of 100).

If the market value of those $1430 then fell 2 percent to $1401 the bank would first have to register a $28 loss but if that “super-senior” was also concurrently down-rated to an “awful” A, then the new risk weight applied was 20 percent which signified that the risk-weighted assets increased to $280 (20% of $1401); and therefore requires $48 in additional equity ($280 times the 8 percent equity minus the $8 of previous equity).

And so we not only have $28 in mark-to-market losses that must be covered but the bank has also to find additional equity of $48 to cover for the higher equity requirements... and so the bank is induced to sell those super-seniors but for which there is now not a market since buyers have been scared off by a credit rating downgrade... and so down and down it goes... not so much because of the intrinsic quality of the super-seniors but because of the minimum capital requirements for the banks

The above describes the most vicious part of the current vicious circle in the bank sector and the Basel Committee is fully responsible for it. Never ever has the financial regulators and the financial experts been so gullible and naive like when they believed that “risk-weighted assets” were correctly risk-weighted assets.

By the way when reading the recent stress tests prepared for the largest 19 bank holdings in the US the possibility of this misconception still being in existence is what frightens me the most.