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How a secret rule caused the crisis

Allister Heath
SLOWLY but surely, some economists are beginning to piece together the real causes of the crisis. And as you might imagine, their findings are strikingly at odds with the conventional explanations, which tend to revolve around greed, bankers’ animal spirits and deceit.

One brilliant new paper shows how an obscure regulation deliberately encouraged US retail banks to buy CDOs – supposedly safe bundles of mortgages that lost most of their value in 2008 – and to get rid of safer assets. It is an astonishing tale, wonderfully retold by Jeffrey Friedman and Vladimir Kraus and published by the American Enterprise Institute.

Banks are required to set aside specified amounts of capital against their assets to protect themselves against possible losses; some assets require more capital and others less, dependent on perceived riskiness. Holding back capital is expensive for the banks but it is useful when things go wrong.

The Basel Accords govern banks’ capital; in 2001, the US?amended the Accord with its so-called “recourse rule”. US retail banks were required to retain just $2 in capital for every $100 invested in AAA or AA-rated CDOs (or any asset-backed security issued by the state-sponsored Fannie Mae and Freddie Mac), compared to $5 for the same amount in actual mortgage loans and $10 in commercial loans. The recourse rule – pushed through by the Fed and other regulators – was deliberately designed to steer banks’ funds into CDOs – and it worked a treat. The banks gorged on them. No fewer than 93 per cent of their holdings of mortgage-backed securities were either AAA-rated or were issued by Fannie or Freddie, as stipulated by the regulations; as far as the banks were concerned, they were merely following the new best practice.

Because they owned so many CDOs, retail banks suffered more than any other investors – except investment banks, which packaged mortgages into CDOs and were caught out with stocks of both when the music stopped. The recourse rule only covered commercial banks; hedge funds, insurers and others were not cajoled into buying CDOs. It is clear that the US authorities were therefore not only complicit but also directly responsible for the destruction of the US banking system. Their rule also helped inflate the demand for CDOs, securitisation and even sub-prime mortgages, especially when Wall Street had run out of mainstream mortgages to bundle up.

The authors remind us that the crisis was not directly caused by mortgage defaults – rather, it was triggered by a collapse in the market price of CDOs caused by fears about the effect of declining house prices. It was this which decimated balance sheets – not mortgage defaults per se. Had the regulatory system not encouraged retail banks to hold securitised bundles of hard-to-value, opaque CDOs, and instead treated other assets more fairly, the crisis might have been avoided.

The 1988 Basel I accords favoured the use of off-balance sheet vehicles such as structured investment vehicles (SIVs), which became huge in the UK and Europe and had a similar effect on the demand for CDOs. By 2006, Basel II began to be implemented outside America; it contained similar incentives to those contained in the recourse rule. The regulatory induced pro-CDO madness had gone global. Needless to say, nobody responsible for these pernicious regulations has been sacked. Bureaucrats, it seems, always get off scot-free.