Arnold Kling writes;
1. An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.
So it seems banks have to hold more money in reserve if they hold low risk mortgages than when they hold a “good” slice of much riskier mortgages.
That is, the banks can leverage the good slice of bad mortgages a lot more than they can the actual good mortgages.
I think “regulatory arbitrage” could add another piece to the puzzle.
Well, that tarnishes FDIC’s hero image a bit.
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ks 10.12.08 at 9:54 am
Here is the problem in understanding a tranche: A tranche is in no way a “slice” of mortgages. If you own a tranche you DO NOT own any particular mortgage. You would, instead, own a slice of risk. This is another thing that the media does a horrible job explaining.
I know that on the surface this sounds crazy, however, it is not. On a purely mathematical basis this makes perfect sense. The whole problem is in determining what “good” means. IF the default rates can be well estimated, then owning a high level tranche of low quality mortgages can be much less risky than owning a “good” mortgage outright.
This should NOT be something to dispute. What should be in dispute is the estimated default rates. The models used to determine these rates have performed in a dismal fashion.
Be careful when reading any financial articles from the big media outlets. When you do read these things, DO NOT trust that the reporter is representing the financial terms correctly. If you do not understand a particular term, go find out the actual meaning. These reporters are trying to make the complicated sound simple, and in the process, are destroying the actual meaning.