Tuesday, February 16, 2010

Why the Greek Debt Panic?

The key to understanding the "Basel thesis" about the cause of the crisis, advanced in Critical Review's special issue on the crisis by coauthors Viral Acharya & Matthew Richardson, and by coauthors Juliusz Jablecki & Mateusz Machaj, as well as by Wladimir Kraus and me in our forthcoming Engineering the Perfect Storm: Banking Regulation, Capitalism, and Systemic Risk (University of Pennsylvania Press, 2010), is to understand one thing: The bursting of the housing asset bubble would not, alone, have caused (1) a financial crisis, and thus probably would not have caused (2) a worldwide recession of such depth.

This is also a point made by the other coauthor team in Critical Review's special issue, Steven Gjerstad and Nobel laureate Vernon L. Smith. Asset bubbles pop all the time, but worldwide financial crises are rare.

A financial crisis is a banking crisis. So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the "real" economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today's FT brings the news that "European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds." Why do they hold so much Greek government debt? Because under Basel II, implemented (outside the United States) in 2007, Greek government bonds, rated A-, had the same 20 percent risk weight as AA/AAA asset-backed securities in the United States. That is, until S&P downgraded Greek debt from A- to BBB+. That raised the risk weight to 50 percent, suddenly requiring 60 percent more capital from banks holding Greek bonds.

This appears to be the reason that the possibility of Greek default has led to fears of another banking crisis.

5 comments:

Milton Recht said...

For a given amount of capital, Basel rules establish the maximum bank investment in that category. In your example, if the bank had $40 of capital, it could hold $1000 of mortgages, or $2500 of AAA MBS (2500x.08x.20=40).

Assuming the riskiness of mortgages and AAA MBS are identical, one still needs to explain why banks would increase their MBS holdings, and the risk of their holdings, by 2.5x by switching to MBS from mortgages.

Moreover, there is an additional risk to the holdings from the loss of the diversification effect by increasing the amount of loans/investments backed by housing. Why didn't banks keep their MBS holdings equal to their prior amount of mortgage holdings and use the freed capital to diversify.

Simultaneously, borrowers through refinancing and through purchases were increasing their risk by higher debt leverage in their homes. If banks wanted to hold their risk constant as they increased their holdings of MBS, the banks could have asked for a higher down payment on their mortgage loans. A higher down payment is equivalent to putting aside higher capital. For example, if a bank requires a 10 percent down payment for a mortgage, $1000 of mortgages is backed by $1111 of home values. At 25 percent down payment, $1000 of mortgages is backed by $1333 of home value. In the later case, the bank increases it collateral by 20 percent giving the bank an extra cushion against defaults and home price declines.

Banks increased their risk three ways. They lowered the capital for the loan; they lowered the down payment and amount of collateral; they over invested in one asset class, residential houses, and lost the benefit of diversification from holding more of other asset classes.

Basel lowered capital, but it does not explain the banks willingness to increase the risk of its holdings, especially when they could have lowered the risk, or kept it constant, by diversifying and by raising down payment requirements on their mortgage loans to compensate for the additional risk.

Basel capital rules for MBS are one important part of the puzzle but it is not the whole story. Other factors affecting banks and borrowers' risk tolerances and risk avoidance were also at play.

Marcus said...

Milton,

Because asset-backed securities are more diversified from the get go. It's similar to the difference between buying $100 in stock of one company or buying $100 of a mutual fund which holds stock. The latter is a more diversified investment.

A bank can lend a home owner $100,000 to buy a house or a bank can buy $100,000 worth of mortgage-backed securities and be diversified across hundreds of mortgages.

It's these very facts that lead to the lower risk rating of mortgage-backed securities over holding mortgages directly.

So why did banks buy the securities? Because they believed the same risk models which lead to the rules to begin with.

Anonymous said...

You should mention that governmental deposit insurance has removed the discipline of the market that depositors would otherwise bring to bear on banks, keeping the banks from over-leveraging themselves. All that is left to restrain them is governmental regulation, which can always be (and was) gamed.

Dela @ Chromatic Tuner said...

I am concerned that the Greek debt crisis might lead to a war (although I don't know who would be fighting who). The problem is economic at its heart, and such a war might involve the breakup of the EU or departure of a country from the euro.

Here's the current situation: Some 27 countries, some with small overseas territories, are in the European Union, and many of those are also in NATO. Greece happens to be bankrupt (and Italy is allegedly also heading that way, not to mention Spain and/or Portugal). France and Germany are arguing over what to do about it. France pretty much wants money to be created and poured into its banks to shore them up. Germany is afraid of inflation and wants most of Greece's debt to be written off. (At least that's what I think their positions are.)

People are afraid that this situation is going to get out of control (the so called "debt contagion"). If that happens, then there might be departures from the euro/EU, attempts at "military Keynesianism", and, for all we know, attempts at taking over assets in other countries by force. After all, Hitler built up his forces and broke various international treaties before going to war - in the wake of the Great Depression.

How big is the risk of a war from a European recession/ depression stemming from the debt crisis? Is the hatchet truly buried?

QUALITY STOCKS UNDER 5 DOLLARS said...

Its one financial panic after another.