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Klaus Regling's Bar-None Bailout Circus: The ESFS Bond Frenzy


Are banking regulations spawning yet another "riskless" asset bubble?

In the afterglow of yesterday's "hugely oversubscribed" bond issue by the European Financial Stability Facility, (the "EFSF"), EFSF CEO Klaus Regling noted that demand was growing for AAA-rated assets "spurred by Basel III capital rules."

While I am sure this was intended as one of those throwaway lines issuers use to explain the success of a transaction after the fact, the overt linkage of investor demand for ESFS bonds to regulatory capital got my attention.

In the post-mortem of the 2008 banking crisis, blame has been attributed to any number of causes, but for all of the attention given to the meltdown, little has been paid to the role that Basel risk weightings may have played.

For those unfamiliar with bank capital regulations and risk weightings, beginning back in the late 1980s, bank regulators have been developing rules which attempt to standardize how much capital is necessary to support different types of loans and securities. In 2001, for example, these regulators reached an agreement that AA and AAA mortgage backed securities, (whether private or backed by Fannie and Freddie) for example, only required 20% of the capital of normal loans (20% of approximately 8% of the principal balance -- or a "risk weighting" of 20% to 1.6% capital/assets). In addition the regulators said that unsecuritized first mortgages (kept on balance sheet) required just 50% capital. And that was whether the underlying loans were prime or subprime.

By linking risk weighting to ratings, Basel regulators allowed (and continue to allow) Moody's, S&P, and Fitch to set the regulatory capital levels banks hold.

If you believe Mr. Regling that demand is "spurred by" capital rules, I don't think it is a big stretch to conclude that some of the irrational exuberance witnessed in the mortgage lending market may have been the result of banks and other regulated investors "optimizing" their capital efficiency for regulatory purposes.

But mortgages aren't the only category with a risk-weighting hierarchy. Sovereign debt has one, too. And under current Basel rules, here are the risk weightings for sovereign debt by ratings level:

AAA to AA- 0%
A+ to A- 20%
BBB+ to BBB- 50%
BB+ to B- 100%
Under B- 150%

So when Mr. Regling noted yesterday that demand was growing for AAA-rated assets, "spurred by Basel III capital rules" I'd offer that what he was really saying is that investors want to buy his debt because they don't need to hold regulatory capital against it.

Or, to better align "cause" and "effect" in the eyes of the regulators, there is no need for capital because there is no risk.

In the case of the ESFS, I'd offer that that is not true at all. Back in September, I noted that when Moody's issued a AAA rating on EFSF debt, it noted that "the facility's grade could be endangered if any of the three AAA-rated countries [Germany, France, and The Netherlands] was to be downgraded or if they wavered in their support."

And then there is just the risk of ratings downgrades for sovereigns in general. Greece's sovereign debt, for example, went from A1 to Ba1 in seven months -- December 2009 to June 2010 -- resulting in a risk-weighting increase from 20% to 100%; while Ireland's debt fell from AA1 in July to Baa1 in December -- a risk-weighting move from 0% to 50%.

To me these are not insignificant ratings declines over very short periods of time, and with Moody's and S&P increasingly now focused on capital markets access as a ratings factor, the potential for steep ratings declines for other sovereign issuers is very high. And with banks and other regulated entities around the globe all using the same risk-weighting hierarchies, there is a significant chance that we could see a large number of financial institutions all rushing to raise capital at the same time to buttress their regulatory capital base should a major sovereign borrower be downgraded.

Nowhere do current or proposed sovereign debt risk weightings consider the systemic risk resulting from interconnectedness and cross-holdings.

Clearly policymakers in Europe are working hard to make sure that additional sovereign debt downgrades don't happen. But as has already been made clear, at this point in Europe it all comes down to "willingness" and whether the strong are willing to save the weak, and whether the weak are willing to be saved by the strong.

And nowhere do I see any of these risks factored into the Basel II or III sovereign debt risk-weighting requirements and by association into current bank capital levels.

As we discovered in our own banking crisis two and a half years ago, "riskless" assets are great, until everyone owns too much of them and then discovers they weren't so riskless after all.

Mr. Regling's comments from yesterday suggest that we are now well on our way to repeating history yet again.

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