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Comments:"Hi Ruben, thanks for your insights above.
- firstly, there's a disconnect between the US banks, which are primarily on Basel 1 (with securitization perceived to transfer risk out, when in reality, the risk is merely transformed
- out of the window and entering back via another window in another form, e.g., securitised investments), and the other banks outside the US which are on Basel 2 IRB or AIRB approach, where these non-US banks have to demonstrate evidence of the "use test" - that loans at origination are actually based on the internal credit ratings model (not merely used for capital calculations) and then monitored in terms of their behavioral credit quality - not the case for Basel 1)´ - hence, accountability is with the IRB banks, unlike in the US where the upstream risk is transferred to the likes of Freddie Mac, etc.
- unless there's a revamp, I foresee latent problems.
- diversification is appropriate but into how many asset classes or capitalizing on the intrinsic/natural (hedges) lead-lag cycles of say the various hard and soft commodities would be the issue
thanks"
(by Guan Seng Khoo, PhD)
"Agree with Dr. Khoo's comments. I would say that the regulatory arbitrage he mentions has been a problem and agree with the assertion that mortgage capital arbitrage has been a bigger problem. Under both Basel I and II, as I understand it, mortgages have been assigned very low risk weightings in the calculation of risk-weighted assets, meaning a bank has to hold less tangible equity and other long-term capital against these assets. 50-70 years of increasing nominal real estate prices convinced everyone this was a can't-lose category of collateral, which of course invited everyone into the lending pool.
I think we would have had an asset problem with or without securitization, but securitization just made it worst. Also, US generally accepted accounting principles have never, ever been very good about properly counting long-term returns for companies involved with securitization. I think it is generally misunderstood, however, that companies that have securitized loans have no risk overhang. Because they retain in many cases residual interests in these securitizations and those are deeply subordinated to the senior tranches, there is risk that remains.
As for business lending, I am not too worried, at least in the US. The Small Business Administration process, venture capital, business development corporation business model, local banks, credit unions, credit card companies, etc. all provide a robust and flexible system to provide for excellent secular growth in small and medium-size enterprises, in my opinion.
Finally, on Basel I and II, what worries me most is the majority of sovereign credits carry no risk weightings in the calculation of risk-weighted assets because sovereign debt is seen as "risk free." That brings up the whole problem of regularlory arbitrage we saw with mortgages. Given the steepness of the yield curve and this regulatory arbitrage, I am sure there will be accidents that flow from the tightening cycle when carry trades blow up and capital is shown to be inadequate for those institutions engaging in such carry trades."
(by Dale Wettlaufer)
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