This says it all….
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.
http://www.fdic.gov/news/news/financial/2008/fil08069a.html
http://econlog.econlib.org/archives/2008/10/some_useful_not.html
**
Sept. 24 (Bloomberg) — Frank Raiter says his former employer, Standard & Poor’s, placed a “For Sale” sign on its reputation on March 20, 2001. That day, a member of an S&P executive committee ordered him, the company’s top mortgage official, to grade a real estate investment he’d never reviewed.
S&P was competing for fees on a $484 million deal called Pinstripe I CDO Ltd., Raiter says. Pinstripe was one of the new structured-finance products driving Wall Street’s growth. It would buy mortgage securities that only an S&P competitor had analyzed; piggybacking on the rating violated company policy, according to internal e-mails reviewed by Bloomberg.
“I refused to go along with some of this stuff, and how they got around it, I don’t know,” says Raiter, 61, a former S&P managing director whose business unit rated 85 percent of all residential mortgage deals at the time. “They thought they had discovered a machine for making money that would spread the risks so far that nobody would ever get hurt.”
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ah839IWTLP9s
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ax3vfya_Vtdo
