Some Useful Notes on the Crisis
By Arnold Kling
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.
2. A paper written in 2001 by Paul S. Calem and Michael Lacour-Little. The abstract reads,
We develop estimates of risk-based capital requirements for single-family mortgage loans held in portfolio by financial intermediaries. Our method relies on simulation of default and loss probability distributions via simulation of changes in economic variables with conditional default probabilities calibrated to recent actual mortgage loan performance data from the 1990s. Based on simulations with varying input parameters, we find that appropriate capital charges for credit risk vary substantially with loan or borrower characteristics and are generally below the current regulatory standard. These factors may help explain the high degree of securitization, or regulatory capital arbitrage, observed for this asset category.
3. Another “teach-in” (I’m showing my Vietnam-era age) on the crisis, this one at MIT. William Wheaton offers some interesting stats: home ownership rose from 64 percent to 69 percent in 8 years. 78% of mortgages are securitized; home building exceeded household formation by 6 percent.