CDO Part III- The Ghosts of Basle I and II

From Part II we left off with the Italian bankers being very happy because they were able to both monetise some of their balance sheet and maintain the same risk position and get paid a higher rate of return for holding the equity piece.

Of course, most transactions are a zero-sum game so someone else would have to get paid less as the total return available had not been changed.

To help facilitate these transactions there were important changes in the rules concerning Risk-weightings as the market moved from Basle I to Basle II.

The Basle Rulings emanate from the Bank for International Settlements in Basle and is an institution which acts as Banker to the world's Central Banks and issues guidelines to banks in general.

The relevant rules from Basle I were focused on Capital Adequacy Ratios and specifically were designed to determine the correct amount of capital that banks reserved relevant to their credit risks.

Banks are required to hold 8% capital reserves against their holdings which is viewed as being sufficient to cover declines in said holdings. The trouble with this approach, from a bank's point of view was that they had to hold 8% regardless of the credit risk of the holding. In other words if a bank held a position in a US Treasury or in a small BBB rated company, they still had to reserve the same amount of capital. This could have led to banks only holding low rated corporates which would increase their credit risk position. The Regulators wanted to avoid this and so came up with a methodology to differentiate between credits known as Risk-weighting.

Basically starting at the bottom all corporate bonds with a minimum rating of investment grade were given a Risk-weighting of 100% of the 8%. Mortgages were given a weighting of 50% i.e.50% of 8% or 4%; Banks were given a 20% weighting i.e. 1.6%; Government Sponsored Enterprises (like FNMA or EADS as example) were weighted 10% requiring .8% capital reserve, and OECD Sovereign Risk was given a 0% risk-weighting meaning no capital reserve was required. All of these Risk-Weightings were then applied to the assets held by the bank to determine the banks Capital Adequacy Ratio.

This was obviously not perfect but it allowed for a better understanding of a bank's risks and by default pushed banks towards lower risk weighted assets which were of a higher credit quality. Basle I didn't however differentiate between BBB and AAA corporate assets and so banks tended to gravitate to the lower end of the range in order to maximise their return.

Basle II was intended to remedy this and so it introduced, amongst a number of changes designed to minimise credit arbitrage opportunities, new calculations to determine Risk-weightings. What was important in this was the introduction of a differentiation of risk weightings for corporates. AAA to AA- corporates were no longer 100% but were reduced to 20%;A+ to A- were reduced to 50%; BBB+ to BBB- stayed at 100%; below B-went up to 150%; and unrated were weighted 100%.

Now we go back to the "risk-free portion of a corporate bond that the banks split off from the credit "put". Yes, the corporate credits on the books of the Italian banks were BBB+ at best, or often unrated. The AAA piece that was created however, was weighted 20%. Of course it had to be sold cheaper than a "real" AAA piece, but it wouldn't be as cheap as it should given that regardless of how you slice it, the credit was still backed by the original issuer-but the buyers didn't look at that. They looked at the AAA rating; at a 20% weighting; and piled in.

And everybody was happy. The Italian bank raised some cash; the investor got a cheap AAA and only had to put up 1.6% instead of the standard 8%; and the investment bank made 6-8% on the face value! Selling BBB as a cheap AAA leaves a lot of spread!

Tomorrow we will move from these structured credit trades into true CDO's and introduce the sub-prime mortgage into the mix.