Regulatory Arbitrage, Negative Basis Trading, AIG and Goldman

Thanks to the Credit Crisis, the interested general public now have a peep hole into the guts of the dead / near dead investment banks and their accomplices. How these people were making billions of dollars in earnings is truly fascinating. One FT article that talks about a strategy that worked until it didn't is below.

Paul Kedrosky at Infectious Greed posted yesterday on how the US bailout of AIG “saved the European banking system”.

He picks up on a report from the Centre for European Policy Studies:

The AIG case shows the importance of another link across financial markets, namely massive regulatory arbitrage. The K-10 annex of AIG’s last annual report reveals that AIG had written coverage for over US$ 300 billion of credit insurance for European banks. The comment by AIG itself on these positions is: “…. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”. AIG thus helped to organise regulatory arbitrage on a gigantic scale. A formal default of AIG would have had a devastating impact on banks in Europe.

Yves Smith at Naked Capitalism also has a post.

It’s all true, but it’s only one half of the story. This kind of “regulatory arbitrage” is not just a game played in Europe. More or less every Wall Street bank does it - did it - too.

Under the Basel II capital rules securities have risk weightings based on their risk ratings. The riskier a security, the more capital a bank must set aside as a regulatory requirement. In the case of securitised securities, the standard Basel II risk weightings look like this:

(Tangentally, if it isn’t already, it should be pretty clear how absolute devastating mass rating agency downgrades can be to banks’ balance sheets)

This exciting table, however, isn’t the whole story.

And so we turn to the Basel II Accord, Part 2, section IV, subsection D, rule 4, paragraphs 583-588: treatment of credit risk mitigation for securitisation purposes.

Credit risk mitigants include guarantees, credit derivatives, collateral and on-balance sheet netting.

…

586. Credit protection provided by the entities listed in paragraph 195 may be recognised. SPEs cannot be recognised as eligible guarantors.

587. Where guarantees or credit derivatives fulfil the minimum operational conditions as specified in paragraphs 189 to 194, banks can take account of such credit protection in calculating capital requirements for securitisation exposures.

588. Capital requirements for the guaranteed/protected portion will be calculated according to CRM for the standardised approach as specified in paragraphs 196 to 201.

In non-Basel speak: if you own a risk weighted security, you can reduce its regulatory risk weighting by hedging against it using credit derivatives. A bank could thus own a security rated BBB (implied risk weighting: 100%) but using sufficient hedging -with, for example, AIG - treat the security as if it was rated AAA (implied risk weighting: 20%).

As noted, it wasn’t just Europe cashing in on this trick. Wall Street banks were huge players. Take Merrill Lynch, for example. Merrill virtually wrote its massive, $40bn+ billion subprime CDO out of regulatory existance using a negative basis trade - the fancy phrase that describes buying a security, and then using a hedge to offset its regulatory capital impact (while still skimming the spread of the bond yield over the hedge payments).

The difference between Europe’s banks and America’s in regard to the regulatory arbitrage trade is that by and large, European banks hedged with more reliable counterparties. Wall Street tended to use the monolines.

As the monolines went down, a lot of Wall Street’s banks saw their negative basis trades unwind.

With - it should be noted - the exception of one big player: Goldman Sachs. In an article in the NYTimes last week, it was stated that Goldman had hedges on around $20bn of securities with AIG:

Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements.

So the US decision to bailout AIG might have saved Europe’s banks - but it had a much more direct aim of saving Goldman too.

A blunt metric for observing a bank’s dependency on negative basis trading might be to look at leverage and compare it to capital ratios. If the two are out of sync (with, perhaps, a sector average) it might imply excessive hedging to reduce capital requirements in some way.

Negative Basis trading sounds very much like the investment bankers getting a free lunch at the expense of tax payers - in the form of an implicit put against the collapse of the financial system. Also the link between Goldman and AIG puts the rescue of AIG into perspective. Goldman is the quintessential well run company which just can't be let go. The confidence in US is at stake here.

The reluctance of the ratings agencies to downgrade the monolines earlier this year once again makes sense. In one fell swoop, the banks would all be ridiculously under capitalized. Truly fascinating once in a lifetime events.

PS: Paul Kedrosky and Yves Smith are suggested reading above.