August 07, 2017

Should not regulators know that what is perceived safe has the largest potential of being what’s dangerous for banks?

Sir, John Authers writes: “In January 2007, credit was priced on the assumption that virtually all US sub-prime mortgages (to people with poor credit histories), would be repaid in full. House prices were already falling. Several subprime lenders went bankrupt in early 2007, with no great effect on credit prices. Banks felt obliged to stay in the market”, “Warning signs existed during decade before credit crunch” July 7.

Of course signs of distress in the housing markets were already seen. In August 2006 you published a letter I wrote to you in response to an editorial titled “Hard edge of a soft landing for houses”.

But to say that these credits were based on some direct assumptions or knowledge about subprime mortgages is blatantly wrong. It was strictly based on the AAA ratings that credit rating agencies issued to many of the securities backed with mortgages to the subprime sector.

And Sir, when with Basel II of 2004 regulators had authorized banks to leverage their capital 62.5 times when investing in what carried an AAA rating, but only 12.5 times when lending to for instance SMEs, there were absolutely no incentives to question such ratings. Banks did not feel obliged to stay in the market they loved it.

It all comes back to one of the fundamental mistakes made by current regulators, namely that of believing what is perceived as risky to be more dangerous to the banking system than was is perceived safe.