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Thursday, August 23, 2007

Dummies, Here's How You Do It

Update: A day late, but all oars in the water. See an article in CNNMoney regarding another workaround. Hat tip Pavel Levin at Calculated Risk:
The Aug. 20 letters from the Fed to Citigroup and Bank of America state that the Fed, which regulates large parts of the U.S. financial system, has agreed to exempt both banks from rules that effectively limit the amount of lending that their federally-insured banks can do with their brokerage affiliates. The exemption, which is temporary, means, for example, that Citigroup's Citibank entity can substantially increase funding to Citigroup Global Markets, its brokerage subsidiary. Citigroup and Bank of America requested the exemptions, according to the letter.
This will cover the short-term paper, but is it a good idea? Now they aren't subject to Reg W. The exemption goes up to 30% for Citi, and is only in effect while the special discount window provisions are in effect. They say they have to be overcollateralized. End update.

On August 21, FRB published an extremely relevant legal interpretation relating to a question about the appropriate risk-weighting for oh, say, boat loans used as collateral to get cash. Pdf, 4 pages. Naturally this question was presented by a legal firm, so that no bank had to ask the question.

Normally such items would be risk-weighted at 100%, but not to worry, it turns out there's all SORTS of circumstances under which they would qualify as 20%. Or, what the heck, ruminates the FRB, if you really feel it's good stuff, why bother to risk-weight at all? Read the interpretation, and consider selling your bank stocks. (Full disclosure, yes I have some and no I have not shorted any.)

(Risk-weighting is relevant because the higher the risk-weighting, the more the bank's reserves must be increased to compensate under regulations.)

Hi MOM, I like your posts! I have a quick question about risk-weighted capital. If the FRB used to apply a 100% risk-weighted capital metric to a boat loan, does that mean that a bank would have to have $1,000 in equity capital set aside for a $1,000 boat loan?

I get the sense that the change in FRB standards is a big deal. I just don't understand what it all means. Can you elaborate some more on the subject? I just want to get a sense for the implications.

Thanks again!
Lacker was quoted saying that banks could turn in boat loans or whatever as collateral at the discount window for those 30 day loans treasury loans, borrower renewable. If they are your own loans, that's one thing. You probably have a reasonable valuation of them. If you are taking some of those loverly MBS thangies that Fitch, S&P & Moody's thought were so wonderful, but no one else wants to buy, it's questionable. And as for someone's scratch and dents...

As to reserve capital, no. It's not a one to one. The 100%, 20%, 0% refers to whether any or how much of the total amount will be added to the total used to calculate necessary reserves.

I think the Wikipedia explanation is pretty good in explaining how capital ratios are calculated. In 2005, this ANPR provided a nice summary of how it is currently done. Also this 2004 interpretation should give you an idea of how the agencies were looking at such things.

The really short explanation is that the more risk-based assets you have, the higher your capital reserve requirement will be. A 0% risk-weighting is the best, and a 200% is the worst. Tier 1/RBA should be at least 4%, and Tier 1 + Tier 2/RBA should be at least 8%. There are higher requirements to get the "well-capitalized" rating.

So, if I lend fully collateralized with Treasuries, I don't have to add to my capital reserves. It is very expensive to add to capital reserves, because these don't really make you money. They are a cost of doing business.
Also, in 2005 I wrote about the effects on the markets of that ANPR (proposed regulation) if implemented. That post is here.
Visiting from Calculated Risk....

MOM, I'm not sure the sky is falling. The conditions and the footnotes seem to me to put some pretty strict limits on the letter. Really, only the fourth alternative provides much leeway and, as I said on CR, for the pledged security to be deemed "liquid and marketable," you have to show that it has "a robust historical record of an active market characterized by daily market prices." The word "historical" is the key; it probably means that temporary disruptions don't automatically make a security illiquid, which would only add to the instability.

But the "historical record" of an "active market characterized by daily market prices" has to be "robust." Like prime mortgages, is my guess. Not boats. My second guess is that this is designed to keep daily mark-to-markets in place, but allow for short-term disruptions in a normally liquid market without also disrupting capital requirements.

Don't think a bank could rely on this letter for any assets that didn't have daily market prices and liquidity over a period of several years. Unless it got its own letter from the Fed.

I actually think the letter is a good thing.
Thanks so much for the explanation. I understand now why that letter is a big deal. Thx!
RBL - First, thanks for your participation.

If I agreed with your interpretation, I might think the letter was a good idea too.

How do you sustain your interpretation in light of the fact that the letter begins by excluding government-sponsored agencies, and ends by restating the fact that the interpretations are only valid for transactions described in the letter?

Each credit is secured by by collateral consisting of securities that the Guidelines do not formally recognize (that is, the collateral does not take the form of . . . securities issued or guaranteed by . . . U. S. government-sponsored agencies; would seem to exclude GSEs.

A credit based securities traded could be something like swaps, etc, in some forms. Loans in various forms are traded all the time, bought for securitized pools, etc. I think they meet the definition.

relevant page from Handbook of Mortgage-Backed Securities The last change I was aware of put both AAA and AA private on par with GSE at 20%.

Now do you see why I'm quite surprised? Or am I misinterpreting the situation? Did I miss a recent change? (This stuff is not my primary focus.)
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