Tuesday, March 16, 2010

Regulation gone awry

This sentence, from a friend's senior thesis, was terrifying:

"In the beginning days of CDOs, it was common for underwriters to keep the most junior or equity piece of their CDOs as a way to protect against adverse selection and moral hazard. However, the Basel Accords imposed a 100% capital charge against equity tranches, deterring banks from holding these bonds."

the thesis, by the way, was featured in the Wall Street Journal, as well as winning just about every award Harvard has to offer its thesis writers. I'm reading it now, and the data collection alone is unlike anything I've ever seen anywhere. It's a fascinating read, and as soon as I have permission, I'll post it.

(I'd also love to post my own senior thesis for posterity's sake, though perhaps I shouldn't invite the comparison with hers...)

Anyway, that sentence above is a perfect reason why the answer is rarely more regulation, but instead, better regulation. If banks had been forced to keep the riskier junior/equity piece instead of the senior secured tranches, it's a safe bet this mortgage meltdown wouldn't have happened. Well-intended capital regulation, intended to make bank assets safer, actually worsened the crisis.

How bout a regulation that states that a bank must retain a junior piece of every deal it originates? This isn't just for mortgage securities, it's for everything - equities and corporate debt, credit and other ABS and project finance, etc.

EDIT: To clarify, I'm not advocating for banks to be able to lend against junior capital - that would be a house of cards. I am arguing for banks to be forced to retain pieces of their deals and NOT lend against them. This could distort the structure of deals (by putting a high-risk, high-reward option value on the junior capital, you may actually perversely cause some tranches to have INCREASED risk. This would require some very deep thought by a regulator as to how, exactly, to structure that regulation).

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