Remic arbitrage: Banks are using the magic of resecuritisation to minimise the regulatory capital they need to hold against troubled asset-backed securities. But revamping these instruments to salvage their credit ratings leaves the underlying assets and their potential losses unchanged. It’s another case of regulators relying too much on ratings.
Essentially, these deals — often called re-remics, which is short for “real estate mortgage investment conduit”, the vehicle at the heart of a mortgage bond — involve taking the triple-A-rated slice of an asset-backed security that’s in danger of a ratings downgrade and shifting a percentage of its assets into a new subordinated, or mezzanine, tranche. This gives more credit support to the remaining triple-A bond, allowing it to avoid a downgrade.
The pool of assets, and the portfolio’s potential loss, remains the same. But the total amount of regulatory capital needed to back the restructured instrument can be significantly lower. For example, if a bank-owned triple-A-rated bond is downgraded to single-B, it requires 20-30 times as much capital. Insurance rules require three to four times as much capital under similar circumstances.
Minimising the net capital requirement is clearly in the interest of the financial firm that owns the bond. But whether it makes sense from the perspective of regulators is another matter.
If the resecuritisation brings the capital requirement for the security better in line with the asset pool’s net potential losses, then it serves a useful purpose, both for the holder of the instrument and its regulator. But if it causes the capital requirement to fall below what’s appropriate, it can let the owner operate with too small a buffer.
Ideally, regulators would set capital requirements for such instruments on the basis of their net potential losses. Unfortunately, watchdogs don’t have the resources to conduct such detailed analyses, so they outsource the task to ratings firms. Given those companies’ recent track records in assessing structured finance instruments, that represents a big leap of faith.