Basel II – failing to prevent high-risk fund losses?

In a letter in today’s Financial Times, Sean Egan of new-breed US ratings agency, Egan-Jones Ratings, raises the question of whether Basel II is providing sufficient protection against current developments in global mortgage lending and calls for more realistic ratings regarding mortgage securities, particularly regarding the higher-risk sub-prime assets.

Egan uses the recent failures of two Bear Stearns hedge funds to illustrate his arguments. These were rated AAA, the same level as the secure US Treasury bonds, or one rate lower at AA, and at 15%, exceeded the Basel II required debt to equity ratios. Yet the two funds were wiped out and lost US$ 1.5 billion.

As Egan points out, the days when a mortgage lender evaluated the borrower’s ability to pay are long past. In the modern securitised mortgage market, all parties – brokers, bankers, secondary lenders and ratings firms – only earn revenues if the deal goes through. As the ratings are used to calculate capital requirements, the agencies are under pressure to keep their ratings high. For example, under Basel II, US$ 100 of AAA securitised assets requires 56 US cents of equity to back up the debt, whereas the same value of BBB assets require US$ 4.80. Moody’s have said that it lost market share when it toughened up its ratings.

Egan argues for tougher ratings, regulatory attention to be paid to the incentives that rating agencies receive, and closer supervision of the underlying assets used to support securitised debt. Whilst this is ultimately not a Basel II failing, the fact that Basel II has based its capital calculations on ratings rather than the definition of the underlying asset, has created the pressure on these agencies to raise their ratings.

The problem is not just a US one. Last week Australia’s Basis Capital missed its margin calls, and Germany’s IKB is having to be rescued by the government. Other global banks have also made large provisions for these losses. Nor is the problem just a sub-prime mortgages one. Last week shares in the Australian bank, Macquarie, fell more than 10% on the news that one of its retail funds, which invested in secured corporate lending, could lose 25% of its value. But the ratings played a large part in the capital reserves of this fund.

Are we seeing the onset of a credit crisis? What will Basel II do to prevent or reduce this? Should we reopen the debate as to whether ratings, by external commercial companies, are the best basis for calculating regulatory capital?