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 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

The Recourse Rule also imposed a new framework for asset-backed securities.
The capital requirement would be directly linked to the rating agencies’ assessment
of the tranches. Holding securities rated AAA or AA required far less capital than
holding lower-rated investments. For example,  invested in AAA or AA mort-
gage-backed securities required holding only . in capital (the same as for securi-
ties backed by government-sponsored enterprises). But the same amount invested in
anything with a BB rating required  in capital, or  times more.
Banks could reduce the capital they were required to hold for a pool of mortgages
simply by securitizing them, rather than holding them on their books as whole loans.
If a bank kept  in mortgages on its books, it might have to set aside about , in-
cluding  in capital against unexpected losses and  in reserves against expected
losses. But if the bank created a  mortgage-backed security, sold that security in
tranches, and then bought all the tranches, the capital requirement would be about

.. “Regulatory capital arbitrage does play a role in bank decision making,” said
David Jones, a Fed economist who wrote an article about the subject in , in an
FCIC interview. But “it is not the only thing that matters.” 
And a final comparison: under bank regulatory capital standards, a  triple-A
corporate bond required  in capital—five times as much as the triple-A mortgage-
backed security. Unlike the corporate bond, it was ultimately backed by real estate.
The new requirements put the rating agencies in the driver’s seat. How much
capital a bank held depended in part on the ratings of the securities it held. Tying
capital standards to the views of rating agencies would come in for criticism after
the crisis began. It was “a dangerous crutch,” former Treasury Secretary Henry

Paulson testified to the Commission. However, the Fed’s Jones noted it was better
than the alternative—“to let the banks rate their own exposures.” That alternative
“would be terrible,” he said, noting that banks had been coming to the Fed and ar-
guing for lower capital requirements on the grounds that the rating agencies were
too conservative. 
Meanwhile, banks and regulators were not prepared for significant losses on
triple-A mortgage-backed securities, which were, after all, supposed to be among the
safest investments. Nor were they prepared for ratings downgrades due to expected
losses, which would require banks to post more capital. And were downgrades to oc-
cur at the moment the banks wanted to sell their securities to raise capital, there
would be no buyers. All these things would occur within a few years.