FDIC policy – A good tranche of bad loans considered less risky than actual good loans!

Arnold Kling writes;

1. An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.

So it seems banks have to hold more money in reserve if they hold low risk mortgages than when they hold a “good” slice of much riskier mortgages.

That is, the banks can leverage the good slice of bad mortgages a lot more than they can the actual good mortgages.

I think “regulatory arbitrage” could add another piece to the puzzle.

Well, that tarnishes FDIC’s hero image a bit.