U.S. Bank Regulators Set Up Greek Tragedy

WASHINGTON ( TheStreet) -- Federal bank regulators have found a way to solve the European debt crisis: Allow U.S. banks to buy up Greek bonds.

According to the Proposed Rule on Risk-Based Capital Standards jointly announced Friday by the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency, there is no chance of a sovereign default by the Hellenic state and therefore make a perfect place for U.S. banks to story their previous capital.
The regulators say it can't happen.

The regulators are required under the Dodd-Frank Wall Street Reform and Consumer Protection Act -- signed into law by President Obama in July of last year -- to move away from relying on ratings agencies when setting capital guidelines for large banks, but it would appear that the ratings agencies actually provide a more conservative approach.

Banks are required to determine how much capital must be set aside to protect against losses on various asset classes.

Assets that are considered the most safe, such as direct obligations of the United States and many other countries have a zero risk-weighting, while riskier assets, including loans, mortgage-backed securities and non-government bonds, have much higher risk-weighting, depending on the underwriting standards, for loans, and the ratings of Standard & Poor's, Moody's, or Fitch, for securities.

The federal regulators propose to base risk-weighting for sovereign debt investments on Country Risk Classifications (CRC), for countries that are members of the Organization for Economic Co-operation and Development (OECC). For countries with no CRC assigned, the risk-weighting would be 100%.

The risk-weighting for sovereign debt issued by OECD members with CRCs of zero or 1, would be zero. For OECD members with a CRC of 2 the risk-weighting would be 20%. For members with a CRC of 3, the risk-weighting would be 50%. For CRCs ranging from 4 to 6, the risk-weighting would be 100%, and for a CRC of 7, the risk-weighting would be 150%.

The federal regulators said that "to alleviate concerns about potential misclassifications, the agencies are proposing to apply a specific risk-weighting factor of 12.0 percent to sovereign debt positions where the sovereign has defaulted on any exposure during the previous five years." This means a bank would have to set aside capital totaling 12% to protect against default.

The regulators justified their reliance on the OECD Country Risk Classifications -- rather than on Standard & Poor's, Moody's, or Fitch, which together are known as the Nationally Recognized Statistical Rating Organizations (NRSROs) -- by saying that the OECD "is not subject to the sorts of conflicts of interest that affected NRSROs because the OECD is not a commercial entity that produces credit assessments for fee-paying clients, nor does it provide the sort of evaluative and analytical services as credit rating agencies." The regulators added that they were "considering additional measures that could supplement the CRCs to determine risk-weighting factors for sovereign debt positions."

It's a good thing they're considering "additional measures," since, according to a report from Oct. 28, available on the OECD website, the United States and Germany both had Country Risk Classifications of zero, but so did Greece.

FBR Capital Markets analyst Paul Miller pointed out that while federal regulators have been "talking tough on tangible common equity," and have excluded various types of equity, including most trust preferred stock, from regulatory capital calculations, "on the flip side, nobody can really calculate risk-weighted assets," which is why many investors "still look at financials as a black box."

It's been great fun bashing the ratings agencies over the past several years, especially because of their outrageous conflicts of interest when they were assigned AAA ratings to some questionable mortgage paper, for fees.

But applying a zero percent risk-weighting to investments in the sovereign debt of troubled countries is a complete farce.

S&P downgraded its sovereign rating for Greece to a below-investment grade BB-plus, in April of 2010. In June of this year, Greece's S&P rating was downgraded to CCC, with default of some debt appearing "increasingly likely." S&P would appear to be ahead of the curve, or at least ahead of the OECD and federal bank regulators, on this one.

According to Bloomberg, the current composite sovereign debt rating for Greece is CC+, and two-year Greek notes closed Thursday at 26 cents on the dollar. In comparison, two-year notes issued by Spain closed at 98 cents on the dollar.

So, by the new capital rules, sovereign paper trading at a 74% discount, would still have a zero percent risk-weighting.

Frank Mayer -- a partner in the Financial Services Practice Group of Pepper Hamilton LLP -- said that "the regulation of any asset as risk-free often distorts bank behavior to create systemic risk," pointing out that before the credit crisis, "there was similar treatment with zero percent risk-weighting for AAA-rated mortgage backed securities."

Mayer added that another interesting point that will be discussed at length during the regulatory comment period is the definition of "sovereign debt," since euro zone members "are not necessarily in full control of their own monetary and fiscal policy."

The term "default" will also need to be more clearly defined, according to Mayer, since a country can have an "outright default," where they fail to pay interest on debt, or the country could simply start printing money, "which can be construed a type of default. "

Mayer said that the U.S. regulators' "CRC reliance is a starting point, since it is considered less subject to conflicts of interest," but that "under Dodd Frank, that the you have to monitor your own portfolio to do your own analysis. You are responsible for your balance sheet."

Fitch Ratings on Thursday cut its ratings on eight "Global Trading and Universal Banks," including U.S. giants Bank of America ( BAC), Goldman Sachs ( GS) and Morgan Stanley ( MS), as well as Deutsche Bank ( DB), Barclays PLC ( BCS), BNP Paribas ( BNP) Societe Generale, and Credit Suisse ( CS), saying that the group's "business models are particularly sensitive to the increased challenges the financial markets face," including "economic developments as well as a myriad of regulatory changes."

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.