If an asset-backed security can produce a book return less than zero for reasons other than default, that asset-backed security should not be permitted as a reserve investment.
Compared to most of my rules, this one is a little more esoteric, so let me explain. Reserve investments are investments used to back the promises made by a financial institution to its clients. As such, they should be very certain to pay off. In my opinion, that means they should have a fixed claim on principal repayment, with risk-based capital factors high enough to take away the incentive invest too much in non-investment grade fixed income claims.
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Other assets are called surplus assets. There is freedom to invest in anything there, but only up to the limits of a company’s surplus. After all, surplus assets are the company’s share of the assets, right?
If I were rewriting regulation, I would change it to read that only “free surplus” is available to be invested in assets that do not guarantee principal repayment. Free surplus is the surplus not needed to provide a risk buffer against default on the reserve assets.
But back to the rule. I think the reason I wrote it out 10+ years ago was my objection to interest only securities that received high ratings, despite the possibility of a negative book yield if prepayments accelerated, and they were rated AAA, and could be used as reserve assets with minimal capital charges. Buying an asset that can lose money on a book basis for a non-default reason is inadequate to support reserves. (This leaves aside the ratings’ arbitrage of interest only securities, where defaults hit the yield. Many have negative yields at levels that would impair related junk rated securities)
This can be applied to other assets as well. Reverse convertibles that under certain circumstances can be forcibly converted to a weak preferred stock or common stock should only be allowed as surplus assets. Risk based capital formulas should consider the greater possible risk and adjust required capital up.
Now, maybe this is a rule for another era. Maybe there aren’t as many games being played with assets today, but games will be played again — having some sort of rule that stress-tests securities to see that they will at least repay principal (leaving aside default), would prevent a certain amount of mischief the next time Wall Street gets creative, putting other financial companies at risk in the process.
By David Merkel, CFA of alephblog