The Secret Plot to Prop Up the Municipal Bond Market

Back in September of 2010, I wrote:

Governments like to operate deep in complex technical details, when they are up to really no good. Few in the general public understand or pay attention to complex technical details of obscure regulatory moves, though those moves can be highly damaging for a country's citizens. 

In Basel, Switzerland, global banking capital regulations, known as the Basel III rules, are in the process of being finalized.  The rules are nothing but a stunning move by governments and the elite to direct money flows in their direction. 

Developments since then support my earlier concerns. In fact, it is worse than I expected. Not only are capital regulations, written as parts of Basel II and Basel III, driving banks to hold government instruments such as US Treasury securities, but it is also driving banks to buy junk municipal debt.

Reuters reports today:

European Union policymakers paved the way for the region's banks to load up on U.S. municipal debt by creating a loophole that lets them hold minimal capital against the bonds of local authorities like Detroit, which buckled last month under debts of $18.5 billion.

EU banks, including bailed-out Belgian lender Dexia (DEXI.BR), could together face hundreds of millions of euros of losses from the bankruptcy of Detroit.

Dexia alone has set 59 million euros aside to deal with its potential losses, while German banking giant Commerzbank (CBKG.DE) told investors on August 8 that it had taken a "substantial number" as a write-down on its Detroit holdings but declined to say exactly how much.

There is concern that Detroit's filing could eventually create legal precedents that could encourage some cities with a heavy pension and health benefits burden to take a similar route, leaving their lenders nursing losses.

The exposure of Europe's banks to Detroit's debt came as a surprise to some, since unlike U.S. investors, EU banks do not enjoy tax-free income on "muni" bonds issued by U.S. cities, states and other public sector entities.

What they do enjoy, however, is a favorable EU application of global bank capital rules that allows banks to hold only a small amount of capital to cover potential losses on local authority bonds as long as the country in which the municipalities are based has a strong rating.

This means banks can earn high returns from a lowly rated muni bond in a highly rated sovereign without worsening their capital ratios, a neat trick when regulators are demanding higher capital cushions and interest rates are at record lows.

That treatment was first enabled by the Basel II capital rules, which give banks the option of applying either the usual credit-quality-based approach to assigning risk weights to municipal bonds, or a 'standardized' approach that assumes they are only slightly riskier than the debt of its home country.

Capital ratios are calculated as capital divided by risk-weighted assets, so the lower a bank's risk-weighted asset figure, the higher its capital ratio. Hence the standardized model for munis almost always leads to better capital figures than banks' internal models, allowing them to take on more risk elsewhere or flatter their safety profiles.[...]

Several banking sources told Reuters that the low risk weightings were a key factor in their decision to buy muni bonds. Figures from the U.S. Treasury show that non-U.S. investors held $63.7 billion of munis at the end of March.

I concluded in September 2010:

Bottom line: The Basel III rules which are about to be approved by the Group of 20, in November, and will be trumpeted by governments and mainstream media as a major step toward global protection of the banking system from the type of financial crisis we just experienced, is nothing of the kind. It is nothing but a huge power grab directing money to governments and the elite. Further, since it drives banks to buy extremely risky debt, it will result in making the global banking system more unstable, and set the stage for a huge global inflation, when governments will be forced to bail out these bad investments by printing more money.

The disclosure that European banks are holding bad Detroit paper confirms my suspicions as to the true principles of the so-called safety guidelines capital requirements. They are no such thing, they are crony rules designed to prop up risky government paper. In time, as more government regions from Puerto Rico to Chicago and Los Angeles go into a financial crisis stage, we will learn of even more global bank exposure to debt from these sectors, debt bought under the guise of making banks safer. The truth is they A. don't make banks safer and B. they cause banks to invest in the paper of crony municipalities from afar, instead of locally in entrepreneurial projects that could make the local economy more productive.