Tuesday, May 19, 2009

Capital requirements for dummies:
Here's a simple numerical example: $100 mortgage pool. Before it is carved up, the risk weight is 50 percent, and the capital requirement is 8 percent, so the bank needs to hold $4 in capital.

After it is carved up, the $5 junior tranche gets a 100 percent risk weight, but it is for face value only, so the capital requirement is $0.40. The $95 senior tranche gets a 20 percent risk weight, so the capital requirement is $95 * .08 * 0.2 = $1.52. If the bank holds both pieces, it is obviously taking the same risk, but for $1.92 in capital requirements. If it sells the senior tranche to a European bank, then the American bank is taking most of the same risk for only $0.40 in capital.

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