Why The Europeans Are Scared Of Monoline Downgrades

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Yesterday we heard two discordant voices on the possibility of the monolines getting downgraded. Jamie Dimon, the chief executive of JPMorgan Chase, said that he does not think downgrades of the insurers would be “a big deal.” Deutsche Bank chief Josef Ackerman, however, described the potential downgrades as “a tsunami-like event comparable to subprime.”
So who is right? Well, maybe both chiefs are. As Yves Smith has explained, the European banks were major buyers of CDOs and RMBS. Operating under Basel II, which links reserve requirements to the riskiness of a bank’s investments, the Euro banks were able to treat triple A paper as basically risk free investments they could hold without impacting their reserve requirements. But a downgrade of the insurance on this paper could result in the banks having to bolster their reserves, possibly worsening the credit crunch or requiring a firesale of the CDOs
“A downgrade to AA increases the reserve requirements markedly, and CDOs are generally downgraded more than a mere grade or two when they fall (I wish I could be more crisp here, but Basel II makes matters more complicated). Thus a loss of the bond guarantor AAA has a quick and nasty impact on bank capital adequacy,” Smith writes.
Which is to say, because Basel II requires banks either to hold highly rated (and, on paper at least, less risky) portfolios, or to hold high levels of capital in reserve, the banks could be forced to slow lending in order to accumulate capital, go hunting for additional capital injections or sell off their now risky CDO portfolios.
In the US banks had less incentive to invest in highly rated paper because they have been required to hold the same amount of capital against AAA-rated paper as they do against BBB-rated paper. This is the most likely explanation for why the European banks are more worried about a downgrade of the monolines than their US counterparts.
Deutsche Bank CEO: Bond Insurer Downgrade Will Create Debt " Tsunami" [Naked Capitalism]