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Today, the Counterparty Risk Management Policy Group III (CRMPG III or the Policy Group), a group chaired by former New York Federal Reserve President E. Gerald Corrigan, now Managing Director at Goldman Sachs, and Douglas Flint, Group Finance Director, HSBC Holdings, released a report, “Containing Systemic Risk: The Road to Reform,” featuring proposals that are, in theory, designed to prevent a recurrence of the kind of tectonic financial crisis that has unfolded over the past year or so.
As might be expected, the mainstream media seemed to swallow the notion — hook, line and sinker — that these “experts” know what they are talking about and that this was some sort of noble effort to address structural issues that had only come to light during the past year or so.
As far as I can tell, no one raised the possibility that this “initiative” was actually intended to deflect the blame for the crisis away from where much of it belonged: Wall Street. And no one asked the most pertinent question: How is that “senior executives” and “risk managers” who worked at Lehman, Morgan Stanley, Bank of America, Merrill Lynch, JPMorgan Chase and HSBC — firms that have written down billions and billions of dollars over the past twelve months because of their lack of foresight and inability to control risk — now know what has to be done when they were utterly clueless before things started to unravel?
Anyway, I thought it would be interesting to look at a few snippets from the report’s Introduction and offer up my two cents [in italics] on what they really mean:
The scope of the CRMPG III initiative was designed to focus its primary attention on the steps that must be taken by the private sector to reduce the frequency and/or severity of future financial shocks while recognizing that such future shocks are inevitable, in part because it is literally impossible to anticipate the specific timing and triggers of such events.
[By “specific timing,” do they mean a particular hour of the day? Otherwise, there were a number of individuals, including yours truly, who were warning about a brewing financial crisis within months of its beginning. In fact, it was clear to anyone who took the time to think about what was going on — excluding the highly paid experts on Wall Street, that is — that events leading up to the reckless orgy of speculation that occurred in the spring of last year were the set-up for a major financial earthquake.]
The background to this effort is, of course, the chain of events that is now properly labeled the credit market crisis of 2007 and 2008. In retrospect, these events clearly stand out as the most severe financial shock we have witnessed in decades with visible damage not only to the financial sector but extending to the real economy as well. Indeed, the cost of the credit market crisis in economic, financial and human terms has already reached staggering proportions and, even after 12 months, substantial vulnerabilities remain.
The write-downs experienced by large integrated financial intermediaries – especially in the United States and Europe – are also of staggering proportions. It is probably fair to say that, as late as the summer of 2007, virtually none of us would have imagined that, as of July of 2008, financial sector write-offs and loss provisions would approach $500 billion, even as the write-off meter is still running. Fortunately, the starting capital positions of the affected institutions were relatively strong and, even more fortunately, most of these institutions have been able to raise very large amounts of additional capital in recent months.
[Since “none of {the people who put this report together} would have imagined that…financial sector write-offs and loss provisions would approach $500 billion,” my question is: Why are they qualified to write the report? Shouldn’t it have been written by those who actually anticipated those sorts of losses, including people like Nouriel Roubini, Dean Baker, Mike Shedlock — and, again, yours truly?]
Even with the benefit of hindsight, there exists a large and troubling question as to the manner in which events unfolded beginning in the July to August interval of 2007. Namely, why were so many, in both the official and private sectors, so slow in recognizing that we were on the cusp of a financial crisis of the magnitude we have experienced? The list of possible explanations is long. For example, it could be that the underlying complexity and risk characteristics of certain financial instruments were so opaque that even some of the most sophisticated financial institutions in the world and their supervisors were simply caught off guard. A much more plausible explanation lies in the fact that the preceding eight to ten years had witnessed multiple financial disturbances with multiple causes – all of which resolved themselves with limited damage and negligible contagion. These experiences undoubtedly gave rise to a false sense of security that the emerging problems of the summer of 2007 would also resolve themselves with little or no systemic damage.
[In effect, the preceding paragraph seems to be saying that not only was most of Wall Street utterly clueless about what a few thoughtful individuals saw coming, these wheeler-and-dealers were also risking corporate funds on products and strategies they didn’t understand and apparently took the fidicuiary duty they owed to shareholders with a grain of salt.]
Much has been written and said about the underlying causes of this systematic failure in financial discipline. For that reason, the Policy Group does not wish to repeat that litany in any detail, but it does see some value in briefly highlighting what it considers the most critical of these underlying causes of the credit market crisis:
First: for several years running, global financial markets had been awash with liquidity. This condition reflected in part the recycling of (1) excess savings from Asia in general and China in particular and (2) excess cash from energy producing countries. It may also have reflected the phenomenon of an extended earlier period of very low interest rates, especially in the United States. These factors are also related to global economic and financial macroeconomic imbalances that have long been recognized as potential sources of instability.
[If “these factors are…related to global economic and financial…imbalances…that have long been recognized as potential sources of instability,” why weren’t they taken into account by the firms that employed the individuals who wrote this report?]
There can be no doubt that ample financial market liquidity and relatively low interest rates were an important driving force behind the pervasive “reach for yield” phenomenon of recent years and that the “reach for yield” phenomenon was, in turn, an important factor in driving the surge in demand for and supply of highly complex structured credit products.
[”There can be no doubt…” — huh? Up until about a year ago, Wall Street, the Federal Reserve, administration officials and sundry others seemed to have no doubt that the rush into “highly complex structured credit products” was anything but a good thing.]
Second: reflecting in part the forces discussed above and the intensity of competitive factors in the financial marketplace, it is clear that credit risk had been mispriced for some time. The evidence of this is clear in the terms and conditions of credit extensions in the subprime mortgage market, in the leveraged finance sector, and in the willingness of market participants to acquire highly leveraged structured credit products whose attractiveness relied on a continuation of benign credit conditions for an extended period of time. More generally, the extraordinary tightness of credit spreads across virtually all classes of credit products was widely seen as unsustainable. In these circumstances, it was recognized that, sooner or later, credit spreads and credit terms would inevitably adjust. However, it was all too easy for many, if not most, market participants to conclude that when the correction took place it would be gradual and orderly. Obviously, that conclusion was wrong.
[If “the extraordinary tightness of credit spreads…was widely seen as unsustainable,” why did so many Wall Street firms end up with billions of dollars of mispriced securities on their balance sheets? Otherwise, history clearly shows that “corrections” have rarely been “gradual and orderly.” Tell me again: Why are people who work for firms that don’t understand how the financial world works writing reports about how Wall Street should work?]
Third: for a variety of reasons – some structural, some technological and some behavioral – contemporary finance has become incredibly complex. We see this in the speed and complexity of capital flows, we see it in the complexity of many classes of financial instruments (some of which contain significant embedded leverage), and we see it in the extraordinary complexity faced by individual financial institutions in their day-to-day risk management activities and in their policies and practices related to valuation and price verification for some classes of financial instruments. Needless to say, the complexity factor is an issue as it pertains to the capacity of the international community of supervisors and regulators to discharge their responsibilities.
The key issue here is not complexity per se but rather the extent to which complexity feeds on itself thereby helping to create or magnify contagion risk “hot spots” that may have systematic implications. Thus, we are faced with the pressing need to find better ways to manage and mitigate the risk associated with complexity, a subject that will continue to challenge the best and the brightest among us.
[Ahem. I seem to recall regulators, policymakers and financial industry executives claiming for years that “the best and the brightest” on Wall Street knew exactly what they were doing. Was that a lie? Or was it simply another layer of incoherence and incompetence?]
Fourth: reflecting in part the forces described above, the current crisis has witnessed patterns of contagion the speed and reach of which are different in degree, if not kind, from that which we have witnessed in earlier periods of financial instability. The list is long: asset-backed commercial paper, conduits, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), quantitative funds, auction rate securities, monolines, and hedge funds. To a considerable extent, the “hot spots” where contagion forces have emerged share at least three common denominators: (1) the contraction in market liquidity, which has been largely driven by a huge shift from risk taking to risk aversion, was itself driven by the fear of the unknown and a limited ability to anticipate with confidence the sensitivity to loss in many financial instruments; (2) greater leverage in balance sheet terms and in the use of off-balance sheet vehicles and the presence of embedded leverage in certain classes of financial instruments; and (3) risk mitigation cushions which were either too thin or were at least partially neutralized by basis risk developments.
[Weren’t most, if not all, of these shortcomings known in advance? If so, why didn’t anybody do something about it before the bubble burst? If not, what the heck were these “senior executives” and “risk managers” doing while leverage was increasing and “risk mitigation cushions” were being compressed? Shopping online for Porsches and Ferraris?]
Fifth: it is likely that flaws in the design and workings of the systems of incentives within the financial sector have inadvertently produced patterns of behavior and allocations of resources that are not always consistent with the basic goal of financial stability. Often, when the issue of incentives is discussed, the focus is on compensation and, especially, executive compensation. Consistent with the priorities of this Report noted earlier, the Policy Group has chosen not go into the subject of executive compensation in any detail. Having said that, the Policy Group recognizes that more can be done to ensure that incentives associated with compensation are better aligned with risk taking and risk tolerance across broad classes of senior and executive management. Accordingly, and respecting the role and responsibilities of the board of directors in matters relating to executive compensation, the Policy Group believes that compensation practices as they apply to senior and executive management should be (1) based heavily on the performance of the firm as a whole and (2) heavily stock-based with such stockbased compensation vesting over an extended period of time. The long vesting period is particularly important for high risk, high volatility lines of business where short run surges in revenues and profits can be offset if not reversed in the longer term. In broad terms, the Policy Group recognizes that this philosophy of compensation is hardly new, but its importance looms especially large given the events of the past twelve months.
While the linkage between incentives and compensation is obvious for large integrated financial intermediaries, the incentive question has much broader – and no less important – implications. For example, the framework of incentives at the level of individual firms should help to balance business imperatives by ensuring that the resource base and the recognition/reward system for the support and control functions are such that critical tasks, such as risk monitoring and price verification, are performed in a manner that protects the financial integrity and professional reputation of the institution.
[Go on. Admit it. Stop with the euphemistic talk already. When you say “incentives,” you actually mean pure, unbridled greed. Otherwise, my question is: What are the incentives that led to the writing of this report? Might the letters “CYA” have something to do with it?]
There’s much more, but I have a headache.
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August 15th, 2008 at 11:53 pm
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