Wednesday, August 6, 2008

Change, Yes. But Hope ?: The Road to Reform on Wall Street

Facing a virtual meltdown of large segments of the financial, banking and investments industries, a Wall Street consortium led by Goldman Sachs managing partner E. Gerald Corrigan recommended new standards Wednesday for monitoring and managing risk. The report issued by the study group indicated that the financial industry must be better equipped to contain the potential for apocalyptic aftermaths potentially caused by irrational exuberance. (I said that, they didn't.)

The group's report, addressed to Treasury Secretary Henry M. Paulson Jr. and Mario Draghi, chairman of the international Financial Stability Forum, suggested that big investment houses regularly perform "liquidity stress tests" to measure their expected flexibility in the face of a crisis. It also urged firms to make sure they have accurate snapshots of their exposures to institutional trading partners, with the ability to compile detailed reports within hours if necessary. The report suggests that this will likely require extensive expenditures on "infrastructure" (i.e., human capital and technology)on the part of the financial industry which will no doubt be good news for many in the industry who have found themselves on the street (or, rather off The Street) following this chaotic financial year.

One cherce nugget: "...As discussed elsewhere in this Report, throughout the credit market crisis, the behavioral characteristics of several classes of structured credit instruments have accounted for a significant fraction of the write-downs and losses incurred by large integrated financial intermediaries, hedge funds, specialized financial institutions and other market participants. Moreover, there is almost universal agreement that, even with optimal disclosure in the underlying documentation, the characteristics of these instruments and the risk of loss associated with them were not fully understood by many market participants. This lack of comprehension was even more pronounced when applied to CDOs, CDOs squared,4 and related instruments, reflecting a complex array of factors, including a lack of understanding of the inherent limitations of valuation models and the risks of short-run historical data sets. As a consequence, these instruments displayed price depreciation and volatility far in excess of levels previously associated with comparably rated securities, causing both a collapse of confidence in a very broad range of structured product ratings and a collapse in liquidity for such products."

Translation: Despite all of the legal gobbedlygook issued by financial firms in support of some of the complex equity and investment products issued in the past several years, investors were not fully aware of the level or potenial of risk that these items faced. Like the ads that promise results, accompanied by a counterpuntal voice saying "Prior experience does not guarantee future earnings". But it was a bull market. You have to be in it to win it, etc. Until it fails. Irrational exuberance indeed.

The bottom line? Addressed as it is to Treasury Secretary Paulson and Mario Draghi of the "Financial Stability Forum," it seems Reform is the Better Part of Valor. Or, the mantra on Wall Street, for now, Better to Self-Regulate Than Be Regulated.

One wonders how the outcome of the November 2008 elections will further determine the future direction of regulation on Wall Street, and how that might impact individual and institutional investors, borrowers, and the near term and future growth of the American economy and the global economy at large.

To whit, the decision by some banks and investment firms to freeze home equity loans for customers deemed to be at risk of default (see link below).


Containing Systemic Risk: The Road to Reform here:
http://www.crmpolicygroup.org/docs/CRMPG-III.pdf

Wall Street Advises on New Risk Regulations (Washington Post):
http://www.washingtonpost.com/wp-dyn/content/article/2008/08/06/AR2008080601646_pf.html

Some Banks, Equity Firms, freeze Home Equity Withdrawals:
http://www.bloomberg.com/apps/news?pid=20601087&sid=afQ0PVYvOgzI&refer=home

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