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A group of Wall Street executives released a report on Wednesday that outlined how the industry failed to foresee the financial meltdown of the last year and what companies can do to improve risk management.
The 172-page report, written by chief risk officers and senior executives at banks like Lehman Brothers, Merrill Lynch and Citigroup, also provides suggestions about technical issues at the same time as it offers a bit of a mea culpa.
“Virtually everybody was frankly slow in recognizing that we were on the cusp of a really draconian crisis,” said E. Gerald Corrigan, a managing director at Goldman Sachs and a chairman of the Counterparty Risk Management Policy Group III , which released the report.
Wall Street failed to anticipate how wide-reaching problems with mortgage bonds would spread into seemingly distant corners of the financial markets, the report said. Awash in easy money, banks doled out credit without sufficiently charging for the risk. Wall Street also created complex structures that masked connections between asset classes as well as compensation incentives that pushed traders to take risky steps for short-term gain. The industry’s failings have now translated into pain for the broader economy, the report said.
In many ways, the report acknowledged shortcomings that have already been raised by Wall Street’s critics.
Mr. Corrigan, a former president of the New York Federal Reserve, formed the group in April to develop a private-sector plan for minimizing future problems in the financial markets. He said in an interview that he hoped the report’s suggestions would be adopted industrywide within two years.
The report focuses on several issues, including accounting rules for bundles of mortgages, new tests for liquidity and disclosure of risks in complicated financial instruments. The findings have already been presented to Timothy F. Geithner, the president of the New York Federal Reserve.
In a cover letter to Treasury Secretary Henry M. Paulson Jr., the group attributed some of the crisis to human psychology.
“The root cause of financial market excesses on both the upside and the downside of the cycle is collective human behavior — unbridled optimism on the upside — and fear — bordering on panic — on the downside,” the letter said. The panic underlying the collapse of the investment bank Bear Stearns was clearly on the minds of executives as they worked on the report.
They outlined ways to reduce “counterparty risk,” the intricate links that connect financial companies and their trading partners. As Bear Stearns struggled in early March, investors feared that too many of those links would collapse if the bank folded — leading some Wall Street executives to say that Bear Stearns was not too-big-to-fail but rather too-interconnected-to-fail.
The report suggests that the industry create a way to close-out trades, should another major financial player face trouble. It also said the markets may be more “accident prone” because of new ways of doing business like Wall Street’s loan packaging, in which banks that originate loans to consumers then repackage them to sell to investors. And it listed the ability to make bets against credit — a trade that made some investors rich — as a possible cause of market instability.
Mr. Corrigan said a prior version of his group created rules that helped the financial system through recent turbulence. Under those rules, investors could no longer resell derivatives contracts without the permission of the party on the other side of the trade.
Now Mr. Corrigan is pushing for the industry to establish a central clearinghouse for derivatives. The clearing project is supported by the Federal Reserve, but many Wall Street firms are concerned that such a move could open their lucrative over-the-counter trading operations to competition from exchange companies.
Another hotspot in the report is the section about accounting for bundles of mortgages and other loans that have been packaged. Those have been kept off the balance sheet, and many in the industry think that rules that would put the bundles back on the books should apply only to the future. The report suggests putting loan packages from the past — which will force many banks to raise more capital from investors.
Mr. Corrigan said he knows the report presents a challenge, but that Wall Street firms need to adopt more of a spirit of “financial statesmanship.”
The publication of the report, he said, does not signal an end to the crisis.
“Since roughly March, we’ve kind of been bumping along the bottom,” he said. “That’s likely to continue for at least some period in the future.”
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