Finance Lessons From a Curved World

Part1
in
Corporate Finance
Governance, Risk & Compliance

• This is a "monumental failure of risk management." "Any small business man would have said, 'This is a bet we're making, and if we're wrong about the bet, it could destroy our business,'" says Smick. He also believes that "a financial executive in a $5 million company would be absolutely appalled at the risk management techniques of our largest financial institutions."
• It's also a failure of regulatory oversight. The investment banks are not the only ones to blame. "Look," says Smick, "I can argue that a senior SEC official making $160,000 a year is no match for a Goldman Sachs executive making millions with lawyers who make millions and secretaries who make $200,000, apparently. You look at that situation and you realize, 'OK, if they want to hide risk ... they can figure out ways to circumvent the system.'"
However, he also notes that senior regulators, including the chairman of the Federal Reserve, his vice chairman, the U.S. Treasury secretary, and others at the highest level of the regulatory structure could have asked some fairly obvious questions six months before the collapse of the subprime credit market.
"Nobody asked, 'How can a bank get a 35 percent return on equity at a time when the premier investors are doing less than half of that? How are they doing all this?'" Smick points out. "Nobody asked such questions, and that's pretty incredible. Until it all blew up, nobody said, 'Wait, the numbers don't add up.'"
• Regulatory reform is more important than a bailout. While an immediate response, a "bailout," is necessary, Smick maintains that a massive overhaul of the existing U.S. financial regulatory structure is more important. Why? Because if global investors don't trust our banking CEOs, we're liable to repeat the mistakes that Japan committed in the 1990s when nonperforming loans were left to languish on balance sheets and the country experienced nearly seven years of an economic standstill.
"The bailout is a necessary attempt to clear balance sheets and also to buy time," Smick explains. "But ultimately ... they need to go to where the money is. The money is global." And, right now, trillions of dollars are idling in global money market funds, global hedge funds, sovereign hedge funds, and other types of investment vehicles. "The U.S. went into the slowdown before the rest of the world, and we'll probably be the first to come out if we can get our act together," Smick notes. "The U.S. financial system will be reliquefied a lot faster if we do something to attract this huge pile of capital just sitting on the sidelines globally."
This is where the need for a new regulatory structure comes in. The cornerstones of this overhaul, Smick argues, should address crucial areas with regard to the asset-backed securities market: standardization and liability protection.
By standardization, Smick means truth in labeling. "Future asset-based securities should list their DNA," he says. "Who issued it and what's inside?" In terms of liability protection, there should be penalties for being deceptive or wrong in describing the DNA. This sort of transparency will attract investors back into this market much more quickly than they might otherwise return. After all, there will be bargains to be had, much as there was in the early 1990s, thanks to the Resolution Trust Corporation, the government-owned asset management company that liquidated assets, including mortgage loans, following the savings and loan crisis of the 1980s.
• There are no new risk management lessons to learn here (only the same old behavioral lessons). There is a reason that comparisons to past financial crises are constantly cropping up in the media today: Variations of this crisis have happened before and will no doubt happen again.
"This is just greed and naïveté," Smick says, by way of answering a question as to whether there are any fresh risk management lessons to be gleaned from our latest financial crisis (answer: no). "Intense greed."
The investment bankers who first floated these sophisticated financial instruments were members of the varsity team, Smick explains. "They were pretty smart and they knew how to handle these instruments," he adds. "And then the junior varsity team took over. They weren't as smart, but they copied the varsity and things were OK. During the past four or five years, we've had the freshmen out there or the practice squad. Well, they didn't know what they were dealing with. All they knew was that they were making money hand over fist by shoving this stuff out the door. And they weren't experienced enough to ask what's in the stuff and whether it might come back to pollute the market's sense of the parent company's viability."
by Eric Krell