Wednesday, January 13, 2010

Goldman Sachs's Blankein Testifies before Inquiry Commission

The Financial Crisis Inquiry Commission is holding its first public hearings today in Washington. The star witness for the day is Goldman Sachs CEO Lloyd Blankfein. He lays the blame for the crisis almost entirely on "bad lending associated with the perceived infallibility of the housing market" and says that this "should be a central area of examination and reform." He identified three major factors that contributed to the crisis: massive increase in pools of foreign capital, low long-term interest rates, and government policies to promote homeownership. Blankfein's remarks even included a reference to Ireland.
Here are excerpts from Blankfein's prepared testimony:
... almost all of the losses that financial institutions sustained over the course of the financial crisis thus far have revolved around bad lending practices, particularly in real estate. According to Goldman Sachs Research, the vast majority of the losses can be traced to bad credit decisions in general, and most of those can be traced back to bad real estate loans. While positions in securities like CDOs and in derivatives, such as CDS, led to losses, these instruments embedded and leveraged what were essentially credit risks emanating from lending decisions, not trading decisions.

On risk management:
As I look back prior to the beginning and throughout the course of the crisis, we never knew at any moment if asset prices would deteriorate further, or had declined too much and would snap back. Having to fair value our assets on a daily basis and see the results of that marking in our P&L forced us to cut risk regardless of market or individual views, estimates or expectations.

After the fact, it is easy to be convinced that the signs were visible and compelling. In hindsight, events not only look predictable, but look like they were obvious or known. But none of us know what is going to happen. Risk management begins by admitting this fundamental reality and planning with that mindset as the dominant one running through all of our processes.
Throughout 2007, we were committed to reducing certain of our risk exposures even though we sold at prices that many in the market, including at times ourselves, thought were irrational, or temporary. But our actions were dictated by daily changes that we were seeing in our P&L through fair value accounting.
On compensation:
For senior people, most of the compensation should be in deferred equity. And, senior executive officers should be required to retain the bulk of the equity they receive until they retire.
An individual’s performance should be evaluated over time so as to avoid excessive risk taking and allow for a “clawback” effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise.
... we have consulted with many of our largest shareholders on the issue of compensation, specifically philosophy and structure. We found an overwhelming consensus that our model was effective and an important element in producing our strong record of shareholder returns. To further strengthen our dialogue with our shareholders, we announced that they will have an advisory vote (“Say on Pay”) on the firm’s compensation principles and the compensation of its named executive officers at the firm’s Annual Meeting of Shareholders in 2010.

We do think it is important to recognize that while incentive structures should be improved across our industry, this is not a panacea for poor risk management.
Here's a reference to Ireland:
These factors [govt. policies to support home ownership, security offered by mortgage assets, and new financial instruments based on mortgages] , to varying degrees, contributed to a housing bubble – not just in the U.S. but in many other countries as well. While real home prices increased nearly 50 percent in the U.S. between 1998 and 2006, they increased more than 130 percent in Ireland, 120 percent in the U.K. and Spain and over 100 percent in France.
On lessons learned from the crisis:
While we recognized that credit standards were loosening, we rationalized the reasons with arguments such as: the emerging markets were more powerful, the risk mitigants were better, there was more than enough liquidity in the system.

We rationalized because a firm’s interest in preserving and growing its market share, as a competitor, is sometimes blinding – especially when exuberance is at its peak.
A systemic lack of skepticism was equally true with respect to credit ratings. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them.

... risk monitoring and activities often failed to capture the risk inherent in off-balance sheet activities, such as Structured Investment Vehicles (SIVs). It seems clear now that managers of companies with large off-balance sheet exposure didn’t appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business. Post Enron, that is quite amazing.
... a large institution’s assets should be valued at their fair market value – the price at which willing buyers and sellers transact – not at the (frequently irrelevant) historic value. Some argue that fair value accounting exacerbated the credit crisis. We see it differently. If more institutions had been required to recognize their exposures promptly and value them appropriately, they would have been likely to curtail the worst risks. Instead, positions were not monitored, so changes in value were often ignored until losses at some firms grew to a point when solvency became an issue.

On regulatory reform:
To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across a systemically important financial institution be similarly valued.
... all of the exposures of a financial institution should be reflected through its P&L. If existing and contingent liabilities, credit commitments and other exposures are not transparent, how can risk managers and regulators see all the risks to which an institution is exposed?
Without question, direct government support helped stabilize the financial system. We believe that the government action was critical and we benefited from it. The system clearly needs to be structured so that private capital, rather than government capital, is used to stabilize troubled firms promptly before a crisis metastasizes.

The two mechanisms that seem to hold the most promise for addressing this goal and addressing “too big to fail” are ongoing stress tests, which are made public, and contingent capital, possibly triggered by failing a stress test, for the conversion of capital.
Improving the ability of regulators and the market to assess institutions’ real-time health and making recapitalization automatic if capital levels fall below a public threshold would minimize systemic risk and force shareholders and bondholders to bear the burden of the firm’s mistakes, not taxpayers or the economy.
Problems within financial institutions nearly always become life-threatening as liquidity begins to dry up. That is why regulators should lay out standards that emphasize prudence and the need for longer-term maturities depending on the assets being funded. Institutions should also be required to carry a significant amount of cash at all times, insuring against extreme events. Because of the interconnected nature of finance, one institution’s liquidity crisis can swiftly be transmitted around the system.
With respect to OTC derivatives, Goldman Sachs supports the broad move to central clearinghouses and exchange trading of standardized derivatives.
While we have not expressed a position on the consumer agency and are not engaging policymakers or anyone else on the associated issues, we agree that a more specific focus on consumer protection, whether in the context of a new agency or otherwise, is warranted.

On a related point, we do support the extension of a fiduciary standard to broker/dealer registered representatives who provide advice to retail investors. The fiduciary standard puts the interests of the client first.