Now Is Not The Time to Reduce Investment in Risk Management

As we head into the second half of 2011, the economic recovery here in the US and abroad is taking hold much more slowly than most expected. Given the modest recovery, some executives may be looking to slash expenses to boost profitability and achieve their near-term goals. However, while tempting, cutting staff and investment in the wrong areas may prove to be a company’s undoing. For financial services companies, this is particularly true in the area of risk management because they are still mending their practices in the wake of the recent financial crisis.

According to the Financial Times, US regulators are keenly aware of what may be on the minds of bank executives and are issuing warnings to avoid cutting risk management budgets. According to Michael Alix, a senior vice-president at the Federal Reserve Bank of New York who heads the risk-management function within the regulator’s financial-institutions supervision group, the regulators are paying close attention to any plans to lower investment in risk management programs. “We haven’t seen it yet, but we’re vigilant,” says Alix.

Sacrificing the progress made in strengthening risk management programs at this precarious stage of recovery is certainly short-sighted and could lead to even greater problems for companies looking to weather the next storm.

FDIC Calls for Risk Management Improvements

This week, the Federal Deposit Insurance Corporation (”FDIC”) released a special edition of its Supervisory Insights publication focusing on the recent foreclosure crisis in mortgage banking. In the report, the FDIC provides additional perspective on the deficiencies in internal processes, staffing and control that resulted in a foreclosure moratorium by several of the largest mortgage servicing institutions in late 2010. The FDIC worked with the lead regulatory agencies of the fourteen largest mortgage servicers in the United States to conduct extensive reviews of current foreclosure practices.

The reviews uncovered many common issues among the mortgage servicers. The FDIC noted the following, “concerns included lax foreclosure documentation, ineffective controls over foreclosure procedures, and deficient loss mitigation procedures and controls. Many institutions failed to commit resources sufficient to manage responsibly the rapidly growing volume of mortgage loans in default or at risk of default. Weak governance and controls increased legal, reputational, operational, and financial risks while creating unnecessary confusion for borrowers.”

While the report focuses specifically on the foreclosure shortcomings, it can also serve as a reminder of the value of strong internal controls and risk management practices. As our business processes grow to be more complex and interconnected, the risks inherent in the processes grow exponentially. Unchecked, these risks can quickly propel a business into a full-blown crisis.

U.S. Senate Releases Financial Crisis Report

Yesterday, the United States Senate Subcommittee on Investigations released its report covering the events leading to the financial crisis of 2008. The Subcommittee began its investigation in November 2008 and held several high-profile hearings in April 2010.  The lengthy report includes an analysis into all of the major players involved in the crisis - Mortgage Lenders, Investment Banks, Regulators and Credit Rating Agencies. What is notable about the report is the fact that it received full, bipartisan support unlike the report issued recently by the Financial Crisis Inquiry Commission. In addition, the report is clear and specific in its recommendations.  As noted in the following excerpt, the focus of the report is to prevent a repeat occurrence of a painful shock that could have been averted.

Nearly three years later, the U.S. economy has yet to recover from the damage caused by the 2008 financial crisis.  This Report is intended to help analysts, market participants, policymakers, and the public gain a deeper understanding of the origins of the crisis and take the steps needed to prevent excessive risk taking and conflicts of interest from causing similar damage in the future.

Too Little, Too Late?

At long last, the Financial Crisis Inquiry Commission released its final report today on the causes of the great financial crisis of 2008. Unfortunately, the report probably raises more questions than answers due to the fact that the commission was split on the true cause of the crisis. The Democrat majority provided their view that the crisis was ultimately caused by greedy Wall Street bankers coupled with a lax regulatory system. On the other hand, the Republican minority of three panel members portrayed the following more complicated series of causes in their dissenting view.

1. Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.


2. Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.


3. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.


4. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.


5. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing  prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.


6. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.


7. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policymakers to be willing to allow them to fail suddenly.


8. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock.


9. Financial shock and panic. In quick succession in September 2008, the failures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.


10. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.

In total, the report and dissenting viewpoints provide a great analysis of the risk event. However, both fail to provide a forward-looking view on how such a crisis can be avoided in the future. In addition, the results of their analysis have emerged months after the U.S. Congress finalized the Dodd-Frank Financial Reform Act of 2010. Unfortunately, this is too often the case when it comes to risk management exercises. Most people will spend an inordinate amount of time debating past events rather than determining strategies to prevent emerging risk events.

Assessing Systemic Risk

New York University's Stern School of Business hosted a conference yesterday to discuss how systemic risk should be addressed under the Dodd-Frank Act.  One of the presenters at the conference, Stanford Finance Professor Darrell Duffie, proposed a new approach for identifying systemic risk.  Here's some detail on his proposal as reported by Bloomberg.

The world’s largest banks and investment firms should undergo quarterly stress tests to identify risks that could sink the financial system, according to a proposal by Stanford University finance professor Darrell Duffie. “I’m not talking about the ordinary, matter-of-course, risk management of institutions. We’re looking at what are the sources of risk and how are they flowing through the system. We want to connect the dots.”

Duffie calls his plan “10-by-10-by-10” because it’s based on 10 financial firms undergoing 10 stress tests that expose the banks’ 10 largest trading partners. For example, institutions would be tested on their ability to withstand the default of a single firm that they do business with, an idea replicating the 2008 Lehman bankruptcy.

“The objective is to alert regulators and the public to potential sources of financial instability before they reach dangerous levels,” Duffie wrote in a paper outlining the proposal. The tests, which would be adjusted over time to cover different scenarios, could flush out new systemically important firms as they arise, Duffie said. Central bankers could opt to conduct some of the stress tests using average financial numbers over a given timeframe “to mitigate period-end ‘window dressing,’” Duffie said. Regulators should also audit the way the banks measure the data they present, he said.

More specifics about the Duffie proposal are contained in his working paper, "Systemic Risk Exposures: A 10-by-10-by-10 Approach." By his own admission, Duffie notes that this proposal merely represents a first step for regulators to begin to analyze systemic risk. There are shortcomings to the proposal such as the current lack of data as well as the potential to exclude other entities that may pose risks to the system. However, the regulators must begin somewhere and this approach is a practical method for assessing systemic risk.

Is This Just the Tip of the Iceberg?

The Congressional Oversight Panel released its November report today and it focused on the continued foreclosure crisis. The panel is calling for additional investigation by regulators and is also requesting that the U.S. Treasury provide additional evidence of their claim that the crisis has been averted.  Below is an excerpt from their report as well as video commentary from the chairman of the panel, Senator Ted Kaufman.

At this point the ultimate implications remain unclear. It is possible, however, that “robo-signing” may have concealed much deeper problems in the mortgage market that could potentially threaten financial stability and undermine the government‟s efforts to mitigate the foreclosure crisis. Although it is not yet possible to determine whether such threats will materialize, the Panel urges Treasury and bank regulators to take immediate steps to understand and prepare for the potential risks.

In the best-case scenario, concerns about mortgage documentation irregularities may prove overblown. In this view, which has been embraced by the financial industry, a handful of employees failed to follow procedures in signing foreclosure-related affidavits, but the facts underlying the affidavits are demonstrably accurate. Foreclosures could proceed as soon as the invalid affidavits are replaced with properly executed paperwork.

The worst-case scenario is considerably grimmer. In this view, which has been articulated by academics and homeowner advocates, the “robo-signing” of affidavits served to cover up the fact that loan servicers cannot demonstrate the facts required to conduct a lawful foreclosure. In essence, banks may be unable to prove that they own the mortgage loans they claim to own.

Only time will tell whether the foreclosure issues are merely the tip of the iceberg.  However, if the issues are real, then the financial institutions and other involved parties will be best served to proactively address the problem now rather than hoping it goes away on its own.

Navigating Risk: From Crisis to Innovation

A big challenge for many companies today emerging from the financial crisis is retaining their ability to innovate new products and services. The typical view is that the larger the company, the harder it is to innovate. Why is that? It seems counterintuitive given the vast resources of larger companies compared to their smaller competitors. This issue was recently highlighted in an article on CNN.com. Here are the views of a few who have examined the issue in greater detail.

Can companies grow and continue to be creative and innovative? Or will smaller operations always have a monopoly in the new-ideas department? "I don't think there's any reason why you can't be as big as Goliath and as nimble as David," said Jim Andrew, a senior partner at the Boston Consulting Group, which publishes a yearly list of the world's top innovative companies in conjunction with Bloomberg Businessweek. This year, Apple, Google, Microsoft and IBM led the list. Facebook and Twitter were nowhere to be found.

"Big companies have a tremendous number of advantages that should allow them to actually be, I would argue, more innovative than a given smaller company," Andrew said.  The tech giants tend to have a wide range of products or services to offer -- meaning they can take bets on new ideas without risking their entire business, Andrew said. Start-ups, in contrast, tend to base their future on a single product or concept. They bet big, but most of them "end up dying," said Karim Lakhani, an assistant professor at Harvard Business School. "They go out there, they try different things and then there's a large, large failure rate," he said.

Both Lakhani and Andrew said it's easy for big companies to get too comfortable and forgo the risks that are necessary for innovation to occur. "As companies get bigger that latitude [for employees to be creative] often unfortunately gets taken over by more rigid management structures and more rigid philosophies," Lakhani said.

For those interested in exploring this dilemma further, mark your calendars for an upcoming workshop that will help you navigate the risks associated with innovation.  On January 11 & 12, Wheelhouse Advisors will conduct an executive workshop entitled Navigating Risk: From Crisis to Innovation. The workshop will be held at the highly renowned Old Edwards Inn & Spa in beautiful Highlands, NC.  For more information, email Navigate@WheelhouseAdvisors.com or call 404-805-9203.

Lessons Learned from the Foreclosure Crisis

The recent foreclosure crisis is just another chapter in the financial meltdown that began in 2007.  As a result of the frenzy to securitize mortgage loans back in the middle of the decade, the required paperwork to foreclose on a property is difficult, if not impossible, to retrieve. Now, financial institutions are finding that the outsourced foreclosure work is faulty at best and fraudulent in many cases. Here's what the Wall Street Journal reported today.

In recent days, some lenders named in the foreclosure inquiries have said they would no longer use the services of some of these law firms for new foreclosures. Ally Financial Inc.'s GMAC Mortgage has pulled business and dispatched executives and a new team of lawyers to Florida to ensure foreclosure cases are being handled correctly, according to a person familiar with the situation.

The law firms and a Lender Processing unit, Docx LLC, which did work at a suburban Atlanta office, handled the nitty-gritty paperwork necessary to verify key document batches, including ownership transfer of a loan, known as an assignment, and the amount owed by a borrower losing his home. That paperwork processing at the law firms and lenders allegedly didn't review all information needed, such as who owned the loan or borrower financial information, the Florida attorney general claims. The Florida attorney general's office is looking at possible use of "fabricated documents" used in foreclosure actions in court, according to the attorney general.

This situation provides a few lessons in risk management. First, it demonstrates the lingering effects of poor controls when dealing with massive amounts of transactions complicated by a highly complex securitization process. Second, it also shows that the operational risks to a given company extend well beyond its walls to its outsourcing partners' ability to properly control its business.  Finally, with the crisis today clearly rooted in the actions of the past, it demonstrates the need for more forward-looking risk management programs.

Big Event in Basel

A major event for financial services companies across the globe is happening this weekend in Basel, Switzerland. Regulators from 27 countries are meeting there to finalize new rules that will impact how banks manage risk in the future.  Known as "Basel III", the new set of rules are a direct response to the financial crisis that began over two years ago.  The rules will take time to implement, but they are a significant shift from the Basel II Accord that allowed individual banks to determine their own capital levels based on their own internal rating system.  The Wall Street Journal reported the following today.

Convening in the Swiss city of Basel, the officials are hoping to cinch a deal this weekend. In one of the most far-reaching steps, the current proposal would require global banks to maintain basic levels of capital equal to at least 7% of their assets—much more than existing standards of roughly 4% for large U.S. banks.

The effort would transform banking, potentially forcing banks to take fewer risks, make less profit and face more government scrutiny. It comes nearly two years after the chaotic bankruptcy of Lehman Brothers convulsed the global economy and led to taxpayer-funded bailouts world-wide. U.S., European and Asian officials hope an accord will create new global standards designed to firm up the foundations of large international banks.

The hope of the Basel Committee on Banking Supervision is that the new rules will create a financial system that is more resilient and able to withstand future crises.  Only time will tell if this will be the case.

FASB Chairman Steps Down

Yesterday, Robert Herz, Chairman of the Financial Accounting Standards Board ("FASB"), announced his resignation amidst a number of critical issues requiring resolution by the board.  It is interesting timing given that Mr. Herz had two years remaining for his term as Chairman.  It certainly adds to the uncertainty about the direction the board will take in the areas of mark-to-market accounting and the convergence of GAAP and IFRS.  Here is the Wall Street Journal's view.

Mr. Herz's departure, set for Oct. 1, also comes as the body is enmeshed in a battle over a proposal to expand the use of mark-to-market accounting, which requires companies to use market prices rather than management estimates to value financial holdings. Some investors say this practice brings a more realistic view to the numbers that public companies report, but banks have vigorously opposed the practice. They say it will introduce unnecessary volatility into results and exacerbated the financial crisis.

At the same time, Mr. Herz's departure may affect the board's ability to complete projects designed to bring together its rules and those set by the London-based International Accounting Standards Board. Mr. Herz's long-stated goal was to make both accounting regimes similar enough that U.S. public companies could abide by the international standards.

Mr. Herz may be stepping down now rather than succumb to continuing political pressure being placed on the board. We may never know if that is the case, but one thing is for certain - the new Chairman will certainly have his or her hands full when they begin their term.

Geithner Issues a Call to Action

U.S. Treasury Secretary Timothy Geithner delivered a speech this week at New York University's Stern Business School to kick-off the massive effort to craft new financial regulations to comply with the Dodd-Frank Act of 2010.  In his speech, he promised to streamline and simply the rules while working to codify them at an expeditious pace.  He also provided the following call to action for the financial services industry.

For the financial industry, your core challenge is to restore the trust and confidence of the American people and your customers and investors around the world. You will have to make your own decisions about how best to do that, but, I thought, given that I'm here in New York, I'd offer a few suggestions as an interested observer.

Don't wait for Washington to draft every rule before you start changing how you do business. Get ahead of the process and out in front of your competitors. Find new ways to improve disclosure for your consumers.  End hidden fees. Don't push people into loans they can't afford.

Demonstrate to your business customers – small and large – that after running for cover during the peak of the crisis you are ready and willing to take a chance on them again. Change how you pay your executives so you are not rewarding them for taking risks that could threaten the stability of the financial system.

Make sure you have board members who understand your business and the risks you are taking. And, focus on improving your financial position so that your financial ratings, your cost of capital, the amount you have to pay to borrow, all reflect your own financial strength and earnings prospects, not the false expectation that the government will be there in the future to rescue you.

You can do all of that right now, even before the first new rule of financial reform is written.

Secretary Geithner is right to encourage banks to move now in the right direction as opposed to waiting for the rules to be written.  Doing so will not only better prepare the companies for the change to come, but will also provide a significant competitive advantage that will surely result in a similar increase in shareholder value.

New Basel Capital Accord Announced

Yesterday, the Bank for International Settlements announced that its Basel Committee on Bank Supervision has reached a preliminary agreement on a new capital accord widely known as Basel 3. Here is what the New York Times reported today.

Central bankers and regulators have reached an almost-unanimous preliminary agreement on new standards to reinforce the stability of the global financial system, adding to investor confidence in the outlook for many banks.

In the next few months, the regulators will conduct a detailed analysis of how the standards would affect the biggest banks in Europe, Asia and the United States. Under the plan, banks will have until as early as 2018 to comply with a requirement that they hold at least $3 in capital for every $100 they lend — a so-called leverage ratio of 3 percent. A leverage ratio is considered the broadest measure of a bank’s financial strength.

The regulators said the final amount might be adjusted. Whatever the amount, the requirement should have little effect on U.S. institutions, which already meet the 3 percent standard easily. Some European and Asian banks could have to reinforce their financial positions.

Like many movie sequels, this new capital accord is somewhat anticlimactic. An implementation period of seven years is the length of many business cycles and we will certainly see a need for adjustments to the capital accord by then. So, stay tuned for Basel 4.

Prepare Now for the Tsunami of New Rules

Nearly two years after the worst of the financial crisis of 2008, financial regulatory reform legislation has been signed into law by President Obama. The Dodd-Frank Act of 2010 officially became law yesterday in a signing ceremony at the Ronald Reagan Building in Washington, DC.  Weighing in at over 2,000 pages, the new Act is chock full of mind numbing details.  However, the most important details are still yet to come. The Act provides authority for regulatory bodies such as the Federal Reserve to create new rules for financial institutions to follow. This will serve to significantly increase the compliance risk for these companies.  Here is what the Wall Street Journal reported yesterday.

The legislation is a major revamp of U.S. financial-market oversight, streamlining regulation and giving agencies such as the Fed much broader authority to deal with the most complex financial institutions. Many of the new rules will depend on regulators to write specific restrictions and regulations, and Bernanke said the onus is on officials to ensure that they are “sufficiently tough that the risk of another crisis is very low.”

Financial services companies should brace themselves for an onslaught of new rules and also should ensure they have the appropriate infrastructure to respond in a quick and efficient way. Much like the formation of a tsunami, the Act is essentially the earthquake preceding the gigantic wave.

Increasing Demand for Strong ERM Solutions

A new survey by IDC Financial Insights confirms that demand for Enterprise Risk Management ("ERM") solutions is increasing as the new regulatory environment becomes more certain in the wake of the financial crisis. This is not a surprising result to readers of this blog, but one that will become even more apparent as we enter the latter half of 2010 and into 2011.  Here is an excerpt from the survey as reported by American Banker and Bank Technology News.

The microscope that’s fixed on enterprise risk management is getting more powerful, from both internal and external sources, says IDC Financial Insights. In its 2010 survey of senior risk managers at Tier One and Tier Two U.S. banks, the research firm found that both top management and regulatory agencies are paying more attention, and that delinquency and other customer credit risks linked to the banking crisis are still front and center.

Key findings from this study include the following:

• Enterprise risk management is now getting more attention from internal (boards) and external (regulators) parties than ever before.


• The overall economy still has question marks, which is increasing the pressure on consumers and commercial customers to make payments – stress on delinquency is still front and center.


• With the focus on speed, accuracy, and efficiency, cloud or hosted risk management solutions are gaining more and more consideration by financial institutions. When asked about whether the institution is looking to replace in-house solutions with hosted solutions over the next 12 months, 25% of respondents gave a positive answer.


• According to the survey results, 58% of respondents are concerned about increased levels of systemic risks over the next 12 months.

Well constructed ERM programs are the best antidote to the increasing pressure from key stakeholders such as regulators and boards. For help in determining the necessary steps to construct your program, visit www.WheelhouseAdvisors.com.

Taking a Hard Look at Risk Management

The Mortgage Bankers Association just issued an insightful report into the risk management practices at financial institutions leading up to the financial crisis of 2008.  The report is entitled "Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future" and is authored by Clifford V. Rossi from the University of Maryland. The findings in the report are very candid in their criticism of the financial institutions and their reluctance to acknowledge the risks being taken.  Here is one of the reported lessons to be learned in the aftermath of the crisis.

Risk managers may have been effective in identifying risks, however, many firms appeared tone deaf to these subject matter experts. If senior management had elevated the risk officer position to one that had direct or even indirect reporting to the risk committee on the board of directors, it may have helped staunch some of the risk taking that occurred. Further, executive management must inculcate a culture of risk management where all employees actively are on guard for risks that exceed the risk appetite of the company. One way to incent depository institutions to build strong risk functions and culture is for FDIC to strengthen risk-based assessments on deposit premiums reflecting the strength of the risk management organization and quality of the firm’s risk infrastructure. By blindly following the herd, the largest mortgage originators effectively competed themselves out of business. Reliance on information gathered from brokers and sales staff regarding the competition can be valuable to firms, however, the information obtained needs to be carefully vetted against specified corporate objectives. A clear vision of what risks the firm is willing to take must be part of the strategic roadmap, and deviations from that plan must be accompanied by sound analytics and information even if short-term losses of market share and key individuals are likely. A corollary to this recommendation is that risk vision and therefore business strategy must take a long-run view into account in shaping risk direction.

It is refreshing to see an organization like the Mortgage Bankers Association taking a hard look at what went wrong and how we can work to prevent a similar crisis in the future.  However, the report also reminds the reader that a similar crisis occurred only 20 years ago during the Savings & Loan debacle.  So, it is crucial for companies to take the necessary steps this time around or we could be having a similar conversation in the very near future.

Too Much Risk

Yesterday, the Financial Crisis Inquiry Commission conducted a hearing to examine the failure of Bear Stearns in 2008.  The theme of the testimony by Bear Stearns was that there was too much risk in the broker-dealer's capital structure. Here is what the Wall Street Journal reported.

Former Bear Stearns Chief Executive Officer James Cayne said Wednesday that his firm's risk level was too high in the year before it collapsed. "That was the business," Mr. Cayne told a hearing held by the Financial Crisis Inquiry Commission, a congressional panel scrutinizing the financial crisis. "That was really industry practice. In retrospect, in hindsight, I would say leverage was too high." Commission Chairman Phil Angelides said Bear Stearns was leveraged at a ratio of 38 to 1, sometimes as high as 42 to 1, and held $46 billion in exposure to mortgages. "How is that model sustainable in the event of any market disruption of significance?" he asked.

The simple answer to Chairman Angelides' question is that the model is not sustainable at that level of leverage. The problem is that in 2004 the SEC allowed firms like Bear Stearns to increase leverage from a prior limit of 12 to 1 to much higher levels.  So, the government can also look to itself when seeking to place blame for the market collapse.

A Week to Remember

This week has been full of activity that will shape the nature of enterprise risk management ("ERM") programs in the months and years to come.  First, the logjam in the U.S. Senate finally broke with the start of floor debate on financial regulatory reform.  At the same time, hearings into the dealings at investment banks during the height of the financial crisis surfaced some interesting points on the need for more integrated risk management across financial institutions.

There were also several risk management industry conferences with significant keynote addresses.  A great summary of these events can be found on the OpenPages blog.  OpenPages is a strategic partner with Wheelhouse Advisors and provides a technology platform that enables the integration of risk management practices within companies.  As companies look to ready themselves for regulatory reform and strengthen their ERM programs, they will certainly need solutions like OpenPages to become more resilient to the rapidly changing risk and regulatory landscape.

No doubt that this will certainly be a week to remember for the evolving state of ERM and regulatory reform.

Out of Control

Yesterday, the U.S. Senate Subcommittee on Investigations conducted hearings to examine the largest bank failure in U.S. history and its role in the 2008 financial crisis.  The failure of Washington Mutual ("WaMu") was largely the result of years of increasing involvement in the mortgage-backed securities market.  Over a four year period, WaMu increased their securitizations of subprime mortgages from about $4.5 billion in 2003 to $29 billion in 2006.  Altogether, from 2000 to 2007, they securitized at least $77 billion in subprime loans.  At the same time, WaMu allowed its lending practices and controls to erode in the pursuit of greater loan production and short-term profits.  Here is a summary of the investigators' findings.

(1)   High Risk Lending Strategy. Washington Mutual (“WaMu”) executives embarked upon a high risk lending strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans.

(2)   Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (“Long Beach”), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors.

(3)   Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up.

(4)   Polluting the Financial System. WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss.

(5)   Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered.

(6)   Destructive Compensation. WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when its high risk lending strategy placed the bank in financial jeopardy.

These findings are not surprising in the aftermath of the financial disaster.  However, without significant oversight and change in the operations of financial institutions, a similar scenario will likely occur in the not too distant future.

Financial Reform Bill Emerges from Senate Committee

The financial regulatory overhaul bill finally emerged from the Senate Banking Committee yesterday after a 13-10 vote along party lines.  According to many experts surveying the political landscape in Washington D.C., the bill will likely be modified to gain broader support to ensure passage by the full Senate.  Here is what Bloomberg reported about the voting outcome and the bill today.

The final version “will be a much more business-friendly bill,” because Democrats will need to make concessions to win support from Alabama Senator Richard Shelby, the banking panel’s top Republican, said Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia. “They won’t get a bill done until Dodd and Shelby agree on the compromise, but Republicans do want to get a bill done this year,” said Miller. “So there’s incentive for both sides to come to agreement.”

The likelihood of major regulatory change this year continues to grow.  Are you prepared?  If not, Wheelhouse Advisors can help.  Visit www.WheelhouseAdvisors.com to learn more.

FASB Looks to Expand Mark-to-Market Rules

The Wall Street Journal reported today that the Financial Accounting Standards Board ("FASB") is looking to expand requirements for mark-to-market accounting at banks.  If successful, the FASB will require banks to report the market values of loans rather than the historical cost.  This change could have a dramatic impact on the balance sheets and income statements for many financial institutions.  Here is some additional perspective from the WSJ.

Banks generally loathe mark-to-market rules, which rely on what they feel are too-often irrational market prices. The market value of some loans did fall excessively in the depths of the crisis. And many bankers, and bank regulators, believe the rules worsened the financial crisis.

But that argument ignores the fact that banks clearly didn't pay enough heed of market values in the run up to the crisis, and their own estimates of potential losses were woefully inadequate. This left bank balance sheets, and investors, unprepared for the credit crunch. If banks had focused on market values as well as internal models, many may have acted sooner to raise equity.

If these new rules are adopted, then the divide between the winners and losers among financial institutions will widen precipitously.  Investors and bankers alike will be keeping a close eye on this potential development.