Financial meltdown dissected in report

A group of Wall Street executives on Wednesday released a report outlining 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, by chief risk officers and senior executives at banks such as Lehman Brothers, Merrill Lynch and Citigroup, also provides suggestions about technical issues while offering 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 Gerald Corrigan, a managing director at Goldman Sachs and a chairman of the Counterparty Risk Management Policy Group III, which released the report.

The report said Wall Street failed to anticipate how wide-reaching problems with mortgage bonds would spread into seemingly distant corners of the financial markets. 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.

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 Geithner, president of the New York Federal Reserve.

In a cover letter to Treasury Secretary Henry Paulson, 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.

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.”