Never before in history was a financial crisis predicted so early as the current one.
But why were some banks able to see what was happening and react accordingly?
Why did some CEOs and risk managers ignore all the warning signs?
Winners were Goldman Sachs, Credit Suisse, Lehman Brothers while others, such as Citigroup, Merrill Lynch and UBS, just carried on playing the markets until they ran into a brick wall?
Close Management – Successful firms have CEOs with either a risk management or a trading background who have remained involved in day-to-day risk-related decisions. Their risk managers are empowered to take businesses apart and to insist that traders explain their positions and unwind them if necessary.
At Goldman at least 10 people in senior management have at one time or another run its mortgage business. Wilson Ervin, chief risk officer at Credit Suisse, has hands-on experience of product engineering.
Market Mistiming– The biggest write-downs were at firms that were still talking about ramping-up their risk or making acquisitions, when subprime default rates were rising steadily. – Why to catch-up with competitors.
Merrill Lynch, for example, bought First Franklin Financial for $1.3bn in September 2006. A year later (one month before he was ousted as chief executive), in an interview in Sep -07, Stan O’Neal justified the purchase by saying that Merrill had not bought a portfolio of bad loans, but had invested in an origination platform; despite the correction, this was still a good business, he argued. In the same interview he continued to argue that Merrill had not been taking enough risk.
Morgan Stanley when it bought non-prime lender Saxon Capital for $706m just as other banks were bailing out.
In July 2007 Citi’s CEO Chuck Prince famously said that the bank was “still dancing” to the tune of the buyout boom, shortly before investor demand for leveraged loans collapsed.
Market Intelligence – Some firms clearly been better at spotting when the markets turned and therefore better at getting out. – These have unrivalled market intelligence using, for example information from in-house mortgage servicing companies to track market gyrations.
Credit Suisse decided that the market was going the wrong way and took hits to its P&L in November and December 2006. Undoubtedly, additional market intelligence made a difference. Credit Suisse traders were helped by the bank’s ownership of Select Portfolio Servicing, a company which services about 270,000 subprime US residential mortgages. The insight that this provided on volumes and default trends must have given their hedging and trading strategies extra muscle.
Lehman Brothers, too, benefited from its US mortgage service provider (MSP), Aurora Loan Services, which at its height was servicing almost 1.5 million mortgages. (That said, it was not able to time the market so well: it did not move to shut down its American subprime lender BNC Mortgage until August 2007.)
Safety first – How did Goldman avoid big losses? Caution. – Bank simply followed the numbers: the more it had to mark losses in its mortgage book through Q4 2006 and Q1 2007, the more it began to hedge. In Q2 it stopped selling collateralised debt organisations and began closing product warehouses. The bank became increasingly cautious and by early Q3 it finally took the decision to buy protection on the entire mortgage portfolio.
Rise of the trading culture – As the trading businesses grew at every bank, they began to dwarf the classic investment banking operations.
At Deutsche Bank, for example, Q1 2007 figures (ie: prior to the subprime meltdown) revealed sales and trading revenue of €5.1bn, versus origination and advisory revenues of just €798m. Some bankers say that this shift undermined the client relationship-based culture of investment banking and replaced it with a transaction-based culture. Combined with a compensation structure that rewarded virtually unfettered risk taking, a crisis was inevitable.
Human Judgment And Experience – Wall Street is going to have to refocus on relationships with clients, and more importantly, with its own employees. It will have to return to making business decisions based on human judgment and experience, and that is ultimately a good thing for both clients and risk management.”
Soul searching – It is clear that the industry has entered a phase of reflection and adjustment. It is being forced to re-evaluate the way it measures, prices and, most of all, manages risk. Shortly after announcing writedowns, Morgan Stanley said it would be reviewing its risk management procedures.
Rethinking remuneration – Compensation structures tend to be based on longer-term and firm-wide results. – Mr Thain has stated that he will overhaul Merrill Lynch’s compensation structure in an effort to inculcate a sense of bank-wide responsibility and accountability. Bonuses will reflect the firm’s performance first, and then that of the business line, and lastly that of the individual, he says.
But it will be impossible for a single bank to change the system. Any reworking of compensation philosophy will have to be industry-wide to prevent the leaching of senior bankers from low-bonus to high-bonus firms.
Culture – Only time will tell how well banks have prepared for any further market dislocations but one thing is clear. But when investment banks emerge from this latest crisis, they must tackle their cultural problems head-on.
Complete Article from the Banker..
LIKE plane-crash survivors forced to eat their fellow passengers, investment bankers have found some sources of nourishment amid the wreckage of the banking industry. Goldman Sachs notched up a 72% increase in equity-underwriting revenues in the second quarter, much of it from other banks. Now many have their eyes on M&A deals. 
