Lloyd C. Blankfein, chairman and CEO of Goldman Sachs, today outlined a number of lessons he believes have been learned from the global financial crisis. Blankfein was speaking at the International Organization of Securities Commissions (IOSCO) Annual Conference in Tel Aviv today.
The first lesson, according to Blankfein, is outsourcing of risks. "Investors were greatly pleased with the AAA ratings from the international credit rating agencies, based on ratings of the issuers and not on ratings of the commitments," Blankfein said. "This gave rise to bonds designed to fit the rating methodology of these agencies. The fact that bonds were devised so that their risk level would be low enough to bring them above the high rating threshold contributed to the crisis," he added.
Blankfein, who spoke at a session on "Financial Stability in a Global Financial Environment? Learning the Lessons from the Market Crisis", sought to emphasize the importance of drawing conclusions from the financial crisis. "Given enough time, worse scenarios will happen than the crisis we have been through," he predicted, pointing out the necessity of the stress tests being carried out in the US as a means of predicting the durability of the banks in future extreme scenarios. Another aspect that Blankfein mentioned was the mistaken risk management model used by institutions in the financial systems, saying "any risk level higher than zero means risk."
"We learned from Enron that when there are risks, they must be regarded as part of the balance sheet, even if they are off-balance sheet, if only because of the fact that a day is likely to come when you will have to inject capital against the off-balance sheet liabilities," Blankfein said. The Goldman Sachs chairman also commented on the financial engineering that gave birth to complex financial instruments. In his view, "their complexity was underestimated."
Blankfein believes that the culture of risk management must change. "At the end of the day, people must have an incentives and promotion policy in financial organizations that does not reward taking unnecessary risks for the sake of short-range profits," he declared. On the compensation policy that encourages risk taking on Wall Street, he said that "no-one at our firm is compensated just on profit and loss performance, because we want to encourage teamwork."
Commenting on the question of fair-value accounting, Blankfein said, "I understand the destructive effect of mark-to-market valuation at times of distress, but if people identify initial signs of risks when they see a fall in value of the order of about $40 billion, they will react fast. After all, they will have no possibility of continuing to value the assets higher."
Concluding his remarks, Blankfein said, "Every player on the market should know that regulators around the world have joint power. More than half our assets are managed outside the US, and my interest is that regulators throughout the world should work in conjunction."
Martin Wolf, chief economics commentator of the "Financial Times", believes that what has been learned from the crisis is that the market failed. "We had de-regulation, and now it’s clear that the financial system has to be supervised comprehensively," he said. "States must save financial institutions, but only if they are able to do so."
Paul McCulley, managing director and portfolio manager at PIMCO US (which runs the world's largest bond fund, a fund that, among other things, bought Bank Hapoalim's asset backed portfolio last year) classified the securitized assets that were at the eye of the s current storm into three types. The first and most solid instrument is that in which the cash flow from the securitized assets is enough to pay the bond interest and principle. "But that's a boring product," he said.
Another instrument enables payment of the interest in full, so that at the redemption date the principle balance has to be rolled over. "That affects the value of the assets and the risk they embody," McCulley said.
"The third case is one in which the cash flow is not even enough to defray all the interest, so that, at the redemption date, the debit balance exceeds the original debit balance."
"The regulators must distinguish between banks that have safety nets, with access to capital, and those that don't, in order to supervise the financial system," McCulley added. "The markets are efficient and behave rationally most of the time except when they don't. In the latter case, regulators must consider the behavioral psychology behind investors in such circumstances."
Published by Globes [online], Israel business news - www.globes.co.il - on June 10, 2009
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