Tuesday, February 1, 2011

Financial Crisis Retrospect


According to a recently released inquiry report investigating how the 2008 financial crisis unraveled, 12 of the 13 largest U.S. financial institutions "were at risk of failure", while at least 50 hedge funds tried to capitalize on it.

The report indicates a huge run occurred on the bank at Morgan Stanley and describes the alleged trading practices of a secretive hedge fund, while tallying the number of such funds betting against U.S. homeowners. The 545-page document paints a picture of a financial system let loose by lax regulation and spiraling out of control. Regulators now are hammering out a financial-regulatory overhaul spear-headed by the Dodd-Frank act, though some analysts say not enough has been done since to prevent a recurrence.

The report described a shadow banking system that helped trigger a more than tenfold surge in financial-sector debt, to $36 trillion in 2007 from $3 trillion in 1978. Then it crumbled, Federal Reserve Chairman Ben Bernanke told the commission in a November 2009 interview. "As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression," Mr. Bernanke said, according to the commission's report. Of the 13 most important U.S. financial institutions, "12 were at risk of failure within a period of a week or two," the report quoted Mr. Bernanke as saying.

The list of potential failures included Goldman Sachs Group Inc., people familiar with the report said. The only major financial institution not at risk at the time was J.P. Morgan Chase. Spokesmen for J.P. Morgan Chase and Goldman Sachs declined to comment on the report. Hedge funds pulled $86 billion in assets from Morgan Stanley in the week following the Sept. 15 Lehman bankruptcy filing, stemming from concerns about Morgan Stanley's viability, according to a Morgan Stanley email at the time to the New York Federal Reserve titled "Liquidity Landscape." "Many of our sophisticated clients started to liquefy," Morgan Stanley Treasurer David Wong told the commission in October. A Morgan Stanley spokeswoman declined to comment.

The report also provided clarity about the number of hedge funds gambling homeowners couldn't pay their mortgages. In an interview with the commission, former Deutsche Bank AG trader Greg Lippmann, who played a key role in facilitating short bets, told the commission that in 2006 and 2007 he handled trades for at least 50 hedge funds and "maybe as many as 100" betting that mortgage-backed securities would fall. An FCIC survey of some hedge funds found they had a total of $45 billion of short bets, which easily outweighed roughly $25 billion of bullish positions they had on mortgages. The panel also scrutinized the conflicts of interest involving Wall Street banks, hedge funds and investors created by the pools of mortgage debt known as collateralized debt obligations.

We hope that Dodd-Frank will help prevent a repeat of the crisis, as regulators interpret the 254 page document that details sweeping reforms of how financial institutions will conduct their business. This will include derivatives regulation, broker-dealer disclosures and consumer protection clauses that must be implemented by Wall Street firms or by law, they won't be able to continue operating. Look for updates in future articles.

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C. Cohn
Cohn-Reilly Report


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