Tuesday, December 09, 2008

Former NY Fed Chief Tells Congress Credit Default Swap Debacle Was Risk Management Failure

The implosion of the credit default swaps market was due to a massive failure of risk management, said former NY Fed President Gerald Corrigan, rather than any inherent flaw in the instruments themselves. In testimony before the House Agriculture Committee, he also said that, from the viewpoint of financial stability, whether or to what extent credit default swap trades occur on organized exchanges is not a matter of overriding concern so long as the details of all such trades are made available on trade date to a central counterparty clearing system. Mr. Corrigan is also chair of the Counterparty Risk Management Policy Group.

It is now clear, said the chair, that a number of sophisticated financial institutions experienced shortcomings in their risk management before and during the crisis. The presence of a small number of highly concentrated credit default swap risk exposures across the financial landscape unmistakably reveals that some market participants were quite slow in recognizing that these exposures risked material write-downs and very sizeable collateral calls.

With regard to counterparty risk, said the group chair, it is widely recognized that highly concentrated positions at a relatively small number of institutions resulted in massive collateral calls which caused large write-downs and impaired the liquidity position of the institutions in question. Even worse, there were situations in which basis risk, counterparty risk, and the embedded leverage in certain classes of structured credit products interacted with each other in ways that amplified contagion and volatility, and multiplied the size of margin calls and write-downs.

Reforms will now be needed to mitigate systemic risk, probably though enhanced federal oversight. Regardless of which central counterparty process emerges as the industry standard, noted the former Fed official, the authorities must satisfy themselves that its risk mitigation features have virtually failsafe operational and financial integrity, including the capacity to absorb the default of two of its largest members. Consistent with this philosophy, he believes that there should be a single dedicated global central counterparty platform and that any approach that co-mingles credit default swap settlement funds with settlement funds for other financial instruments is unwise.

Moreover, regulators should, as a part of their regular inspections and examinations, ensure that individual institutions are doing their part to ensure that such institutions’ policies and practices regarding the needed infrastructure improvements are in line with industry best practices.

The former Fed official also said that regulators should, on a case by case basis, make inquiries regarding highly concentrated positions and crowded trades and, where necessary, encourage or require individual institution to moderate the risks of such positions. On a voluntary basis, hedge funds and other unregulated financial institutions should be willing to respond to similar inquiries or face the prospects of greater direct regulation.

In addition, major market participants and their regulators must ensure that risk monitoring, risk management and, of special importance, corporate governance practices are in line with best practices with particular emphasis on monitoring exposures and the application of rigorous valuation and price verification practices to complex transactions. Among other things, he noted, such best practices will play a constructive role in quickly resolving collateral disputes.