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"Containing Systemic Risk: The Road to Reform The Report of the CRMPG III August 6, 2008 Containing Systemic Risk: The Road to Reform The Report of the CRMPG III August 6, 2008 www.crmpolicygroup.org Containing Systemic Risk: The Road to Reform TABLE OF CONTENTS Transmittal Letter ................................................................................................................ iii CRMPG III Members .......................................................................................................... vii CRMPG III Working Groups ...............................................................................................viii Section I: Introduction ...................................................................................................1 Executive Summary....................................................................................17 Section II: Section III: Section IV: Section V: Section VI: Standards for Accounting Consolidation.....................................................38 High-Risk Complex Financial Instruments..................................................53 Risk Monitoring and Risk Management ......................................................70 Enhanced Credit Market Resiliency..........................................................102 Emerging Issues .......................................................................................131 Appendix A: Appendix B: Term Sheets for High-Risk Complex Financial Instruments ..................... A-1 CDO Risk Characteristic (Excerpted from CRMPG II).............................. B-1 i CRMPG III August 6, 2008 E. Gerald Corrigan Goldman, Sachs & Co. Co-Chairman Douglas J. Flint HSBC Holdings plc Co-Chairman Madelyn Antoncic Lehman Brothers Craig W. Broderick Goldman, Sachs & Co. Ken deRegt Morgan Stanley Andrew Feldstein Blue Mountain Capital Management Peter Fisher BlackRock, Inc. Adam Gilbert JPMorgan Chase & Co. Christian Lajoie BNP Paribas Gary Lynch Morgan Stanley J. Chandler Martin Bank of America Edmond Moriarty Merrill Lynch Gavin O'Connor Goldman, Sachs & Co. Edward J. Rosen, Esq. Cleary Gottlieb Steen & Hamilton LLP Zion Shohet Citigroup Barry L. Zubrow JPMorgan Chase & Co. The Honorable Henry M. Paulson, Jr. Secretary of the Treasury, and Chairman, President’s Working Group on Financial Markets 1500 Pennsylvania Ave., NW Washington, DC 20220 The Honorable Mario Draghi Governor, Bank of Italy, and Chairman, Financial Stability Forum Via Nazionale 91 00184 Rome Italy Dear Secretary Paulson and Governor Draghi: On behalf of CRMPG III we are pleased to convey to you our Report entitled “Containing Systemic Risk: The Road to Reform.” As the title of the Report suggests, the Policy Group considers the financial crisis of 2007 and 2008 to be the most severe we have experienced in the postwar period. While this turn of events had multiple causes and contributing factors, 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. As history tells us in unmistakable terms, it is virtually impossible to anticipate when optimism gives rise to fear or fear gives rise to optimism. The last twelve months have been no exception to this sobering reality. It is this sobering reality that, for centuries, has given rise to the universal recognition that finance and financial institutions must be subject to a higher degree of official oversight than is necessary for virtually all other forms of commercial enterprise. However, official supervision is not a substitute for effective management of financial iii Containing Systemic Risk: The Road to Reform institutions which is –and should remain – a private function. Yet, here too, there is a dilemma; namely, in a highly competitive marketplace it is very difficult for one or a few institutions to hold the line on best practices or to stand on the sidelines in the face of booming markets. What is needed, therefore, is a form of private initiative that will complement official oversight by insisting on industry practices that will help mitigate systemic risk. The “core precepts” and recommendations in this Report have been framed with that objective in mind. The Policy Group places particular importance on the five core precepts for containing systemic risk that are discussed in Section I. The subsequent four sections of the Report include the following: Section II which covers a reconsideration of the standards for consolidation under US GAAP that contemplates a significant shift of currently off-balance sheet status entities to on-balance sheet status; Section III which is directed at measures to better understand and manage high-risk complex financial instruments with particular emphasis on (1) the establishment of standards of sophistication that would apply to all participants in the market for high-risk complex financial instruments; (2) enhanced disclosures; (3) improved sales and marketing practices; and (4) strengthened issuer and loan diligence; Section IV which focuses on substantial enhancements to risk monitoring and management with particular emphasis on sound corporate governance, risk monitoring, and fostering a single integrated discipline for managing capital adequacy and liquidity and funding; and Section V which outlines a series of truly sweeping measures to enhance the resiliency of financial markets generally and the credit markets in particular with special emphasis on the OTC derivatives market and the credit default swap market. The recommendations in Section V – including the call for the prompt creation of a clearing corporation that would begin clearing credit default swaps in the fourth quarter of 2008 – are extremely ambitious. The final section of the Report discusses a number of important “emerging issues”. While this section, by its design, does not have recommendations, it does point, in very concrete terms, to subject matter that will require close attention during the period ahead on the part of policy members and practitioners alike. Achieving the sweeping enhancement and reform set forth in the Report will require collective and concerted industry-wide initiatives, supported by progressive and enlightened prudential supervision conducted in the spirit of the March 6, 2008 Report of iv Containing Systemic Risk: The Road to Reform the Senior Supervisors Group. In the private sector, greater financial discipline at individual institutions must be reinforced by a renewed commitment to collective discipline in the spirit of elevated “financial statesmanship” that recognizes that there are circumstances in which individual institutions must be prepared to put aside specific interests in the name of the common interest. Such a commitment may require market participants to (1) make costly investments in infrastructure (human capital and technology) and (2) change business processes, and accept changes to market practices, that in the past have generated sizeable revenues but at the cost of weakening the underlying foundation of the markets. Costly as these reforms will be, those costs will be minuscule compared to the hundreds of billions of dollars of write downs experienced by financial institutions in recent months to say nothing of the economic dislocations and distortions triggered by the crisis. In an effort to ensure implementation of these enhancements, the Policy Group strongly urges that all major financial institutions should analyze their internal policies, procedures and practices against the recommendations and reforms outlined in this Report. Senior management at these institutions should ensure ongoing monitoring of progress in relation to these reforms. In closing, we wish to express our gratitude to the Policy Group members and their respective Working Groups for their extraordinary contributions to this Report. We also want to acknowledge that in our work, we have benefited enormously from the earlier efforts of the President’s Working Group on Financial Markets and the Financial Stability Forum. Sincerely, E. Gerald Corrigan Douglas J. Flint v Containing Systemic Risk: The Road to Reform Exhibit I CRMPG III CO-CHAIRMEN E. Gerald Corrigan Managing Director Office of the Chairman Goldman, Sachs & Co. Douglas J. Flint Group Finance Director Deputy Head of Global Markets HSBC Holdings plc POLICY GROUP MEMBERS Madelyn Antoncic Managing Director Global Head of Financial Market Policy Relations Lehman Brothers Craig W. Broderick Managing Director Chief Risk Officer Goldman, Sachs & Co. Ken deRegt Managing Director Chief Risk Officer Morgan Stanley Andrew Feldstein Chief Executive Officer Chief Investment Officer Blue Mountain Capital Management Peter Fisher Managing Director Co-head of Fixed Income BlackRock, Inc. Adam Gilbert Managing Director JPMorgan Chase & Co. Christian Lajoie Head of Group Supervision Issues BNP Paribas Gary G. Lynch Executive Vice President Chief Legal Officer Morgan Stanley J. Chandler Martin Executive Vice President Bank of America Edmond Moriarty Senior Vice President Co-Chief Risk Officer Merrill Lynch & Co. Gavin G. O’Connor Managing Director Goldman, Sachs & Co. Edward J. Rosen, Esq. Partner Cleary Gottlieb Steen & Hamilton LLP Zion Shohet Treasurer Head of Corporate Finance Citigroup Barry L. Zubrow Chief Risk Officer JPMorgan Chase & Co. PROJECT SECRETARIAT Darren Littlejohn Goldman, Sachs & Co. Manar Zaher Goldman, Sachs & Co. Ranbir Hira Cleary Gottlieb Steen & Hamilton LLP Jennifer Philbrick Cleary Gottlieb Steen & Hamilton LLP vii Containing Systemic Risk: The Road to Reform Exhibit II Working Groups I. Standards for Accounting Consolidation Co-Chairmen Gary G. Lynch Executive Vice President Chief Legal Officer Morgan Stanley Gavin G. O'Connor Managing Director Goldman, Sachs & Co. Members John M. James Senior Vice President and Corporate Controller Bank of America Russell C. Picot Group Chief Accounting Officer HSBC Holdings plc Matthew L. Schroeder Managing Director and Global Head of Accounting Policy Goldman, Sachs & Co. II. High-Risk Complex Financial Instruments Co-Chairmen Ken deRegt Managing Director Chief Risk Officer Morgan Stanley Edmond Moriarty Senior Vice President Co-Chief Risk Officer Merrill Lynch & Co. Members Neil Cotty Chief Accounting Officer Bank of America Christian Lajoie Head of Group Supervision Issues BNP Paribas Stephen O’Connor Managing Director Head of Counterparty Portfolio Morgan Stanley Bruce Petersen Managing Director Goldman, Sachs & Co. Frank Roncey Head of Risk Management – Americas BNP Paribas – NY Marc Saidenberg Managing Director Merrill Lynch & Co. viii Containing Systemic Risk: The Road to Reform III. Risk Monitoring and Risk Management Co-Chairmen Craig W. Broderick Managing Director Chief Risk Officer Goldman, Sachs & Co. J. Chandler Martin Executive Vice President Bank of America Zion Shohet Treasurer Head of Corporate Finance Citigroup Members Michael Alix Former Member of CRMPG I and II Madelyn Antoncic Managing Director Global Head of Financial Market Policy Relations Lehman Brothers Liz Beshel Managing Director Treasurer Goldman, Sachs & Co. Douglas J. Flint Group Finance Director Deputy Head of Global Markets HSBC Holdings plc Christian Lajoie Head of Group Supervision Issues BNP Paribas Michael Liberman Blue Mountain Capital Management Arrington Mixon Enterprise Credit Risk Executive Bank of America Ken Winston Managing Director Morgan Stanley ix Containing Systemic Risk: The Road to Reform IV. Enhanced Credit Market Resiliency Co-Chairmen Andrew Feldstein Chief Executive Officer Chief Investment Officer Blue Mountain Capital Management Peter Fisher Managing Director Co-head of Fixed Income BlackRock, Inc. Barry L. Zubrow Chief Risk Officer JPMorgan Chase & Co. Members Peter Axilrod Managing Director DTCC Thomas J. Benison Managing Director JPMorgan Chase & Co. Samuel Cole Chief Operating Officer Blue Mountain Capital Management Athanassios Diplas Managing Director Deutsche Bank Adam Gilbert Managing Director JPMorgan Chase & Co. David Inggs Managing Director Goldman, Sachs & Co. Stephen O’Connor Managing Director Morgan Stanley Robert Pickel Chief Executive Officer ISDA Robin Perlen Managing Director Bank of America Don Thompson Managing Director JPMorgan Chase & Co. Doug Warren Head of US Credit Trading Managing Director Barclays Capital David Weisbrod Managing Director JPMorgan Chase & Co. x Containing Systemic Risk: The Road to Reform SECTION I: INTRODUCTION On April 8, 2008 E. Gerald Corrigan, Managing Director, Goldman Sachs, and Douglas Flint, Group Finance Director, HSBC Holdings Plc, announced the formation of the Counterparty Risk Management Policy Group III (CRMPG III or the Policy Group). This initiative, triggered in part by the guidance of the President’s Working Group on Financial Markets, was undertaken in order to provide a private sector response to the credit market crisis of 2007 and 2008 in a manner that complements the published work of a number of official bodies, including the President’s Working Group on Financial Markets, the Senior Supervisors Group and the Financial Stability Forum, as well as the efforts of the privatesector based Institute for International Finance. The scope of the CRMPG III initiative was designed to focus its primary attention on the steps that must be taken by the private sector to reduce the frequency and/or severity of future financial shocks while recognizing that such future shocks are inevitable, in part because it is literally impossible to anticipate the specific timing and triggers of such events. The CRMPG III effort has focused its attention on four closely related and forward-looking aspects of financial reform and rehabilitation, including: (1) a reconsideration of the standards for consolidation under US GAAP that contemplates a significant shift of currently off-balance sheet entities to on-balance sheet status; (2) measures to better understand and manage complex financial instruments with particular emphasis on their distribution and how their risk sensitivities are disclosed; (3) risk monitoring and risk management with particular emphasis on the role of sound corporate governance and the relationship between liquidity, leverage and capital adequacy; and (4) a series of sweeping measures to enhance the resiliency of credit markets in particular and financial markets more generally with particular attention to strengthening the safeguards associated with the OTC derivatives markets with emphasis on credit default swaps (CDS). Among other things, this section of the Report urges swift industry action to create a clearinghouse for OTC derivatives, starting with CDS. The Policy Group chose to focus on these four areas in the belief that these are the ones in which it could add the greatest value. In making that judgment, the Policy Group was SECTION I: INTRODUCTION 1 Containing Systemic Risk: The Road to Reform mindful that there are other vital areas of inquiry that will not be covered in this Report. Examples of such areas include the need to improve the loan origination and oversight process and the equally obvious need to improve the working of the credit ratings process. In these and other areas, the Policy Group concluded that ample attention is being devoted to these issues by others who are well positioned to identify and implement needed reforms. The background to this effort is, of course, the chain of events that is now properly labeled the credit market crisis of 2007 and 2008. In retrospect, these events clearly stand out as the most severe financial shock we have witnessed in decades with visible damage not only to the financial sector but extending to the real economy as well. Indeed, the cost of the credit market crisis in economic, financial and human terms has already reached staggering proportions and, even after 12 months, substantial vulnerabilities remain. The write-downs experienced by large integrated financial intermediaries – especially in the United States and Europe – are also of staggering proportions. It is probably fair to say that, as late as the summer of 2007, virtually none of us would have imagined that, as of July of 2008, financial sector write-offs and loss provisions would approach $500 billion, even as the write-off meter is still running. Fortunately, the starting capital positions of the affected institutions were relatively strong and, even more fortunately, most of these institutions have been able to raise very large amounts of additional capital in recent months. Even with the benefit of hindsight, there exists a large and troubling question as to the manner in which events unfolded beginning in the July to August interval of 2007. Namely, why were so many, in both the official and private sectors, so slow in recognizing that we were on the cusp of a financial crisis of the magnitude we have experienced? The list of possible explanations is long. For example, it could be that the underlying complexity and risk characteristics of certain financial instruments were so opaque that even some of the most sophisticated financial institutions in the world and their supervisors were simply caught off guard. A much more plausible explanation lies in the fact that the preceding eight to ten years had witnessed multiple financial disturbances with multiple causes – all of which resolved themselves with limited damage and negligible contagion. 2 These experiences undoubtedly gave rise to a false sense of SECTION I: INTRODUCTION Containing Systemic Risk: The Road to Reform security that the emerging problems of the summer of 2007 would also resolve themselves with little or no systemic damage. Much has been written and said about the underlying causes of this systematic failure in financial discipline. For that reason, the Policy Group does not wish to repeat that litany in any detail, but it does see some value in briefly highlighting what it considers the most critical of these underlying causes of the credit market crisis: First: for several years running, global financial markets had been awash with liquidity. This condition reflected in part the recycling of (1) excess savings from Asia in general and China in particular and (2) excess cash from energy producing countries. It may also have reflected the phenomenon of an extended earlier period of very low interest rates, especially in the United States. These factors are also related to global economic and financial macroeconomic imbalances that have long been recognized as potential sources of instability. There can be no doubt that ample financial market liquidity and relatively low interest rates were an important driving force behind the pervasive “reach for yield” phenomenon of recent years and that the “reach for yield” phenomenon was, in turn, an important factor in driving the surge in demand for and supply of highly complex structured credit products. Second: reflecting in part the forces discussed above and the intensity of competitive factors in the financial marketplace, it is clear that credit risk had been mispriced for some time. The evidence of this is clear in the terms and conditions of credit extensions in the subprime mortgage market, in the leveraged finance sector, and in the willingness of market participants to acquire highly leveraged structured credit products whose attractiveness relied on a continuation of benign credit conditions for an extended period of time. More generally, the extraordinary tightness of credit spreads across virtually all classes of credit products was widely seen as unsustainable. In these circumstances, it was recognized that, sooner or later, credit spreads and credit terms would inevitab..."

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