The Wall Street Journal-20080125-Once Again- the Risk Protection Fails- Societe Generale-s Loss Is Example of Controls -Thrown by Wayside-
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Once Again, the Risk Protection Fails; Societe Generale's Loss Is Example of Controls 'Thrown by Wayside'
Societe Generale SA's $7.2 billion loss on a series of fraudulent trades is just the latest example of a breakdown in internal controls that are supposed to protect financial firms from disaster.
Months of misery at Citigroup Inc., Merrill Lynch & Co., Morgan Stanley, UBS AG and other banks and securities firms clobbered by the mortgage crisis are a sign of how much risk-management procedures were weakened when times were good and profits were flowing fast. "The social pressures are huge, and some of the good risk procedures are thrown by the wayside," says Richard Dunn, a former risk-control chief at Merrill Lynch.
At Societe Generale, co-Chief Executive Philippe Citerne blamed a rogue trader who used "pure fraud" to evade computer systems and employees to make big bets on stock-index futures. Other firms were burned by their own failure to ask enough tough questions about collateralized debt obligations and other mortgage-related investments that put huge chunks of capital at risk.
The breakdowns are causing some banks and brokerages to begin overhauling risk-management systems.
Morgan Stanley has hired a slew of new risk managers, with some sitting on the trading floor. The firm's chief risk officer now reports to the chief financial officer. And a weekly risk-management meeting includes the heads of every key trading unit. Since the initial rumblings of what would turn in to a $7.8 billion fourth- quarter write-down tied to bad CDO bets first surfaced in October, Morgan Stanley Chief Executive John Mack has attended the weekly risk- assessment meetings frequently.
As similar losses from other bad investments hammered other firms on Wall Street, it became clear that some soul-searching would be needed.
"Until recently, every investment bank believed it had built an outstanding risk-management system," Ken Moelis, former head of investment banking at UBS, wrote in a November letter to his new firm's investors. Mr. Moelis now runs his own investment bank. "Through computer models and endless analysis, the banks believed they could measure every risk to the nth degree." But reliance on such models and manuals "overlooked" the importance of "human judgment and the ability to evaluate the numbers being generated," he added.
Mr. Moelis left UBS early last year because of a creaky decision- making process on risk-related questions, according to people familiar with the situation. He was having difficulty getting approval for loans and other services for clients, and was discouraged at times from asking about other assets on UBS's $1 trillion balance sheet, the same people said. The Swiss bank was forced to write down $14 billion in subprime-related holdings and is seeking shareholder approval for a capital infusion.
At Merrill Lynch, after the firm suffered $1 billion in bond-trading losses in 1998, Mr. Dunn imposed new limits on assets that could be kept on the firm's balance sheet after an underwriting. The controls included penalties that kicked in if the assets weren't sold within 90 days. Mr. Dunn also warned then-CEO David Komansky in twice-a-month meetings about anything that might blow up. In the mid-1990s, another top risk manager at Merrill, Daniel Napoli, reported directly to the CEO.
But as Mr. Komansky's successor, Stan O'Neal, zeroed in on boosting Merrill's profitability, risk moved down the pecking order. The top risk manager at Merrill lost his seat on the firm's executive committee, and numerous risk controls lost their teeth, current and former executives say.
One consequence: In August 2006, Merrill Lynch bond executives decided to retain on the firm's books more than $900 million in mortgage securities to help Merrill complete a $1.5 billion underwriting of a CDO called Octans. One Merrill trader refused to hold the bonds and attempted to alert other executives to the rising risks, but the decision stood, former employees said.
By last year, Merrill had amassed more than $40 billion in CDOs and securities backed by subprime mortgages. As losses worsened, Mr. O'Neal upgraded the risk-control function by naming a firmwide risk officer, Ed Moriarty, who had been head of credit risk. Mr. O'Neal was ousted a month later.
John Thain, Merrill's new CEO, said in an interview last week that the previous risk-management structure separated market risk from credit risk in a way that "didn't make sense because they are both permutations of the other." Risk-management officers now report directly to Mr. Thain, who also has hired Noel Donohoe, a former Goldman Sachs Group Inc. risk executive, to work with Mr. Moriarty.
"Merrill had a risk committee," Mr. Thain said. "It just didn't function."
Morgan Stanley's net loss of nearly $4 billion in last year's fiscal fourth quarter was caused largely by a trading misstep that had eluded risk managers. Howard Hubler, a senior trader who made bets with the firm's capital, had taken large CDO positions. Mr. Hubler's supervisor, Tony Tufariello, and risk managers signed off on the trading position, according to people familiar with the matter. But the risk managers didn't anticipate the tumultuous market conditions that made CDO positions far riskier than they would have been under normal circumstances. Messrs. Hubler and Tufariello were forced out last fall. Neither could be reached for comment.
As part of Morgan Stanley's recent changes, all proprietary trading now is supervised by Michael Petrick, the firm's new head of sales and trading.
Citigroup, which has suffered more than $20 billion in losses from mortgage-related woes, now acknowledges that different teams responsible for monitoring CDO holdings didn't spot the ballooning risks until it was too late to sell the CDOs at reasonable prices or to hedge the bank's exposure.
"The [cross-pollenation] between the credit-risk team and the market-risk team was not as strong as it needed to be," Gary Crittenden, Citigroup's chief financial officer, told analysts in October. "We have to have more integration between the way those teams operate."
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Robin Sidel and David Enrich contributed to this article.
