You may make a mess, but please don’t try to clean it up

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It’s hard to believe, but people are starting to express outrage over the New York Fed hiring the former chief risk officer of Bear Stearns to help supervise banks. To be fair, I feel like I should acknowledge that it would be practically impossible to clean up this mess without employing some of the people who created it. If you  de-Baathify the finance industry, who will be left to run things?

To be fair again, I feel like I should go back and see what, exactly, Michael Alix has been saying these past few years. Just because he was running risk management at Bear Stearns when the company collapsed from a lack of sound risk management doesn’t necessarily mean he was sitting idly by. The other day, I was reading a Bloomberg article about how Keishi Hotsuki, Merrill Lynch’s co-head of risk management, tried to get his firm to stop making such risky bets. He was essentially told to shut up. Eventually he left the firm.

So I did a little rooting around, and found this June 2006 BusinessWeek story about Wall Street’s “culture of risk” for which Alix was interviewed. An excerpt:

Yet for all the risks they’re taking on, banks insist they’re safer than ever. They’ve hired many of the greatest mathematical minds in the world to create impossibly complex risk models… “Right now everything on my screen is flashing red,” said Michael Alix, chief risk officer at Bear, Stearns & Co., on May 11, the day after Federal Reserve Chairman Ben S. Bernanke raised interest rates, sending the market gauges he was looking at tumbling. But “that doesn’t make me nervous,” says Alix. The bank has built such powerful computing systems that Alix can reevaluate every day the risks of thousands of positions across the firm’s trading businesses under various stressful scenarios to be sure the firm doesn’t hold too much of any risky investment at any one time. That type of analysis used to take a week to complete. “The machine works,” he says.

This, we now know, didn’t work so well.

It seems that as chairman of the Securities Industry Association’s risk management committee, Alix was also an important part of the effort to convince regulators that investment banks didn’t need to hold nearly as much capital as their commercial bank brethren.

Here’s a letter (PDF!) he wrote to the Federal Reserve’s board of governors in August 2003, explaining why investment banks should be treated differently under the international standards known as Basel II, which say how much money institutions should put aside as a cushion for when things go wrong.

This, we now know, didn’t work so well, either.

But my favorite thing I found in my rooting around was Alix’s June 2004 House testimony (PDF!) on the topic of Basel II. One of the reasons investment banks should be allowed to use more leverage, he said, was because of the protective qualities of mark-to-market accounting:

There is yet another – and fundamental – difference in the way banks and investment banks manage their activities, and we would ask regulators to be particularly aware of this distinction… Banks generally accrue earnings and establish formula reserves, while securities firms mark-to-market and would expect to treat virtually all business lines as part of the trading book. Mark-to-market accounting forces firms to immediately recognize changes in the risk profile of any position or business, and to take timely action to reallocate capital to address problems or opportunities.

This, we now know, not only didn’t work so well, but is also, we’re told, causing a lot of the problems we’re having.

Look, I don’t envy the position the New York Fed is in. I have the luxury of not having to go out and hire people who 1) deeply understand the operations of finance firms, and 2) are willing to take a job in the public sector. At the same time, I’m guessing I’m not the only person a little squinty-eyed over this one.

Barbara!

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