Arthur,
You will recall from my previous long residence on Futurework list that I
wrote many times that Greenspan's absurdly low interest rates were
irresponsible and would cause disaster one day.
I had the same feeling about credit derivatives but I didn't write about
these because I didn't understand them. And I'm pleased to see from the
quotes below that George Soros didn't understand them either! I think I
understand them a little better now and thus (belatedly) agree with Felix
Rohatyn and Warren Buffet that they're dynamite -- as they are now proving
themselves to be!
And why are they dynamite? I used the analogy of Chinese Whispers in a
posting of a day or two ago. It's not totally apt but it will do. As
derivatives are passed from one to the next (with brokers or lawyers or
accountants charging a fee each time!) the gist of the story remains the
same (that is, the nominal value of the original credit) but with greatly
changed circumstances occurring since the original (sound) credit was first
issued. However, the first or any of the intermediaries may have gone bust
during subsequent travels and the document on which the derivatives is
written is only worth the paper it's written on. All this should be known
in theory to purchasers of derivatives but, in practice, derivatives are
re-packaged so frequently that any competent paper trail is time-consuming
(and very expensive in paying accountants to do this). (Or, as happened in
a similar manner in the case of Enron, the accountants don't really
investigate but cover up the black holes and take their fees all the same.)
The result of all this is that many banks in America and Europe are now
crying out for government help -- but very discreetly, 'cos they don't want
the public to know that they are stuffed with securitized mortgages and
credit derivatives, many of which are worthless. To greater or lesser
extents they few assets -- and many of them are technically bankrupt, just
as some of our largest banks became during the fiasco of lending to South
American countries 20 years or so ago. This only became more widely known
until well after the event when the banks had had chance to put some real
cash back in their coffers.
I think the UK government's bail-out might possibly work. It might just
give the 7 recipients (6 banks and a large building society) sufficient
working capital to start working again. If America and Europe do the same
then the West's economic system might survive. In the meantime, however, a
host of (previously sound) business will have collapsed, the public's
confidence will have been shaken and they will never resume their previous
spending levels for many years. I foresee that the stock markets will be
zigzagging on a downward path for many months, perhaps a year or two, and
that property values will fall to a fraction of what they were -- just as
happened in Japan 20 years ago (those in city centres to a quarter of what
they were).
Keith
At 07:44 09/10/2008 -0400, you wrote:
Content-Class: urn:content-classes:message
Content-Type: multipart/alternative;
boundary="----_=_NextPart_001_01C92A04.EE2EB105"
NY Times
October 9, 2008
The Reckoning
Taking Hard New Look at a Greenspan Legacy
By
<http://topics.nytimes.com/top/reference/timestopics/people/g/peter_s_goodman/index.html?inline=nyt-per>PETER
S. GOODMAN
Not only have individual financial institutions become less vulnerable to
shocks from underlying risk factors, but also the financial system as a
whole has become more
resilient.<http://topics.nytimes.com/top/reference/timestopics/people/g/alan_greenspan/index.html?inline=nyt-per>Alan
Greenspan in 2004
<http://topics.nytimes.com/top/reference/timestopics/people/s/george_soros/index.html?inline=nyt-per>George
Soros, the prominent financier, avoids using the financial contracts known
as derivatives because we dont really understand how they
work.<http://topics.nytimes.com/top/reference/timestopics/people/r/felix_g_rohatyn/index.html?inline=nyt-per>Felix
G. Rohatyn, the investment banker who saved New York from financial
catastrophe in the 1970s, described derivatives as potential hydrogen bombs.
And
<http://topics.nytimes.com/top/reference/timestopics/people/b/warren_e_buffett/index.html?inline=nyt-per>Warren
E. Buffett presciently observed five years ago that derivatives were
financial weapons of mass destruction, carrying dangers that, while now
latent, are potentially lethal.
One prominent financial figure, however, has long thought otherwise. And
his views held the greatest sway in debates about the regulation and use
of derivatives exotic contracts that promised to protect investors from
losses, thereby stimulating riskier practices that led to the
<http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/index.html?inline=nyt-classifier>financial
crisis. For more than a decade, the former
<http://topics.nytimes.com/top/reference/timestopics/organizations/f/federal_reserve_system/index.html?inline=nyt-org>Federal
Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives
have come under scrutiny in Congress or on Wall Street. What we have found
over the years in the marketplace is that derivatives have been an
extraordinarily useful vehicle to transfer risk from those who shouldnt be
taking it to those who are willing to and are capable of doing so,Mr.
Greenspan told the Senate Banking Committee in 2003. We think it would be
a mistaketo more deeply regulate the contracts, he added.
Today, with the world caught in an economic tempest that Mr. Greenspan
recently described as the type of wrenching financial crisis that comes
along only once in a century,his faith in derivatives remains unshaken.
The problem is not that the contracts failed, he says. Rather, the people
using them got greedy. A lack of integrity spawned the crisis, he argued
in a speech a week ago at
<http://topics.nytimes.com/top/reference/timestopics/organizations/g/georgetown_university/index.html?inline=nyt-org>Georgetown
University, intimating that those peddling derivatives were not as
reliable as the pharmacist who fills the prescription ordered by our physician.
But others hold a starkly different view of how global markets unwound,
and the role that Mr. Greenspan played in setting up this unrest.
Clearly, derivatives are a centerpiece of the crisis, and he was the
leading proponent of the deregulation of derivatives,said Frank Partnoy, a
law professor at the University of San Diego and an expert on financial
regulation.
The derivatives market is $531 trillion, up from $106 trillion in 2002 and
a relative pittance just two decades ago. Theoretically intended to limit
risk and ward off financial problems, the contracts instead have stoked
uncertainty and actually spread risk amid doubts about how companies value
them.
If Mr. Greenspan had acted differently during his tenure as Federal
Reserve chairman from 1987 to 2006, many economists say, the current
crisis might have been averted or muted.
Over the years, Mr. Greenspan helped enable an ambitious American
experiment in letting market forces run free. Now, the nation is
confronting the consequences.
Derivatives were created to soften or in the argot of Wall Street,
hedgeinvestment losses. For example, some of the contracts protect debt
holders against losses on mortgage securities. (Their name comes from the
fact that their value derivesfrom underlying assets like stocks, bonds and
commodities.) Many individuals own a common derivative: the insurance
contract on their homes.
On a grander scale, such contracts allow financial services firms and
corporations to take more complex risks that they might otherwise avoid
for example, issuing more mortgages or corporate debt. And the contracts
can be traded, further limiting risk but also increasing the number of
parties exposed if problems occur.
Throughout the 1990s, some argued that derivatives had become so vast,
intertwined and inscrutable that they required federal oversight to
protect the financial system. In meetings with federal officials,
celebrated appearances on Capitol Hill and heavily attended speeches, Mr.
Greenspan banked on the good will of Wall Street to self-regulate as he
fended off restrictions.
Ever since housing began to collapse, Mr. Greenspans record has been up
for revision. Economists from across the ideological spectrum have
criticized his decision to let the nations real estate market continue to
boom with cheap credit, courtesy of low interest rates, rather than
snuffing out price increases with higher rates. Others have criticized Mr.
Greenspan for not disciplining institutions that lent indiscriminately.
But whatever history ends up saying about those decisions, Mr. Greenspans
legacy may ultimately rest on a more deeply embedded and much less
scrutinized phenomenon: the spectacular boom and calamitous bust in
derivatives trading.
Faith in the System
Some analysts say it is unfair to blame Mr. Greenspan because the crisis
is so sprawling. The notion that Greenspan could have generated a totally
different outcome is naïve,said Robert E. Hall, an economist at the
conservative Hoover Institution, a research group at Stanford.
Mr. Greenspan declined requests for an interview. His spokeswoman referred
questions about his record to his memoir, The Age of Turbulence,in which
he outlines his beliefs.
It seems superfluous to constrain trading in some of the newer derivatives
and other innovative financial contracts of the past decade,Mr. Greenspan
writes. The worst have failed; investors no longer fund them and are not
likely to in the future.
In his Georgetown speech, he entertained no talk of regulation, describing
the financial turmoil as the failure of Wall Street to behave honorably.
In a market system based on trust, reputation has a significant economic
value,Mr. Greenspan told the audience. I am therefore distressed at how
far we have let concerns for reputation slip in recent years.
As the long-serving chairman of the Fed, the nations most powerful
economic policy maker, Mr. Greenspan preached the transcendent,
wealth-creating powers of the market.
A professed libertarian, he counted among his formative influences the
novelist
<http://topics.nytimes.com/top/reference/timestopics/people/r/ayn_rand/index.html?inline=nyt-per>Ayn
Rand, who portrayed collective power as an evil force set against the
enlightened self-interest of individuals. In turn, he showed a resolute
faith that those participating in financial markets would act responsibly.
An examination of more than two decades of Mr. Greenspans record on
financial regulation and derivatives in particular reveals the degree to
which he tethered the health of the nations economy to that faith.
As the nascent derivatives market took hold in the early 1990s, and in
subsequent years, critics denounced an absence of rules forcing
institutions to disclose their positions and set aside funds as a reserve
against bad bets.
Time and again, Mr. Greenspan a revered figure affectionately nicknamed
the Oracle proclaimed that risks could be handled by the markets themselves.
Proposals to bring even minimalist regulation were basically rebuffed by
Greenspan and various people in the Treasury,recalled
<http://topics.nytimes.com/top/reference/timestopics/people/b/alan_s_blinder/index.html?inline=nyt-per>Alan
S. Blinder, a former Federal Reserve board member and an economist at
<http://topics.nytimes.com/top/reference/timestopics/organizations/p/princeton_university/index.html?inline=nyt-org>Princeton
University. I think of him as consistently cheerleading on derivatives.
<http://topics.nytimes.com/top/reference/timestopics/people/l/arthur_jr_levitt/index.html?inline=nyt-per>Arthur
Levitt Jr., a former chairman of the Securities and Exchange Commission,
says Mr. Greenspan opposes regulating derivatives because of a fundamental
disdain for government.
Mr. Levitt said that Mr. Greenspans authority and grasp of global finance
consistently persuaded less financially sophisticated lawmakers to follow
his lead.
I always felt that the titans of our legislature didnt want to reveal
their own inability to understand some of the concepts that Mr. Greenspan
was setting forth,Mr. Levitt said. I dont recall anyone ever saying, What
do you mean by that, Alan?
Still, over a long stretch of time, some did pose questions. In 1992,
<http://topics.nytimes.com/top/reference/timestopics/people/m/edward_j_markey/index.html?inline=nyt-per>Edward
J. Markey, a Democrat from Massachusetts who led the House subcommittee on
telecommunications and finance, asked what was then the General Accounting
Office to study derivatives risks.
Two years later, the office released its report, identifying significant
gaps and weaknessesin the regulatory oversight of derivatives.
The sudden failure or abrupt withdrawal from trading of any of these large
U.S. dealers could cause liquidity problems in the markets and could also
pose risks to others, including federally insured banks and the financial
system as a whole,Charles A. Bowsher, head of the accounting office, said
when he testified before Mr. Markeys committee in 1994. In some cases
intervention has and could result in a financial bailout paid for or
guaranteed by taxpayers.
In his testimony at the time, Mr. Greenspan was reassuring. Risks in
financial markets, including derivatives markets, are being regulated by
private parties,he said.
There is nothing involved in federal regulation per se which makes it
superior to market regulation.
Mr. Greenspan warned that derivatives could amplify crises because they
tied together the fortunes of many seemingly independent institutions. The
very efficiency that is involved here means that if a crisis were to
occur, that that crisis is transmitted at a far faster pace and with some
greater virulence,he said.
But he called that possibility extremely remote,adding that risk is part
of life.
Later that year, Mr. Markey introduced a bill requiring greater
derivatives regulation. It never passed.
Resistance to Warnings
In 1997, the
<http://topics.nytimes.com/top/reference/timestopics/organizations/c/commodity_futures_trading_commission/index.html?inline=nyt-org>Commodity
Futures Trading Commission, a federal agency that regulates options and
futures trading, began exploring derivatives regulation. The commission,
then led by a lawyer named Brooksley E. Born, invited comments about how
best to oversee certain derivatives.
Ms. Born was concerned that unfettered, opaque trading could threaten our
regulated markets or, indeed, our economy without any federal agency
knowing about it,she said in Congressional testimony. She called for
greater disclosure of trades and reserves to cushion against losses.
Ms. Borns views incited fierce opposition from Mr. Greenspan and
<http://topics.nytimes.com/top/reference/timestopics/people/r/robert_e_rubin/index.html?inline=nyt-per>Robert
E. Rubin, the Treasury secretary then. Treasury lawyers concluded that
merely discussing new rules threatened the derivatives market. Mr.
Greenspan warned that too many rules would damage Wall Street, prompting
traders to take their business overseas.
Greenspan told Brooksley that she essentially didnt know what she was
doing and shed cause a financial crisis,said Michael Greenberger, who was
a senior director at the commission. Brooksley was this woman who was not
playing tennis with these guys and not having lunch with these guys. There
was a little bit of the feeling that this woman was not of Wall Street.
Ms. Born declined to comment. Mr. Rubin, now a senior executive at the
banking giant
<http://topics.nytimes.com/top/news/business/companies/citigroup_inc/index.html?inline=nyt-org>Citigroup,
says that he favored regulating derivatives particularly increasing
potential loss reserves but that he saw no way of doing so while he was
running the Treasury.
All of the forces in the system were arrayed against it,he said. The
industry certainly didnt want any increase in these requirements. There
was no potential for mobilizing public opinion.
Mr. Greenberger asserts that the political climate would have been
different had Mr. Rubin called for regulation.
In early 1998, Mr. Rubins deputy,
<http://topics.nytimes.com/top/reference/timestopics/people/s/lawrence_h_summers/index.html?inline=nyt-per>Lawrence
H. Summers, called Ms. Born and chastised her for taking steps he said
would lead to a financial crisis, according to Mr. Greenberger. Mr.
Summers said he could not recall the conversation but agreed with Mr.
Greenspan and Mr. Rubin that Ms. Borns proposal was highly problematic.
On April 21, 1998, senior federal financial regulators convened in a
wood-paneled conference room at the Treasury to discuss Ms. Borns
proposal. Mr. Rubin and Mr. Greenspan implored her to reconsider,
according to both Mr. Greenberger and Mr. Levitt.
Ms. Born pushed ahead. On June 5, 1998, Mr. Greenspan, Mr. Rubin and Mr.
Levitt called on Congress to prevent Ms. Born from acting until more
senior regulators developed their own recommendations. Mr. Levitt says he
now regrets that decision. Mr. Greenspan and Mr. Rubin were joined at the
hip on this,he said. They were certainly very fiercely opposed to this and
persuaded me that this would cause chaos.
Ms. Born soon gained a potent example. In the fall of 1998, the hedge fund
Long Term Capital Management nearly collapsed, dragged down by disastrous
bets on, among other things, derivatives. More than a dozen banks pooled
$3.6 billion for a private rescue to prevent the fund from slipping into
bankruptcy and endangering other firms.
Despite that event, Congress froze the Commodity Futures Trading
Commissions regulatory authority for six months. The following year, Ms.
Born departed.
In November 1999, senior regulators including Mr. Greenspan and Mr. Rubin
recommended that Congress permanently strip the C.F.T.C. of regulatory
authority over derivatives.
Mr. Greenspan, according to lawmakers, then used his prestige to make sure
Congress followed through. Alan was held in very high regard,said
<http://topics.nytimes.com/top/reference/timestopics/people/l/jim_leach/index.html?inline=nyt-per>Jim
Leach, an Iowa Republican who led the House Banking and Financial Services
Committee at the time. Youve got an area of judgment in which members of
Congress have nonexistent expertise.
As the stock market roared forward on the heels of a historic bull market,
the dominant view was that the good times largely stemmed from Mr.
Greenspans steady hand at the Fed.
You will go down as the greatest chairman in the history of the Federal
Reserve Bank,declared Senator
<http://topics.nytimes.com/top/reference/timestopics/people/g/phil_gramm/index.html?inline=nyt-per>Phil
Gramm, the Texas Republican who was chairman of the Senate Banking
Committee when Mr. Greenspan appeared there in February 1999.
Mr. Greenspans credentials and confidence reinforced his reputation
helping him to persuade Congress to repeal Depression-era laws that
separated commercial and investment banking in order to reduce overall
risk in the financial system.
He had a way of speaking that made you think he knew exactly what he was
talking about at all times,said Senator
<http://topics.nytimes.com/top/reference/timestopics/people/h/tom_harkin/index.html?inline=nyt-per>Tom
Harkin, a Democrat from Iowa. He was able to say things in a way that made
people not want to question him on anything, like he knew it all. He was
the Oracle, and who were you to question him?
In 2000, Mr. Harkin asked what might happen if Congress weakened the
C.F.T.C.s authority.
If you have this exclusion and something unforeseen happens, who does
something about it?he asked Mr. Greenspan in a hearing.
Mr. Greenspan said that Wall Street could be trusted. There is a very
fundamental trade-off of what type of economy you wish to have,he said.
You can have huge amounts of regulation and I will guarantee nothing will
go wrong, but nothing will go right either,he said.
Later that year, at a Congressional hearing on the merger boom, he argued
that Wall Street had tamed risk.
Arent you concerned with such a growing concentration of wealth that if
one of these huge institutions fails that it will have a horrendous impact
on the national and global economy?asked Representative
<http://topics.nytimes.com/top/reference/timestopics/people/s/bernard_sanders/index.html?inline=nyt-per>Bernard
Sanders, an independent from Vermont.
No, Im not,Mr. Greenspan replied. I believe that the general growth in
large institutions have occurred in the context of an underlying structure
of markets in which many of the larger risks are dramatically I should
say, fully hedged.
The House overwhelmingly passed the bill that kept derivatives clear of
C.F.T.C. oversight. Senator Gramm attached a rider limiting the C.F.T.C.s
authority to an 11,000-page appropriations bill. The Senate passed it.
President Clinton signed it into law.
Pressing Forward
Still, savvy investors like Mr. Buffett continued to raise alarms about
derivatives, as he did in 2003, in his annual letter to shareholders of
his company,
<http://topics.nytimes.com/top/news/business/companies/berkshire_hathaway_inc/index.html?inline=nyt-org>Berkshire
Hathaway.
Large amounts of risk, particularly credit risk, have become concentrated
in the hands of relatively few derivatives dealers,he wrote. The troubles
of one could quickly infect the others.
But business continued.
And when Mr. Greenspan began to hear of a housing bubble, he dismissed the
threat. Wall Street was using derivatives, he said in a 2004 speech, to
share risks with other firms.
Shared risk has since evolved from a source of comfort into a virus. As
the housing crisis grew and mortgages went bad, derivatives actually
magnified the downturn.
The Wall Street debacle that swallowed firms like
<http://topics.nytimes.com/top/news/business/companies/bear_stearns_companies/index.html?inline=nyt-org>Bear
Stearns and
<http://topics.nytimes.com/top/news/business/companies/lehman_brothers_holdings_inc/index.html?inline=nyt-org>Lehman
Brothers, and imperiled the insurance giant
<http://topics.nytimes.com/top/news/business/companies/american_international_group/index.html?inline=nyt-org>American
International Group, has been driven by the fact that they and their
customers were linked to one another by derivatives.
In recent months, as the financial crisis has gathered momentum, Mr.
Greenspans public appearances have become less frequent.
His memoir was released in the middle of 2007, as the disaster was
unfolding, and his book tour suddenly became a referendum on his policies.
When the paperback version came out this year, Mr. Greenspan wrote an
epilogue that offers a rebuttal of sorts.
Risk management can never achieve perfection,he wrote. The villains, he
wrote, were the bankers whose self-interest he had once bet upon.
They gambled that they could keep adding to their risky positions and
still sell them out before the deluge,he wrote. Most were wrong.
No federal intervention was marshaled to try to stop them, but Mr.
Greenspan has no regrets.
Governments and central banks,he wrote, could not have altered the course
of the boom.
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