"Deriving" A Lesson From Greenspan's Giant Goof

(And by the way, I also posted here.)

To the pages of the Murdoch Street Journal we go for an opinion column today by former Federal Reserve chairman Alan Greenspan, who tells us the following about our current economic crisis (I believe “The Great Recession” is the catchphrase currently being trial-tested by our corporate media, though I can see absolutely nothing “great” about it).

(By the way, since I am hardly an economist, this post will contain primarily extended excerpts from more knowledgeable individuals in that subject than your humble narrator – I think they can make my case much better than I can).

For now, though, here is what Greenspan said in the Journal today…

There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

“Debt” is the crucial word in that prior sentence, by the way; as noted here from a New York Times series appropriately called “The Reckoning”…

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, “hedge” — investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value “derives” from 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. Greenspan’s record has been up for revision. Economists from across the ideological spectrum have criticized his decision to let the nation’s 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. Greenspan’s legacy may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and calamitous bust in derivatives trading.

…

As the long-serving chairman of the Fed, the nation’s 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 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. Greenspan’s record on financial regulation and derivatives in particular reveals the degree to which he tethered the health of the nation’s 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 Alan S. Blinder, a former Federal Reserve board member and an economist at Princeton University. “I think of him as consistently cheerleading on derivatives.”

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. Greenspan’s 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 didn’t want to reveal their own inability to understand some of the concepts that Mr. Greenspan was setting forth,” Mr. Levitt said. “I don’t recall anyone ever saying, ‘What do you mean by that, Alan?’ ”

Still, over a long stretch of time, some did pose questions. In 1992, 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 weaknesses” in 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. Markey’s 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.”

Pardon me while I retch (a typical “Randian” – I’d love to see Greenspan “go Galt” with the rest of his foul ilk).

So what could have been done to prevent this (thus serving as a bit of a “way forward” to ensure we NEVER find ourselves in a fix like this again)?

Well, in addition to the fact that Rep. Markey introduced a bill requiring more derivatives regulation as a result of the hearing noted previously (the bill “went nowhere”), ProPublica tells us the following (from here)…

Later, in 1997, a lawyer on the Commodity Futures Trading Commission pushed to regulate derivatives. That, too, went nowhere, largely due to Greenspan's opposition, along with then-Treasury Secretary Robert Rubin. The two even pushed Congress to strip the CFTC of regulatory authority over derivatives.

And then there is Warren Buffet's famous warning in 2003 that derivatives were "financial weapons of mass destruction."

Greenspan's opposition to regulation has its source in his libertarian philosophy, the Times notes, marshalling a number of his quotes from over the years about how the market will take care of itself.

In 1994: "The risk of a crisis stoked by loose derivative trading was "extremely remote."

And then in 2000: "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."

And then in 2003: "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 shouldn't be taking it to those who are willing to and are capable of doing so." It would be a "mistake" to increase regulation.

Meanwhile, on March 11, 2009, Greenspan states as follows…

Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

And that includes you, Alan, every bit the “market player” as much as anyone else.

Update 3/12/09: More on Greenspan from here...