Posted on 04/11/2008 5:25:07 PM PDT by Kaslin
Economy: Ex-Fed chief Alan Greenspan has spent the past few weeks denying he deserves blame for the housing crisis. Sorry, maestro, you do deserve some blame — but not for the reasons people think.
Writing recently in the Financial Times of London, Greenspan said he was "puzzled" why so many blame the Fed for the housing bubble, since the same thing was happening around the world. The real culprit, he argued, was a "dramatic fall in real long-term interest rates," a result of a glut of global savings seeking a safe haven.
Those who blame Greenspan for the housing crunch usually say he kept interest rates too low for too long, thereby encouraging market speculation with cheap borrowed money. Indeed, he kept rates at a record-low 1% from June 25, 2003, to June 30, 2004.
The problem with this argument — and Greenspan's defense of himself — is it has things exactly backward. The trouble came not from being too loose with credit, but too tight.
It's easy to say in retrospect that any market boom was a bubble. But as we've noted here before, the U.S. and the rest of the world undergo periodic financial crises, typically after a bout of central bank tightening. How soon we forget.
(Excerpt) Read more at ibdeditorials.com ...
cool. I get to put in my post without having to wade through all the mad ranting about Mr. Greenspan.
You know there is truth in the fact that the media, the DNC, often talk down the economy and perception becomes reality. The Dems did this as Bush took office. When the Tax Cuts built a huge economy then the regulators, the Pelosi led Congress tore into them, down went some economic indicators.
IBD begs the question. IBD presumes that there is a difference between a market boom and a bubble, but the Austrians would tell you that they are the same thing.
The editors/owners of IBD are stock touts, and this sounds like a repeat William Jennings Bryan "cross of gold" speech.
ping
What I don’t like a bout Greenspan is he approved of derivatives. Thus the Fed did nothing to stop their growth. Warren Buffet has condemned them -— “Weapons of mass economic destruction”
OTC Derivatives: Risking an F for Prudence
With regards to the OTC market, the popular presumption — one that Greenspan shared in his speech last week — is that they perform the useful function of smoothing-out some of the otherwise exogenous shocks to the system by mitigating and dispersing risk:
“The use of a growing array of derivatives and the related application of more-sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries.” Greenspan. May 8, 2003.
Greenspan goes on to say that derivatives have helped ‘unbundle’ risks and, due to this unbundling process, concentrations of risk have become manageable on a ‘portfolio basis’. He provides anecdotal, media ready evidence of this by stating “Even the largest corporate defaults in history (WorldCom and Enron) and the largest sovereign default in history (Argentina) have not significantly impaired the capital of any major financial intermediary.”
Greenspan should shut up and go away.
Warren Buffet on Derivatives
Following are edited excerpts from the Berkshire Hathaway annual report for 2002.
I view derivatives as time bombs, both for the parties that deal in them and the economic system. Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. Forexample, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contractsare of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties recordprofits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.
Reported earnings on derivatives are often wildly overstated. That’s becausetoday’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed formany years.The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. Butoften there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief.
As a general rule, contracts involving multiple reference items and distant settlement datesincrease the opportunities for counter-parties to use fanciful assumptions. The two parties to the contractmight well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.I can assure you that the marking errors in the derivatives business have not been symmetrical.
Almostinvariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEOwho wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited fromhis options. Only much later did shareholders learn that the reported earnings were a sham.
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into forcompletely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases,trigger still more downgrades.
It all becomes a spiral that can lead to a corporate meltdown. Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay offmuch of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time.
A participant may see himself as prudent, believing his large credit exposures to bediversified and therefore not dangerous. However under certain circumstances, an exogenous event thatcauses the receivable from Company A to go bad will also affect those from Companies B through Z.In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the FederalReserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn.
The Fed nowinsulates the strong from the troubles of the weak. But there is no central bank assigned to the job ofpreventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.
Page 2
Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands.
These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands ofrelatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.
On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serioussystemic problems.Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort.
In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutionshad the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.
One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts upall of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at afuture date it will receive any gain or pay any loss that the bank realizes. Total-return swaps of this type make a joke of margin requirements. Beyond that, other types ofderivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investorsand analysts encounter major problems in analyzing the financial condition of firms that are heavilyinvolved with derivatives contracts.
The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have sofar found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
I believe this writer is totally forgetting about the unchecked and unregulated and encouraged expansion of derivatives by Greenspan.
Leverage is the issue, not too tight credit.
LOL! Who invented this and what possible purpose could it serve?
In addition, Greenspan approved of the “non-conventional” mortgages that are at the heart of the problem now.
Two excellent questions for which there are answers.
The first answer is: Large investment banks.
The second answer is: it serves the purpose of helping a bank that is over-committed on their balance sheet limits off-load an asset synthetically to another bank that has balance sheet “room” available for taking on another asset.
These instruments can then be leveraged up, like so many other derivatives, which also makes them faves among hedge funds as “receivers” of the TRS.
The advantage for the banks that use them is that they’re off balance sheet instruments. Sound familiar to the CDO/CLO/CDS issue? You betcha.
"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage."~~Alan Greenspan, February 22, 2004
“The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions.”~~Alan Greenspan, May 2005
"We're not about to go into a situation where (real estate) prices will go down. There is no evidence home prices are going to collapse."~~Alan Greenspan, May 21, 2006
Great essay.
And if you have inquired at all into the structuring of the derivative securities, you will see that they are laced with derivatives themselves, interest rate swaps, currency swaps, mortgage default insurance and swaps, etc. The purchaser of one of these is acquiring a lot more than just a right to a stream of principal and interest payments.
THanks..... In many ways I don’t like or respect Warren Buffet but he’s old and stodgy in some ways making him a believer in economic commonsense. That’s why he despises derivatives
Meanwhile it takes the airy fairy intellectual Allan Greenspan to be shilling for derivatives. I’m sure Wall Street was overjoyed to get that endorsement. You posted four good quotes showing the stupidity of the “master”
I’ll pick Warren Buffet any day over Greenspan
Buffet lives in Nebraska giving him a better perspective than Greenspan who is a creature of the incestuous Washington/NY axis.
Your namesake got rid of the United States Central bank....the Second Bank of the United States———>>>>
Second Bank of the United States -
By the early 1830s, President Andrew Jackson had come to thoroughly dislike the Second Bank of the United States because of its fraud and corruption. ...
en.wikipedia.org/wiki/Second_Bank_of_the_United_States - 48k - Cached - Similar pages - Note this
Warren Buffett poses an interesting problem for a conservative. On the one hand his investment philosophy has for the most part been conservative. He purchases companies outright, which he sees having sound business models and then invests in their expansion. In doing such he expands the productive capacity of the US. If you believe his commentators, his insurance company investments are much in this same mold, i.e. insurance companies have enormous quantities of money to invest and by controlling insurance companies he can steer their investments into productive chanels. Is WB a financial opportunist when opportunities for a profitable trade arise. Of course.
I think that our differences with WB are along the lines of what is the ends of government and how best are those ends to be achieved. In securing the advantages of a prosperous economy for the productive members of society, which I think most of us would agree to be the conservative approach to political economics, we may not like WB and his espousal of the philosophies of the democratic party very much. On the other hand we cannot assert that the Republicans have been much to our taste in the last 7.5 years either. Tax cuts accompanied by spending increases, dragging out of a very costly and illfought war in Iraq through pursuit of a non-strategy (until Petraeus), and continuation of a Fed chairman who has pursued an out of control monetary policy are not conservative positions in the least.
At least WB's investment philosophy would pay off for him and his investors, even under a sound money policy. Those of much of the rest of the investment community, such as you have so eloquently outlined for us, cannot.
Amen!
Exceptional post. Thanks for it. I’ve seen Buffet’s “weapon of mass destruction” quote many times, but not an excerpt from the rest of it. Derivatives are indeed scary stuff.
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