ON THE INGREDIENTS OF A BUBBLE (Part II)

POINTING FINGERS (Part II)

The blame game for the current global financial crisis, will inevitably gather major force in the coming months, especially as politicians and the media really get at it in earnest.  In that vein, this meaty New York Times article titled "Taking hard look at a Greenspan Legacy", is a great case in point.

It's one of the first pieces on the crisis that shifts the focus on the origins of this crisis from sub-prime real estate driven causes, to the explosion of the unregulated, multi-hundred trillion dollar derivatives "insurance" markets, that have grown and thrived globally over the last decade.

The article argues the following:

"George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.”

Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And 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 financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan  has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street."

Here's the crux of the indictment made by the piece:

"“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."

Particularly dramatic is the segment in the piece, where regulators who wanted to address the growing risk of derivatives, were apparently squelched by the Fed with the help of the Treasury in a Clinton administration, and the Republican leadership in Congress:

"In 1997, the 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. Born’s views incited fierce opposition from Mr. Greenspan and 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."

And it lead to this dramatic climax:

"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 Jim Leach, an Iowa Republican who led the House Banking and Financial Services Committee at the time. “You’ve 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. Greenspan’s steady hand at the Fed.

“You will go down as the greatest chairman in the history of the Federal Reserve Bank,” declared Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee when Mr. Greenspan appeared there in February 1999.

Mr. Greenspan’s 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 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.

“Aren’t 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 Bernard Sanders, an independent from Vermont.

“No, I’m 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."

What a story.  One can almost see it on the big screen as an Oliver Stone movie.

The piece apparently is  part of a series planned by the paper called "The Reckoning, Risk in Hindsight: Articles in this series are exploring the causes of the financial crisis." 

As I've said for a while now, the current predicament has lots of blame to go around, not just on Wall Street as the current media and political focus seems to indicate, but also on Main street.  In addition, we need to also address the blame to be accorded to our politicians and the media coverage over the decade that this crisis has been brewing.

But most of all, while we're in the midst of this crisis, we all need to put aside our anger at our favorite perceived villain for the current state of events, and really think hard about how we fix things for the long-term in a non-partisan and non-class warfare manner.

Comments

[Alex Tolley]

"...we need to also address the blame to be accorded to our politicians..."

And let's not forget who was financing these politicians to act the way they did.

Greenspan is correct in that the way we structure markets was a choice. We took a high risk/high reward ratio and are paying the price for the risk that events went against us. But let's also see where the rewards went - mostly to bankers. In other words, the structure ended up benefiting a small class of players who are not on the hook to pay the price.

[PeakeAdvantage]

Yep! Finger pointing begins. But nobody will want to blame the Community Reinvestment Act of 1977 and various other Federal banking acts that require risky loans to be made. The whole Federal system which is designed to swallow up banks and funnel wealth to New York's elite may yet give us another depression. This will be "The Greater Depression" if we keep handing out money as we did in the 1930s. When will we learn?!

[Miles Rose]

yes, its over and its over for a while. You can fix the numbers but you can't fix the emotion which people have experienced. fear takes a long time to lose. the reality is that those who made it happen, looser government regulation, are now the ones trying to fix it. There are too many similarities between now and 1929. Each generation thinks they are different then history but they are not. Its over and its over for a while. those buying too early are the ones who got really hammered.