Tuesday, January 17, 2006

Derivatives–The Greenspan Legacy

“Derivatives are financial weapons of mass destruction...The dangers are now latent -- but they could be lethal.”
World renowned investor Warren Buffet of Berkshire Hathaway.

With Fed Head Alan Greenspan slated to retire at the end of the month a lot has and will continue to be said about his legacy. He was a champion of free markets, he was the most blatantly political fed head ever, his easy money policy created numerous bubbles—stock/real estate, under him America’s indebtedness skyrocketed, he oversaw the deregulation of financial markets and the rise of fringe banking and the end of the Glass Steagal,...One thing does stand out and will continue to stand out–the growth of derivatives which he advocated and protected like a doting mother over her baby.

"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago," Greenspan said late last year.

Derivatives are leveraged financial instruments that allow companies, speculators, banks to either manage their risk or substantially increase it–which it is, is dependant upon who is doing the talking and who is doing the listening. Basically derivatives are a back door for credit and easy money. They give the holder the right to buy several times the amount of the underlying security. No doubt historians will in retrospect draw comparisons between derivatives of the Free Market Era (Floating Exchange Rate Regime 1973 to present) to the easy access of stock financing and borrowing of the roaring twenties and the ensuing stock market crash.

Derivatives have grown from around a few trillion when Greenspan assumed office in 1987 to over well over 221 trillion dollars (notional value) globally (June, 2004; Source BIS
http://www.bis.org/press/p050316.htm ). There has also been the growth of highly leveraged funds, so called hedge funds and commodity funds that invest in derivatives. Hedge funds manage well over a trillion dollars globally. Greenspan said that hedge funds—which require individuals have a high net worth and sign numerous disclosures before they can invest in them-- provide “financial stability”. http://www.federalreserve.gov/boarddocs/speeches/2005/20050606/default.htm

The idea that derivatives and hedge funds provide financial stability flies in the face of reality. Many lay the blame for the 1987 stock market crash on derivatives (stock options and futures) and their trading by financial institutions (program trading). The October 1987 stock market took place two months after Greenspan began his reign. Then there was the blowup of Long Term Capital Management (LTCM) a speculative hedge fund in 1998 that brought the world to the brink. Why would someone be such a vocal proponent of something that has threatened him, the country and the world?

Advocacy—Zealotry or Cover-up?

Greenspan’s passionate, arguably reckless advocacy and defense of derivatives borders on zealotry, even fanaticism. But his zeal for derivatives must be considered in relation to his political nature. As Senate Minority Leader Harry Reid noted Greenspan is "one of the biggest political hacks we have in Washington". In this context his advocacy of derivatives and defense of hedge funds may be more about cover-up than religious fervor.

Many have argued that the Fed cobbled together the bailout of Long Term Capital Management (LTCM) because it would have exposed the Fed’s lack of oversight and supervision of the banking industry. It was believed that many of LTCM’s lenders (Big Banks) had over-extended themselves and, as omnibus supervisor of the Financial industry, the Fed was on the hook.

Consider the words of Martin Mayer in his book "THE FED:The Inside Story of How The World's Most Powerful Financial Institution Drives the Market", (The Free Press, 2001):

The belief here is that the reason why the Federal Reserve Bank of New York engineered the rescue of long Term Capital Management hedge fund in September 1998 was fear that the collapse of the fund would have exposed to public view the sloppy performance of the world's great financial Institutions--and the careless, trusting supervision that had permitted this overconfident crowd of Ph.D. economists, mathematicians, and gamblers to carry positions in excess of $100 billion, and derivative contracts with nominal values over $1 trillion, on a capital base of less than $2 billion.” Page 266

Martin goes on to note Greenspan’s hypocrisy:

"Only a few days before the New York Fed felt it had to intervene to save Meriwether from losing his hedge fund, Alan Greenspan had testified to the House Banking Committee that 'hedge funds were strongly regulated by those who lend it money'. The belief that Alan Greenspan knew whereof he spoke, a central tenet of the Fed's status, had been put in hazard." Page 267

How could Greenspan speak ill of derivatives and hedge funds after the LTCM bailout?

An Old Dog up to its old Tricks

The cover-up that Mayer and others found with LTCM does not end there. Because Congress has never adequately investigated LTCM or the many other Greenspan bailouts, nor scrutinized Greenspan--instead they chose to idolize him--he was left to his own devices.

It could be argued that the low interest policy of recent years was like the bailout of LTCM, an effort to resuscitate previous bad policy decisionsand failures. The problem with cover-ups as Greg Ip of the Wall Street Journal in

"Treating US After Bubble Fed Helped Create New threats’ (June 9, 2005) notes, is that the can compound the problem:"By many yardsticks, the Federal Reserve's response to the bursting of the stock and tech-spending bubbles in 2000 has been a remarkable success. The 2001 recession was mild and economic growth since has been brisk. Employment is up and inflation remains within the Fed's hallowed zone of price stability."

"But five years after the stock market's peak, the economy faces other
threatening imbalances: a potential housing bubble, rock-bottom personal saving rates and a gargantuan trade deficit. And the Fed's post-bubble prescription bears some responsibility for all three. Fed officials acknowledge as much but say the alternatives were worse."

Self-supervising, self-regulating, Secretive, Un-elected

How was Greenspan able to get away with- policy failures and bailouts? He was able to do so because the Fed is self-supervising, self regulating and really answers to no one, and is un-elected to boot. The Fed both sets policy and then supervises itself. At a time when the country is debating executive power and the constitution an even bigger abuse is seen with the Fed.

Consider the words of Amity Shlaes, of the Financial Times of London, January 9, 2001, ‘COMMENT & ANALYSIS: A fitting legacy for America’s beloved dictator: The legislation guiding US interest rate policy is flawed. Alan Greenspan should lead a reform effort before he retires’:

"How can it be, at a time of unprecedented faith in free markets, that
we even think a government authority might have such strength? And how can it be that the world’s monetary order rests on the shoulders of an individual, much admired but still fallible economist?

"The answer is America’s uniquely flawed and outdated monetary law,
which gives the nation’s monetary chief the sort of discretion of which his peers in other developed countries can only dream. Mr. Greenspan is so powerful that today he is perceived as a loving dictator. This is only natural. For as we know from history, wherever the law is weak-in any area of politics-public credibility tends to vest itself in an individual.”

The End is Nigh

The reason that Derivatives will be the Greenspan legacy is because they are a ticking time bomb of immense proportions that when unraveled will make a shattered humpty dumpty look whole. Worse derivatives present challenges, arguably benefits to those looking to hide or manipulate, errors and transgressions. For example, OTC derivatives that were deep in the red have been known to be rolled over at advantageous rates at the present that pushed the loss far into the future. Thereby postponing the loss for some one else or for a better time when the market was hopefully more favorable. A quasi bailout that is so Greenspan like.

As the failure of Long Term Capital Management taught us logic, reason and efficiency can be thrown out the window during a crisis. The Nobel Laureates at LTCM found out that markets can gap or jump in price that defy historical measures or they can just stop trading.

Many have argued that derivatives have stood the test of time and have weathered several bull and bear cycles. But there is one large cycle that they have not withstood and that is a new monetary regime. Monetary or currency regimes last 25 to 30 years on average. The current Floating Exchange Rate regime (The Float) is 33 years old. Derivatives are this regime’s leveraged instrument that still have to meet the test of time—a new monetary regime. Then we will see if they meet the fate of other regimes leveraged products and disappear. History shows that with each new monetary regime speculators find a new and better ways to speculate after having professed learning the lessons of previous regimes.

Buffet is right. Derivatives are Weapons of Mass Destruction. But with Greenspan about to go they may go from being a latent risk to a lethal one he fears, especially since Greenspan will no longer be around to shield the industry and speculators.

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