Hands up, Mr Greenspan!

August 18th, 2007

THE latest scapegoat for the market turmoil last week, which saw billions wiped off equity values as fear and loathing gripped Wall Street and the Square Mile, is the ratings agencies.

Standard & Poor’s, Moody’s and Fitch were fingered for misleading investors by giving the “all clear” to what were, in fact, distinctly dodgy debt instruments. These may have been called structured investment vehicles, collateralised debt obligations or any number of other jargony names.

But they shared a fatal flaw. Many were the wrappers for vast bundles of home loans issued to “sub-prime” US borrowers. It is strange that last month Moody’s and S&P placed on negative review large quantities of residential mortgage-backed security (RMBS) and collateralised debt obligations (CDOs) that had exposure to US subprime mortgage loans. This caused some investors to question the accuracy of their ratings and accuse them of not reacting fast enough to evidence of a rise in subprime delinquencies as early as 2006.

It’s fair to say many ‘subprime’ borrowers should probably never have been issued with home loans in the first place. Now, with the US housing market in freefall, they are defaulting and becoming “delinquent” in droves.

The rating agency model is clearly flawed – the objectivity of their research is bound to be compromised, given that it is the investment banks who are doing the underwriting and issuing of RMBS and other asset-backed securities who pay the fees. However, they probably only had a bit part in the current fiasco.

Are the “masters of the universe” – including investment bankers, prime brokerages, hedge funds and private-equity investors – whose irrational exuberance drove them to invest in and trade in complex and opaque financial instruments that they didn’t fully understand the real villains of the piece?

The global financial elite may have genuinely believed that by lumping pools of debt together into humungous securitised parcels they would somehow eliminate the risk. They didn’t. They just made the risk harder to fathom. They were also foolhardly enough to believe that their “black box” systems designed to automate the trading activity of quantitative hedge funds were invincible. After last week’s debacle, which saw Goldman Sachs and its clients forced to inject $3 billion into its global GEO fund, it became clear they may had deluded themselves here too.

However, in the end of the day true architects of the current market malaise are not the pointy-headed nerds behind the toxic debt parcels and those who managed hedge funds, but the regulators and central bankers who were supposed to police their activities. Their job was meant to be to promote responsible and ethical behaviour in financial markets and ensure wider financial stability, at the same time as keeping inflation in check.

However they have failed on at least two counts, and are looking as if they could also fail on all three. When markets go pear-shaped the central bankers, driven by panic that the condition might infect the wider economy, invariably respond by bailing out their friends on Wall Street and in the City, irrespective of the moral hazard.

We saw this last week from Jean-Claude Trichet at the European Central Bank and, to a lesser extent, Ben Bernanke at the US Federal Reserve. Their largesse will doubtless ensure they get offered plenty of non-executive roles by investment banks once they retire, but has done nothing to lance the boil that has infected our financial system.

By bailing out troubled hedge funds and troubled investment banks with rate cuts and liquidity injections, Trichet, Bernanke and their ilk are in fact giving irresponsible market participants a “get-out-of-jail-free card” — and probably also egging them on to behave even more irresponsibly in future.

They appear to have taken their cue from Alan Greenspan. When chairman of the US Federal Reserve from 1987-2006, Greenspan was criticised for doing more harm to the US economy than Osama bin Laden ever could (click here to read about the parallels between the ex-Fed governor and the al-Qaida founder).

Greenspan’s response to the dotcom crash and the terror attacks of September 11th, 2001 (which bin Laden had devised as a means of sapping Americans’ spirit and destroying their financial system and economy) was to turn on the monetary taps as if there was no tomorrow. He slashed US interest rates – they fell from 6.5% to 1% after December 2000 and held them too low for too long – at the same time as condoning President George W Bush’s tax-cutting programme.

For a period, this massive monetary easing did what the doctor ordered, rebuilding momentum in the US housing market and restoring confidence in the financial markets. However it was little more than a confidence trick. The long-term effect of Alan’s medicine was to inflate another bubble which, if anything, was bigger and more hazardous than the last.

The waves of volatility that have been rocking financial markets around the world in recent days owe their origins to the absurdly low interest rates introduced on Greenspan’s watch and by his earlier cheerleading for the subprime mortgage industry, securitization and derivatives. What we now need is a what might be called a “cleansing” correction, not just another temporary pause before reverting to the debt-fuelled madness that came before.

Christopher Whalen, a former investment banker and editor of Institutional Risk Analyst, explained Greenspan’s pivotal role in engineering the current crisis on the Seeking Alpha blog last week. He said:-

Greenspan’s culpability in the latest credit fiasco stems not just from his easy money monetary policy, but from the Fed’s consistent advocacy of derivatives as an appropriate vehicle for banks and investors to take risk. Under the guise of improved risk management, the Fed led the charge in Washington to lend legal and regulatory support for the development of the OTC derivatives markets, in part because other sources of profitability to the largest banks were diminishing.

Derivatives did boost profits at larger banks and dealers, but at the cost of decreased transparency and increased risk to the financial system as a whole.

It seems obvious to us that a breakdown in prudential guidelines on Wall Street and among federal regulators has led to the confusion that financial markets face today. Over the past decade, the Fed, the SEC, other financial regulators and the managers of many private financial institutions, threw away a century worth of prudential rules and best practices for ensuring the safety and soundness of US banks, and instead embraced a culture of speculation.

Investors and regulators alike need a way to monitor risk via real market pricing, not ersatz derivative models.

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Posted by Ian Fraser on Aug 18 2007. Filed under Blog. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry