Hands up, Mr Greenspan!

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 credit rating agencies.

Standard & Poor’s, Moody’s and Fitch were accused of misleading investors by giving the “all clear” to what were, in reality, distinctly dodgy credit derivatives.

Many of the derivatives were vast bundles of home loans issued to “subprime” US borrowers. It’s strange that last month both Moody’s and S&P placed on negative review large quantities of residential mortgage-backed security (RMBS) and collateralised debt obligations (CDOs) with 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 since 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 their 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 the RMBS and other asset-backed securities who pay their 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 genuinely have believed that by lumping pools of debt together into humungous securitised parcels they would eliminate the risk. However this was not the effect the practice had. It simply made the the risk harder to fathom.

In the end, the true architects of the current market malaise are not the people who were putting together parcels of toxic debt but the regulators and central bankers who were supposed to be policing 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 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 is polluting 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.

The regulators and central bankers appear to be taking their cue from Alan Greenspan. When chairman of the US Federal Reserve from 1987-2006, he 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 11 September 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-cuts.

For a period, this monetary easing did what the doctors 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 Greenspan’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 fomenting 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.

Hear, hear.

This blog post was published on 18 August 2007