Financial War Games

BEFORE GETTING TO “war games,” let’s recap some past wisdom from the man formerly behind the curtain:

1996 – Greenspan warns about irrational exuberance in the stock market
2000 – Greenspan embraces the “productivity miracle” and says there is no stock market bubble
2001 – Greenspan said bubbles can only be detected in hindsight
2004 – Greenspan says there is no housing bubble
2005 – Greenspan says there is no national housing bubble, even though he admits we have “froth.”

It’s Different This Time

Here are some select comments from just-released FOMC minutes from the May 16, 2000 meeting shortly after the Nasdaq blowoff top:

Chairman Greenspan:

“My own judgment, and what I plan to recommend to the committee, is that we have an opportunity now to move the funds rate up 50 basis points, remain asymmetric, and effectively adjust our longer-term posture to a better position than the one we are in at the moment. The reason I am not concerned about moving the rate up quickly at this stage is that I think the evidence indicates that productivity, indeed perhaps underlying GDP, is still accelerating. I recognize that the staff’s estimate of productivity growth for the first [quarter] is 1 1/2%. I don’t believe that estimate for a fraction of a second. Indeed, using the available data on income and profits, which essentially reflect the unit cost structure of nonfinancial corporations, the productivity growth number that falls out of that system according to staff estimates is a 6% annual rate.

“I think we are in a quite different environment than we have seen in the past. In such an environment real long-term interest rates have to rise, and indeed they have risen very significantly in the last several weeks. Real long-term BBB rates are up over 50 basis points after gradually edging higher for quite some period of time. This indicates that the markets are adjusting rapidly to the evidence that overall demand forces are becoming very strong, driven in large part by the supply factors themselves.

“I think what we have is still the beginning, or perhaps we are well into it at this stage, of a significant long-term change in the behavior of the economy. I believe the risks in moving 50 basis points today are not very large because I think the underlying momentum in the economy remains very strong. What is going to happen in the future is probably going to be dependent on a number of developments that we can’t really forecast.”

Mr. Hoenig:

“Mr. Chairman, everything you said convinced me that a 1/4-point hike seems right. Inflation is not taking off and in fact a lot of the evidence suggests some easing off in the expansion. Moreover, I don’t think we should be validating the market necessarily. I think we should be looking at what is in front of us, and 1/4 point with asymmetric language seems most appropriate. A year ago when we were at 4 3/4% on the funds rate, there was a better case for moving more aggressively in the sense that we had put in a lot of stimulus. And yet we were very cautious in moving up.”

Is it possible for anyone to have been more wrong? In one meeting he was wrong about productivity, the strength of the economy, where the risks were…and most importantly, right after the start of the Nascrash, came out with one of his most absurd statements ever when he commented, “I think we are in a quite different environment than we have seen in the past.” Hook, line, and sinker, Mr. Greenspan bought into “it’s different this time” logic, right as the bubble was bursting in front of his own eyes.

Greenspan on Financial Stability

What should have everyone worried right now is this Greenspan flashback from May 5, 2005, when he spoke about risk transfer and financial stability:

“Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth. 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, which was so evident during the credit cycle of 2001-02 and which seems to have persisted. Derivatives have permitted the unbundling of financial risks. Because risks can be unbundled, individual financial instruments now can be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Partly because of the proposed Basel II capital requirements, the sophisticated risk-management approaches that derivatives have facilitated are being employed more widely and systematically in the banking and financial services industries.

“As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers.”

The greatest evidence of the benefits of derivatives is spectacular growth? That sounds like bubble logic to me. There is $17 trillion in derivatives floating around with $1 trillion bet on GM alone, even though GM has a market cap of $20 billion or so. Is that a sign of a spectacular success, or is that a sign of unbelievable speculative leverage? Obviously, Greenspan learned nothing from the stock market crash of 2000. He is now claiming that derivatives have permitted the unbundling of financial risks. Have they? I have a couple of questions for you, Mr. Greenspan, that might bring you back to reality. Is there not a counter party to those trillions of dollars worth of derivatives? Has that risk been magically offloaded to Pluto or Mars? If not, who has that risk?

Clearly, Greenspan was babbling nonsense in May 2005, just as he was babbling nonsense in May 2000 and at nearly every other point in his career as well.

Liquidity Concerns

On April 11, the IMF warns over credit derivative liquidity.

“Investors in structured credit products risk not being able to sell or obtain an acceptable price following a market downturn because buyers may shun the fast-growing market, the IMF said on Tuesday.

“The risk of liquidity disturbances is ‘material … (and) certain products and market segments are particularly vulnerable,’ the International Monetary Fund said in its annual Global Financial Stability Report.

“The secondary market, away from the biggest banks, was more likely to be at risk, it said…

“Still, IMF concern over credit derivative liquidity was set in the report against a largely positive overview.

“‘Credit derivative and structured credit markets help to improve financial stability by facilitating the dispersion of credit risks,’ the Fund concludes, as ‘banks, especially systemically important institutions…shift credit risk to a broader set of investors’…

“In addition, the Fund said, the rapid growth of the $17.3 trillion market raised concerns over the potential for operational failures.

“The Fund welcomed moves by regulators to tackle operational issues, but said the industry should be ‘encouraged to pursue these efforts expeditiously in order to avoid potential disputes in the event of a default’…

“In some cases more credit default swaps have been written on specific companies than there are bonds of that company outstanding. After a default there is a need for a system to settle the contracts without conventional delivery of a bond.”

Leave it to the IMF to ruin a decent report with “Greenspanesque” talk such as “credit derivative and structured credit markets help to improve financial stability by facilitating the dispersion of credit risks.” There is little evidence of dispersion, but there is mammoth evidence of speculation when hedge funds and others have massively leveraged bets on whether companies go bankrupt or not, even when they have no vested interest. Even the mortgage market is insane, with everyone attempting to pass the trash to Fannie Mae while trying to keep the “good loans” on their books. Even if everyone did miraculously manage to disperse the risk, will it be a good thing if trillions of dollars in bets vanish on some sort of blowup?

It seems to me there is some sort of uncertainty as to what might really happen in a derivatives meltdown. Back on Feb. 28, the Bond Market Association announced a “new bank” to provide crucial liquidity in emergencies:

“The Bond Market Association announced that it has accepted an invitation by a private-sector working group established by the U.S. Federal Reserve Board to develop and lead the creation of a so-called ‘NewBank’, a standby bank that would only be activated if one of two existing clearing banks in the U.S. government securities markets was suddenly forced to leave the business. Both government officials and market participants have long been concerned about the possibility, even if remote, of one of the banks suddenly exiting the markets and have agreed the NewBank concept is an appropriate precautionary measure…

“Since the mid-1990s all of the major participants in the U.S. government securities markets have depended critically on one of two clearing banks, Bank of New York and J.P. Morgan Chase, to settle their trades and to facilitate financing of their securities inventory positions. Interruption of a clearing bank’s services has the potential to severely disrupt those markets, as was evident in the wake of the tragic events of Sept. 11.

“‘Securities dealers need a contingency plan in the event one of the clearing banks is forced to exit the markets,’ commented Micah S. Green, president and CEO of the Bond Market Association. ‘Establishing NewBank is a prudent market-based initiative aimed at mitigating any potential problems caused by the sudden involuntary exit of one of the banks.'”

Preparation for a Crisis

Over in the United Kingdom, The Times Online is reporting that E.U. regulators are told to be prepared for a crisis:

“Financial regulators in all E.U. countries are to be asked today to prepare for the collapse of a big hedge fund or a similar sudden financial shock. E.U. finance ministers and central bankers, meeting in Vienna, were told that the collapse of a hedge fund could now destabilize European financial systems as well as the financial markets.

“They have equally raised anxieties about the rapid growth of private equity. They fear that this could unravel if one of the key sources of funds or markets for selling on companies dries up. Officials also argue that many regulators do not understand the risks involved in the £10,000 billion market in credit derivatives, which are traded privately between banks rather than on public exchanges.

“A private report drawn up by finance ministry officials of E.U. states says: ‘Hedge funds can contribute to market efficiency and sharing of risks but can also be a source of systems risks.’ The report urges the central banks and regulators to monitor banks’ exposure to hedge funds, both as lenders and as counterparties to massive speculative positions in financial and commodity derivatives. Banks are also heavy lenders to private equity buyouts, which provide them with more profitable but riskier business.”

War Games

Also in the United Kingdom, I am pleased to report that Europe simulates a financial meltdown:

“Europe’s financial regulators have held a ‘war game’ exercise, simulating a continent-wide financial crisis, amid fears they are ill- prepared to stop a problem in one country spreading across borders.

“The exercise involved simulating the collapse of a big bank with operations in several large countries to see whether the European Central Bank, national central banks, and finance ministries could work together to contain the crisis.

“It is understood the exercise took place at the headquarters of the ECB in Frankfurt at the end of last week. One person involved said: ‘It is like checking whether a nuclear power plant can survive a plane crashing into it’…

“Europe’s vulnerability to a cross-border financial crisis was revealed in a confidential report prepared by officials for the Ecofin council. Regulators are particularly worried about the risks to financial stability posed by the growth in hedge funds and credit derivatives.

“It said that ‘progress has been insufficient in most of the member states’ in putting in place national structures for crisis management, and urged national regulators to stage their own crisis simulation exercises.

“The E.U. has rejected the creation of a single European financial regulator to manage cross-border risks, and has instead placed its faith in national authorities working together.”

What We Are Saying vs. What We Are Doing

Here is a recap of what Greenspan said:

· Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth
· 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
· The development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively.

Here is what we are doing:

· Creating a ‘NewBank’ to provide liquidity in emergencies
· Simulating financial meltdowns caused by an explosion in hedge funds and credit derivatives.

I have three questions:

1. If the explosion in credit derivatives is making us safer, why do we need to create a new bank to deal with liquidity issues?
2. If the explosion in credit derivatives is making us safer, why are we simulating financial meltdowns based on those very same derivatives blowing up?
3. How long will it take before Greenspan is proven spectacularly wrong once again?

Regards,
Mike Shedlock ~ “Mish”
April 19, 2006