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April 14, 2008

He Did It His Way (Unfortunately)
by Brady Willett and Todd Alway

Greenspan did another media tour last week, this time defending his legacy in the Financial Times, Wall Street Journal, and on CNBC Television. Unfortunately the story from Greenspan was much the same: he reiterated that the financial markets are best left to self-regulate, and that investors around the world (not the Fed) took control of long-term interest rates thus leading to the U.S. housing bubble. Astonishingly, Greenspan added, 'I have no regrets on any of the Federal Reserve policies that we initiated back then...' and 'I don't remember a case when the process by which the decision making at the Federal Reserve failed.' Having already amassed a fair amount of criticism as the U.S. housing bubble deflates and the financial system teeters on the brink, is it any wonder that Greenspan's most recent comments sparked a further lambasting? Who does 'no regrets' and never 'failed' Mr. Greenspan think he is - a cross between Frank Sinatra and Jesus?

Having attacked Mr. Greenspan on numerous occasions - and many years before the current onslaught began - there is little need to reiterate what we have said before verbatim (many of our criticisms are documented below).

Instead let's start by stating that squabbling over whether or not Greenspan's 1% Federal Fund rate was 'too low' for 'too long' is pointless. Hindsight is 20-20 folks! Remember also that few of Greenspan's critics believed that a 1% Federal Funds rate was going to help ignite a housing bubble. Rather, much like today, the so called 'bears' (amongst which long-time Greenspan critics Fleck and Roach can be included), believed that no matter what the Fed did they would end up 'pushing on a string' as the historic 2000-2002 stock market bust proved too enormous a strain to counterbalance. You can't really blame Greenspan for setting interest rates irresponsibly low if you believed that no amount of interest rate stimulation could counteract the bursting stock market bubble, can you?

In short, the real case against Greenspan has little to do with his late tenure interest rate policies, and more to do with what he really accomplished in his 18-years as Fed Chairman. In our view what Greenspan's Fed accomplished was to destroy the natural safeguards of free market capitalism. Ironically, he accomplished this Herculean feat not only by his actions, but by the lack thereof...

"...I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken, but not my judgment that free competitive markets are by far the unrivaled way to organize economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?" Alan Greenspan

No Mr. Greenspan, Fed Meddling Is All The 'Evidence' Required

Greenspan is half right. Financial markets should be allowed to operate as freely as possible. If investors want to throw billions of dollars at an internet IPO that doesn't have any earnings, let them. If Wall Street wants to create an OTC derivatives monstrosity that would be incomprehensible to Einstein, so be it. If undeserving Americans are able to acquire a mortgage because subprime paper is wrongly rated triple A and packaged and sold across the planet, wonderful. And last but certainly not least, if hedge funds want to manipulate markets, take on excessive leverage, and operate without almost any oversight, fantastic!

The problem is, in practice the Greenspan doctrine of free markets failed, and miserably so. To be sure, what Greenspan did not acknowledge is that the Federal Reserve itself is the major impediment to the freedom he so greatly desired. Not exactly a complicated notion, the Fed hinders freedom in the marketplace by repeatedly trying to subvert the consequences that rise from poor investment decisions. For example, Greenspan previously claimed that the Fed cannot 'definitively identify a [asset] bubble until it bursts', but he quickly adds that the Fed should step in and 'mitigate the fallout when it occurs'. Question is, if freedom is really the underlying goal, why the need for monetary intervention at all?

By only attacking freedom in the marketplace when the consequences of poor decision making are about to met, the Fed unwittingly delays the natural corrective forces in the marketplace, thus guaranteeing that larger and potentially more devastating problems are around the corner. A helpful analogy is that the Fed erects a rickety damn around a problem hoping isolation will keep the rough waters at bay. These damns, in the form of monetary interventions and regulatory negligence, were constructed around LTCM, Y2K (needlessly so), the 2000-2003 stock market crash, 9/11, and, most recently, the ongoing housing/credit market bust.

While the intent of these damn building projects is to provide immediate shelter, in many cases the Fed hinders its longer-term obligation of safeguarding the marketplace. The water builds up behind the hastily-built dam until the pressure causes it to burst, unleashing a tsunami of damage rather than what was merely the risk of occasional flooding. Using the example of LTCM, co-founder John Meriwether recently made headlines for posting severe losses at another hedge fund. Would the Fed, and the investing public, have been better served to allow LTCM to fail and/or increase transparency in hedge funds when LTCM exploded in 1998?

The Current Crisis Put Into Context

Be it the popping housing bubble, the credit bubble, overvaluation in equities, or the unregulated derivatives labyrinth, the risk today is that many years of regulatory neglect and poor investment decisions have created potential flashpoints across too many financial spectrums for the Fed to direct its payload with precision. Quite frankly, with Fed rate cuts and monetary pumping since August 2007 unable to gain traction in the marketplace, it is as if the Fed has lost its powers to quarantine danger in one area of the marketplace while stoking confidence in another. Recall that even during the vicious 2000-2002 bear market - when trillions in paper stock market wealth vanished - trillions of dollars in housing wealth was soon created thanks in part to easy Fed policies and Greenspan's refusal to regulate the mortgage industry. Contrast this to today, where Fed rate cuts are coinciding with tightening lending standards, liquidity injections only briefly help bruised credit markets, and emergency/unscheduled Fed meetings, while seemingly averting complete disaster, do little to turn the tide of eroding confidence.

In other words, many previous Fed patch jobs risk coming unglued at once. Incidentally, whether or not the Fed is up to the challenge is really irrelevant. Rather, with a two decade history of being able to temporarily quarantine problems, market participants clearly expect Bernanke's Fed to act and keep acting. Freedom, it would seem, can wait for another day, because the entire system is at risk!

The Contradiction To End All Contradictions

With the Fed stepping up to combat the popping housing bubble, dysfunctional credit markets, and opaque Wall Street balance sheets, it is clear that confidence in the marketplace has been replaced, perhaps permanently, with confidence, or lack thereof, in the Fed. Thus, the questions are no longer how long will U.S. housing prices keep sliding or at what price will Citigroup be able to dump some tier 3 assets, but how long will global policy makers continue to believe that the U.S. Federal Reserve Board can avert catastrophe? Put more simply, how long will the U.S. dollar be thought of as being too important to global commerce to be allowed to implode? It goes without saying that Greenspan's Fed has ushered in this period of profound uncertainty not only because the Fed failed to achieve a single regulatory effort of note during Greenspan's tenure, but also because Greenspan explicitly attempted to perpetually delay the consequences of poor investment decisions.

In closing, the consequence of 'Greenspan's freedom' is an even more tyrannical Federal Reserve Board - one that is preoccupied with trying to manage the fallout from asset price bubbles, financial manias, and nontransparent/unregulated financial market quagmires. This is not exactly the outcome Mr. Greenspan would have hoped for and, obviously, this is a situation that should generate many 'regrets'. Unrepentant, Greenspan suggests that public funds could be used to settle the housing crisis.

"...free competitive markets are by far the unrivaled way to organize economies."

Freedom, it would seem, can wait for another day.

May 14, 03
OTC Derivatives: Risking an F for Prudence
In the context of an unregulated market allowed to grow without regulatory prudence, Buffett's 'weapons of mass destruction' comment resonates, while Greenspan's "the benefits of derivatives, in my judgment, have far exceeded their costs" does not.

May 18, 2005
As Greenspan Bids Adieu, Say Hello to Uncertainty
Greenspan's policies have, at least for the foreseeable future, locked the Fed into a dangerous game of asset bubble management.

October 28, 2005
From Greenspan Put To Bernanke Straddle
When Greenspan took over as Fed boss the federal funds rate was 7%, the US savings rate was 7.5%, and foreign and international investors held 17% of outstanding US Treasury Securities...

February 1, 2006
One Good(k)night does not a sweet prince make
Unfortunately the policy of ignoring bubbles, imbalances, and prudent market regulation will result in even more fantastic financial blowups, and, ultimately, serve to speed up the transition away from the US dollar...

August 16, 2006
The Long-Term Consequences of The Long-Term Bailout
So what should happen next time? Put it this way, LTCM should have been allowed to burn. The Fed had the choice 8-years ago: regulate or bailout. They chose the latter, and that has made all the difference.

August 7, 2007
Greenspan's 'Adversity' Fantasy (Log-in required)
"We were overwhelmed by excess global savings that continued to press real long term rates lower."
In other words, 'We tried everything to stop the housing mania from taking shape, but foreigners simply love our markets too much! Sorry about the inevitable housing bust. Here is a couple of rate cuts...please do feel free to take on some more risk.'
Your Uncle,
Al

September 14, 2007
Mr. Bubble Writes A Book
Greenspan said in 1996 that he recognized the "stock market bubble problem" but he later (after doing nothing to stop the mania) concluded that bubbles are not identifiable until they burst. Now Greenspan claims that while he was aware of reckless subprime lending tactics (in 'around 2000'-Gramlich), he didn't understand how widespread the practice was until 2006, or about the same time he was calling for a bottom in the U.S. housing market. Who wouldn't want to read a book written by someone so fascinatingly mad?

January 7, 2008
2008: Is Bernanke The One?
Prophecy #8: Greenspan is already receiving his share of bad press, but by the end of 2008 his image will be fully transformed from that of miracle worker to wacko alchemist. No one will remember the 'good times' Greenspan supposedly helped create as times turn increasingly bad.

April 7, 2008
1Q08 Wish List Report (Log-in required)
...who today is the 'lender of the last resort'? When it's the bottom of the ninth inning and investors desperately need a home run to avoid losing to Armageddon, who steps up to the plate? Not the Fed, they came off the bench before the 7th inning stretch...

Brady Willett and Dr. Todd Alway
FallStreet.com