Reckoning III - A Legend under scrutiny!!!

"Legend: A lie that has attained the dignity of age." ~ H.L. Mencken

Irrational Exuberance – when he uttered this phrase, it took all of the world markets two complete days to stabilize, back in 2000. It was by none other than the longest served US Fed Chief, Alan Greenspan. I was a big fan of him during my B-school days, even read his biography and strangely I was also a Rand-ian, pretty much influenced by the objectivism. He was a close associate of Ayn Rand, who portrayed the collective power as an evil set against the enlightened self-interest of individuals through her novels, Atlas Shrugged and Fountain Head.

As promised in my earlier post, I expose one of the powerful lawmakers who’d successfully resisted the derivatives market out of the realm of financial regulators. George Soros, once the wealthiest man on Earth avoids derivatives “because we don’t really understand how they work; while Felix Rohatyn, the banker who saved New York from financial catastrophe in ‘70s describes derivatives as “Hydrogen Bombs” and Warren Buffet observed presciently five years ago that derivatives were “financial weapons of mass destruction.”

While in campus, I loved the idea of derivatives (the name comes from the fact that their value “derives” from an underlying asset like stocks, bonds, commodities, etc. – were created to soften or “hedge” risks) and really was keen to spend couple of more credits over this subject before my interest waned primarily ‘coz of the professor (I felt he’s not good enough to teach this subject) and secondly of the fact that the intricacies of calculations involved didn’t really excite me.

Greenspan staunchly rejected the idea to put derivatives under regulation whenever they’ve come under scrutiny of Congress or on Wall Street. Moreover, Alan was held in very high regard and it was an area of judgment in which the members of Congress have non-existent expertise. The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a recent speech at Georgetown University, intimating that those peddling derivatives weren’t as reliable as “the pharmacist who fills the prescription ordered by our physician.”

"We are made wise not by the recollection of our past, but by the responsibility for our future." ~ George Bernard Shaw.

The derivatives market is $531 trillion up from $106tn in 2002 and a relative pittance a decade ago. Some argued that these instruments became so vast, intertwined and inscrutable that required a regulatory oversight as on a larger scale such contracts allow financial institutions to take more complex risks that they might otherwise avoid – for instance, issuing more mortgages or corporate debt.

“The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole,” Charles A. Bowsher, head of the accounting office, said when he testified before Mr. Markey’s committee in 1994. “In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers.”In his testimony at the time, Mr. Greenspan was reassuring. “Risks in financial markets, including derivatives markets, are being regulated by private parties,” he said. “There is nothing involved in federal regulation per se which makes it superior to market regulation.”

Mr. Greenspan warned that derivatives could amplify crises because they tied together the fortunes of many seemingly independent institutions. “The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence,” he said. But he called that possibility “extremely remote,” adding that “risk is part of life.”

Later that year, Mr. Markey introduced a bill requiring greater derivatives regulation. It was never passed. As the stock market roared forward on the heels of a historic bull market, the dominant view was that the good times largely stemmed from Mr. Greenspan’s steady hand at the Fed. Mr. Greenspan’s credentials and confidence reinforced his reputation — helping him to persuade Congress to repeal Depression-era laws that separated commercial and investment banking in order to reduce overall risk in the financial system.

Mr. Greenspan said that Wall Street could be trusted. “There is a very fundamental trade-off of what type of economy you wish to have,” he said. “You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either,” he said.

Savvy investors like Mr. Buffett continued to raise alarms about derivatives, as he did in 2003, in his annual letter to shareholders of his company, Berkshire Hathaway. “Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers,” he wrote. “The troubles of one could quickly infect the others.”

But the business continued.

"History repeats itself, first as tragedy, second as farce". ~ Karl Marx

And when Mr. Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street was using derivatives, he said in a 2004 speech, to share risks with other firms.

Shared risk has since evolved from a source of comfort into a virus. As the housing crisis grew and mortgages went bad, derivatives actually magnified the downturn. The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers, and imperiled the insurance giant American International Group, has been driven by the fact that they and their customers were linked to one another by derivatives.

“You will go down as the greatest chairman in the history of the Federal Reserve Bank,” declared Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee when Mr. Greenspan appeared there in February 1999.

In recent months, as the financial crisis has gathered momentum, Mr. Greenspan’s public appearances have become less frequent. His memoir was released in the middle of 2007, as the disaster was unfolding, and his book tour suddenly became a referendum on his policies. When the paperback version came out this year, Mr. Greenspan wrote an epilogue that offers a rebuttal of sorts.

“Risk management can never achieve perfection,” he wrote. The villains, he wrote, were the bankers whose self-interest he had once bet upon. “They gambled that they could keep adding to their risky positions and still sell them out before the deluge,” he wrote. “Most were wrong.”

"All history becomes subjective; in other words there is properly no history, only biography." ~ Ralph Waldo Emerson