A Note on the Greenspan Legacy

Check out this article from the New York Times on the Greenspan legacy.  In my time at RealMoney, I took some heat for being a critic of Greenspan.  I won’t list all of it, but I will echo this one post:

Aaron Task
Speaking of Permabears…
7/26/2006 1:27 PM EDT

Thanks for the response, Rev.

Meanwhile, Merrill’s Rich Bernstein has an interesting note out arguing that the Fed’s 450 basis points of tightening “has not yet severely impacted the U.S. economy” because the expanded use of credit derivatives has created an alternative source of liquidity.

“Whereas the majority of Wall Street is focused on the traditional growth/inflation trade-off, we hope Mr. Bernanke is also considering this new and expanding form of credit creation,” Bernstein writes. “Our belief is that he is indeed quite concerned, and that despite current dovish jawboning, he will ultimately tighten more than investors currently expect.”

Position: Awaiting the Beige Book.

David Merkel
By Default, No Credit Where It Is Not Due
7/26/2006 2:23 PM EDT

Aaron, I read the Rich Bernstein piece. I usually agree with what he writes, but not this time. The amount of yield compression created by credit default swaps is 50 basis points at best, which doesn’t even come close to the 450 basis points that the FOMC tightened. Now, if someone makes the argument that the rates on corporate bonds 10 years and longer haven’t increased significantly over the past 27 months, I would agree with that, but that has little to do with credit default swaps, which are a short maturity phenomenon for the most part.

I thought of writing a note on the article cited in Bernstein’s piece, but ran out of time yesterday. It is a horrendously optimistic article, and too short-sighted. Credit derivatives, as I have noted before, have induced two anomalies into the credit markets. First, they make spreads artificially tight on the short end. Second, they create demand for bonds after they default.

Both of these are “tail wagging the dog” phenomena. When the market for making side bets gets bigger than the main business of financing corporate credit, something weird is going on. The real test will come when we get the next spike in investment grade defaults. When we had the last spike, the credit default swap market had notional amounts smaller than the corporate bond market. Now the credit default swap market is more than four times the size of the corporate bond market in nominal terms. When it happens, all of the negative effect of too much insurance chasing too few bonds to be insured will be revealed.

One more aside, the idea that the low default rates since 2003 is unusual is wrong. We had a longer period in the mid-90s. The effect of credit default swaps and collateralized debt obligations on default in the short run is modest at best (even the article says CDOs lower borrowing costs by 3-5 basis points).

In the long run, it may make the default problem worse. Whenever you lend a debtor money, he immediately looks more creditworthy because of the liquidity. When the liquidity goes away, as it always does for some minority of corporate borrowers, the debt problem is worse not better.

Position: none, but my bet is that Buffett is right on credit derivatives, and Greenspan wrong (why does that seem like an easy bet?)

I’ve always been a skeptic on the macro-level of derivatives, because they don’t change anything for the system as a whole, unless the losing party is undercapitalized.  The seeming calm that derivatives helped to induce merely shifted volatility to parties that could not bear losses under significant stress.  Talking about a “Great Moderation” during a bull market is hooey.  It’s a Great Moderation if lending terms are stable in a bear market.

Greenspan is a bright guy, but like many bright guys who become beholden to the DC establishment, they circumscribe their reasoning to the politics that they live in.  Few of us have the stomach to speak truth to power; I wonder what I would do under the same cirumstances, though my constitution says I would be a short-lived creature in DC, which does not want to hear the truth.

My guess is that Greenspan will fare badly in history books one century from now.  The inflation that he induced, and the false confidence he engendered will be villified.