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:
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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.
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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.
October 9th, 200812:13 pm at
Buffett and you were early in warning of problems with credit default derivatives. What do you think is the best way to unwind the “false” confidence they provided, I mean how would you regulate CD swaps ? If it became mandatory to disclose positions to an institution resembling a clearing house would that help counterparties discover a market price for their claims ? Can this be done in real time, I mean with all the frenzy surrounding the long and short CDS positions with the now bankrupt Lehman ?
organize Is there anything resembling ult a these contracts
October 9th, 20081:28 pm at
I’ve come around to the view that the most important problem with our regulation of highly leveraged public entities like banks, is that we don’t require them to be sufficiently diversified. Sure, credit derivatives are volatile, and CDOs are hard to understand, but there is lots of other stuff out there like oil futures and the Baltic Dry Index (I think futures were just recently introduced on this but I don’t know the details, it’s just and example here) that one would think would be candidates for something that is easy to understand and relatively hard to turn into a bubble, and yet we’ve seen astonishing volatility in those prices over the last year. So given assets that can exhibit that type of vaolatility, getting rid of complexity is not going to make the leverage levels safe. Safety to operate as a leveraged entity is going to involve some combination of lower leverage, portfolio management and fungibility of asset requirements (e.g. stop loss), and high diversification requirements to better insure that assets less correlated (a big problem with the agency ratings of MBS is the assumption that housing markets in different cities would be uncorrelated).
October 10th, 20085:39 pm at
You’re absolutely right that Greenspan screwed up. But the deeper point is that we’ve allowed the existence of a central banking system that allowed him (and all Fed Chairmen and Board members) to wreak havoc on the economy; it’s a system that should never have existed in the first place and has no place in a free society. Every government agency and intervention is the direct result of a failure caused by a previous government intervention. Austrian economists have been warning about this crash for many years, and it’s likely this isn’t the worst one we’ll see as a result of the Fed and fiat money. Hopefully this will force economists and financial experts to understand and adopt the insights of Ludwig von Mises and Murray Rothbard.