Greenspan versus Reality (Part I)

This article is derived from Greenspan’s latest paper. Greenspan’s comments are in italics. Mine are in normal type.

Greenspan begins his argument:

The bankruptcy of Lehman Brothers in September 2008 precipitated what, in retrospect, is likely to be judged the most virulent global financial crisis ever.

Quite a statement, and one that I think is false, at least so far. The Great Depression was far worse.

Yet the ex post global saving – investment rate in 2007, overall, was only modestly higher than in 1999, suggesting that the uptrend in the saving intentions of developing economies tempered declining investment intentions in the developed world. That weakened global investment was the major determinant in the decline of global real long-term interest rates was also the conclusion of the March 2007 Bank of Canada study.5 Of course, whether it was a glut of excess intended saving or a shortfall of investment intentions, the conclusion is the same: lower real long-term interest rates.

The truth was that because central bank policy had not cleared away malinvestment, but had coddled it, when the emerging markets attempted to save more (whether privately or by government fiat), interest rates fell, because there were fewer productive places to invest.

Similarly in 2002, I expressed my concerns before the Federal Open Market Committee that “. . . our extraordinary housing boom . . . financed by very large increases in mortgage debt – cannot continue indefinitely.” It lasted until 2006. (Greenspan footnoted: Failing to anticipate the length and depth of emerging bubbles should not have come as a surprise. Though we like to pretend otherwise, policymakers, and indeed forecasters in general, are doing exceptionally well if we can get projections essentially right 70% of the time. But that means we get it wrong 30% of the time. In 18½ years at the Fed, I certainly had my share of the latter.)

Much as I appreciate Greenspan’s possible intellectual foresight in 2002, and his willingness to admit that he was sometimes wrong, I find fault in that he did not act on it. He kept rates low through 2004, and defended the provision of liquidity by saying it would continue for a considerable period of time.

Clearly with such experiences in mind, financial firms were fearful that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably. Their fears were formalized by Citigroup’s Charles Prince’s now famous remark in 2007, just prior to the onset of the crisis, that “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Such was life under the Greenspan Put. Make money while liquidity is cheap. The Fed has our back, so lend to all but the worst prospects, and sell the loans as quickly as possible.

The financial firms risked being able to anticipate the onset of crisis in time to retrench. They were mistaken. They believed the then seemingly insatiable demand for their array of exotic financial products would enable them to sell large parts of their portfolios without loss. They failed to recognize that the conversion of balance sheet liquidity to effective demand is largely a function of the degree of risk aversion. That process manifests itself in periods of euphoria (risk aversion falling below its long term, trendless, average) and fear (risk aversion rising above its average). A lessening in the intensity of risk aversion creates increasingly narrow bid-asked spreads, in volume, the conventional definition of market, as distinct from balance sheet, liquidity.

In this context I define a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long term trendless averages. Falling capitalization rates propel one or more asset prices to unsustainable levels. All bubbles burst when risk aversion reaches its irreducible minimum, i.e. credit spreads approaching zero, though analysts’ ability to time the onset of deflation has proved illusive (sp).

I think Greenspan would benefit from reading my “What is Liquidity?” series. Risk aversion is a function of asset-liability matching (as he notes), but also of the degree of certainty of being able to make or meet fixed obligations.

I very much doubt that in September 2008, had financial assets been funded predominately by equity instead of debt, that the deflation of asset prices would have fostered a default contagion much beyond that of the dotcom boom. It is instructive in this regard that no hedge fund has defaulted on debt throughout the current crisis, despite very large losses that often forced fund liquidation.

Good, but your prior policies fostered debt-based finance, because recessions were never allowed to get too deep, and businessmen rationally chose to finance with cheaper tax-deductible debt, rather than expensive equity, because they concluded that the Fed would not allow big crises to happen.

Mathematical models that define risk, however, are surely superior guides to risk management than the “rule of thumb” judgments of a half century ago. To this day it is hard to find fault with the conceptual framework of our models as far as they go. Fisher Black and Myron Scholes’ elegant option pricing proof is no less valid today than a decade ago. The risk management paradigm nonetheless, harbored a fatal flaw.

I disagree. Good risk management is dumb risk management. Simple rules outperform complex ones over a full market cycle. Even Black-Scholes is open to question, given better models that reflect fatter tails. Aside from that, B-S did not materially improve on Bachelier (or actuaries that had discovered the same formula on terminable reinsurance treaties several years earlier). Black, Scholes, and Merton get too much credit for what was discovered previously.

Only modestly less of a problem was the vast, and in some cases, the virtual indecipherable complexity of a broad spectrum of financial products and markets that developed with the advent of sophisticated mathematical techniques to evaluate risk. In despair, an inordinately large part of investment management subcontracted to the “safe harbor” risk designations of the credit rating agencies. No further judgment was required of investment officers who believed they were effectively held harmless by the judgments of government sanctioned rating organizations.

Rating agencies offer opinions, not guarantees. They are a beginning for research, not an end. No one should rely on any third party when anything significant is at stake; they should analyze the situation themselves.

A decade ago, addressing that issue, I noted, “There is [a] . . . difficult problem of risk management that central bankers confront every day, whether we explicitly acknowledge it or not: How much of the underlying risk in a financial system should be shouldered [solely] by banks and other financial institutions? “[Central banks] have chosen implicitly, if not in a more overt fashion, to set capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

“I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.”

At issue is whether the current crisis is that “hundred year flood.” At best, once in a century observations can yield results that are scarcely robust. But recent evidence suggests that what happened in the wake of the Lehman collapse is likely the most severe global financial crisis ever. In the Great Depression, of course, the collapse in economic output and rise in unemployment and destitution far exceeded the current, and to most, the prospective future state of the global economy. And of course the widespread bank failures markedly reduced short term credit availability. But short-term financial markets continued to function.

This was not a once-in-a-century event. It was produced by weak monetary policy, and weak credit policy, leading to too much private debt being created. Had the Fed done its duty, and kept monetary policy tighter for longer, we might not have come to this ugly juncture. This situation is not an accident. It could have been prevented by the Fed had it kept interest rates higher for longer.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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