Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (17 page)

A striking characteristic of Greenspan’s term at the Federal Reserve was how his reputation grew as the influence of the Fed diminished. Finance had become much bigger than the banking system. The Federal Reserve historically had acted to expand or contract the economy by adding bank reserves to or subtracting them from the banking system.

Alan Greenspan contributed to the Fed’s loss of control. He ceded the Federal Reserve’s mandate to regulate and rein in financial excess. He reduced or eliminated many reserve requirements for bank deposits. He effectively renounced the Federal Reserve’s authority over stock market margin requirements. While devolving the Fed’s real authority, he spent much of his term acquiring a mystical hold on the American imagination.

Whether by accident or design, his open-mouth policy averted attention from his deficiencies. He missed the recession of the early 1990s. Yet, before Congress in 1994, he reconstructed his heroic anticipation and foresighted action that had averted a deeper recession—the same recession that he never mentioned until it was over. The significance of this recession may not be appreciated.

³
http://www.derivativesstrategy.com/magazine/archive/1999/0799qa.asp.

The recovery was a unique one. It owed more to finance than to work. Banks had bungled in the late 1980s, making real estate loans that left them incapacitated. With the banks unable to lend, the Greenspan Fed cut the funds rate from 9.5 percent in early 1989 to 3 percent by late 1992. That rate sat at 3 percent until February 1994. Banks borrowed at 3 percent and bought longterm Treasuries yielding 6 percent. This refloated their balance sheets, but at a cost.

Banks were no longer the financial traffic cop for the economy. The bond market and derivatives played larger roles. The bank credit system would struggle and recover, but it would not reclaim its predominant role. Savings and investment assets were leaving the banking system and entering markets. The Federal Reserve controls only money supplied to and from the banking system; here again, it lost influence.
⁴
Markets are more fickle than bank lending; thus, the financial machinery was less stable.

Greenspan gave his often quoted “irrational exuberance” speech in December 1996. This was his ever-so-muted warning that the stock market might be overpriced: “how do we know when irrational exuberance has unduly escalated asset values?”

Yet, he claimed he had popped a bubble in 1994. “I think we partially broke the back of an emerging speculation in equities. We pricked that bubble [in the bond market] as well.”
⁵
He offered to pop the bubble at the September 1996 FOMC meeting: “I recognize that there is a stock market bubble problem at this point. . . . We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”

After his “irrational exuberance” speech, Greenspan gave a couple of warnings in early 1997. Critics told him that he should not make stock market predictions. He never addressed the bubble again—that is, until he decided that he could not identify one before it blew up. Greenspan donned his flak jacket before Congress in June 1999: “bubbles generally are perceptible only after the fact.”
⁶
The same man had claimed credit for popping bubbles at four Federal Open Market Committee meetings in 1994. His see-no-evil, hear-no-evil bubble claim would become known as the Greenspan Doctrine among economists.
⁷
His open money spigot policy whenever the stock market buckled became known as the “Greenspan put” among speculators. This was a government welfare program with consequences we continue to delay and magnify.

⁴
Peter Warburton,
Debt and Delusion: Central Bank Follies That Threaten Economic Disaster
(Princeton, N.J.: WorldMeta View Press, 2005), p. 9.
⁵
FOMC meeting, February 28, 1994, p. 3.
⁶
Joint Economic Committee,
Monetary Policy and the Economic Outlook
, June 17, 1999.

One of the most dismaying developments during the Greenspan era was the silence of professional economists. As a whole, they nodded their heads in agreement, no matter what the man said. Greenspan’s most enduring fabrication was productivity. The chairman’s cheerleading for productivity and technology was essential to the stock market bubble, and to Fed policy. Greenspan hypothesized that the stock market was not overpriced; it simply reflected improvements in productivity. Therefore, stocks were worth whatever the market considered the appropriate New Era price.

The gruesome contortions of the productivity calculation are addressed in Chapter 12. It was from this platform that Greenspan launched his tortured justifications for the Nasdaq trading at 200 times earnings by early 2000.
⁸
Central banks around the world aligned their policies with the New Era. That central bank policy was driven by such effervescent claims shows the bankruptcy of economic thought among those making policy today.

Greenspan enthusiastically endorsed this road to the poorhouse. At one FOMC meeting in 2002, Greenspan remarked: “We know … that the average extraction of equity per sale of an existing home is well over $50,000. A substantial part of the equity extraction related to home sales, which is running at an annual rate close to $200 billion, is expended on personal consumption and home modernization, two components, of course, of GDP.”
⁹

On February 23, 2004, the Federal Reserve chairman addressed the Credit Union National Association. Greenspan observed: “Many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages.”
¹⁰
By early 2004, many house buyers could meet monthly payments only with an adjustable-rate mortgage. (These were sold at a low rate that would adjust to a higher rate in later years.) When those became unaffordable, “interest-only” and “negative-amortization” mortgages were necessary. In 2002, 2 percent of California residential mortgages were interest only. This rose to 47 percent in 2004 and 61 percent in January and February of 2005.
¹¹

⁷
A headline in the March 28, 2008,
Financial Times
for an article by Krishna Guha read: “Greenspan Doctrine on Asset Prices Questioned.” First sentence: “The Federal Reserve may have to rethink the Greenspan Doctrine that a central bank should not try to target asset prices.”

⁸
Fred Hickey,
HighTech Strategist
, January 4, 2000.
⁹
FOMC meeting transcript, September 24, 2002, p. 78.

Greenspan also elevated the housing boom by telling Americans how rich they were. He very rarely used the word
debt
—that is, the payments required to pay down mortgage principal. Instead, he threw out multitrillion-dollar figures for the “wealth” that Americans had accumulated through the rising values of house prices.

Shortly before retirement, Greenspan, seemed more forthcoming: “[W]e can have little doubt that the exceptionally low level of home mortgage interest rates has been a major driver of the recent surge of home building and home turnover and the steep climb in home prices.”
¹²
In the same speech, he claimed that if house prices cooled, “these borrowers, and the institutions that service them, could be exposed to significant losses.”
¹³

Greenspan stepped down from the Federal Reserve on January 31, 2006.

¹⁰
Alan Greenspan, “Understanding Household Debt Obligations,” speech at the Credit Union National Association 2004 Governmental Affairs Conference, Washington, D.C., February 23, 2004.

¹¹
“Consumer Finance,” speech at Ruth Simon, “Concerns Mount About Mortgage Risks,”
Wall Street Journal Online
, May 17, 2005.
¹²
Alan Greenspan, “Mortgage Banking,” speech at the American Bankers Association Annual Convention, Palm Desert, California (via satellite), September 26, 2005.
¹³
Ibid.

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1987–1990

Modern particle physics is, in a literal sense, incomprehensible. It is grounded not in the tangible and testable notions of objects and points and pushes and pulls but in a sophisticated and indirect mathematical language of fields and interactions and wave-functions. . . . Even within the community of particle physicists there are those who think that the trend towards increasing abstraction is turning theoretical physics into recreational mathematics, endlessly amusing to those who can master the techniques and join the game, but ultimately meaningless because the objects of the mathematical manipulations are forever beyond the access of experiment and measurement.

—David Lindley,
The End of Physics
(1993)
¹

[A] day like this wouldn’t be expected to happen in the life of our universe, which is 20 billion years. Indeed, it wouldn’t even happen if you were to live through 20 billion of those universes.
²

—Mark Rubinstein, an architect of portfolio insurance, discussing the failure of his product on October 19, 1987

¹
David Lindley,
The End of Physics: The Myth of a Unified Theory
(New York: Basic Books, 1993), pp. 18–19.
²
http://www.derivativesstrategy.com/magazine/archive/1999/0799qa.asp.

109

Looking back, there were several good reasons the stock market crashed in 1987. (Looking back, there always are.) Secretary of the Treasury James Baker enjoined the Germans to devalue the deutschmark. Congressman Dan Rostenkowski had threatened a bill that would hamper leveraged buyouts. Stock prices were too high (the Dow had risen 350 percent over the previous five years). A derivatives strategy had blown apart.

The last topic will be discussed, since that is Alan Greenspan’s legacy. The chairman was to extol the virtues of derivatives over the next 18 years and forever praise their ability to diffuse risk. This first widespread failure of a derivatives strategy demonstrated that when such a product is universally employed, it concentrates risk.

The derivative strategy that came a cropper was portfolio insurance. It was the brainstorm of Mark Rubinstein and Hayne Leland, professors at Berkeley, who formed the firm of Leland O’Brien Rubinstein Associates (LOR).
³
The basic concept was to insure investors against losses in the stock market.
⁴
The thesis was fine, but the execution could be applied on a wide scale only after the introduction of financial derivatives.
⁵

Leland O’Brien Rubinstein’s success bred imitators—oodles of them. As with most investment ideas, success draws too many participants, and it ends in tears.
⁶
A distinguishing flaw was the assumption of a “continuous market.”
⁷
There had to be a buyer at a price linked to the previous price. It would not work if buyers for the “underlying” security disappeared. (The
underlying
is the physical item being delivered: corn, for instance, or the 500 stocks in the Standard & Poor’s index.) A derivative “derives” its price from the physical item. In the case of financial derivatives, the derivative derives its price from the price of a stock, bond, or currency. For example, a derivative gives the buyer the option to purchase a share of General Electric stock for $10. If GE stock is trading at $8 when the option is sold, the contract has no immediate value: why pay $10 when the stock can be bought for $8? If GE stock rises to $40, the option owner is owed (at least) $30 by the broker who sold the derivative.

³
Peter L. Bernstein,
Capital Ideas: The Improbable Origins of Modern Wall Street
(New York: Free Press, 1992), pp. 269–274.
⁴
A simplified example: XYZ company’s pension plan wants to protect against losing more than 8 percent of its principal in any calendar year. The Treasury bill rate is 5 percent. All of its assets are invested in the S&P 500. The stock market falls 13 percent on the first day of the year. The portfolio insurer shifts 100 percent of the money out of stocks and into Treasury bills. At the end of the year, the 5 percent earned on the principal will leave the fund with an 8 percent loss for the year.
⁵
A futures contract on the S&P 500 was inaugurated in 1983. By buying (or selling) an S&P 500 futures contract, the insured would hold a position equal to that resulting from buying (or selling) the 500 stocks. Based on the actual asset mix and portfolio performance of the pension plan (our assumed purchaser of the product), LOR instructed the client to buy and sell the requisite number of contracts to meet the objective.
⁶
If all pension plans set the line in the sand at an 8 percent one-year loss, it would be impossible for all the portfolio insurers to sell stocks at the same moment.

October 19, 1987

On August 25, 1987, the Dow Jones Industrial Average peaked at 2,722. This was a 43 percent rise since the beginning of the year. The DJIA suffered a 10 percent loss over the four days leading up to October 19, 1987. In lockstep with the mathematical formulas, each day portfolio insurers sold the S&P 500 futures contracts and bought Treasury bills. The stocks underlying the S&P 500 Index (or the S&P 500 futures contract) were sold.

On Monday, October 19, 1987, sell orders for stocks overwhelmed

On Monday, October 19, 1987, sell orders for stocks overwhelmed point drop from the Friday close. Markets were not continuous. The most basic of premises was wrong, and it was wrong largely because portfolio insurance overwhelmed the markets.

It was impossible to calculate the S&P 500 Index. The comparative option contracts traded at as much as a 20 percent discount to the stocks; dealers refused to buy stocks; market makers would not answer their telephones; mutual fund shareholders could not sell because of the overloaded telephone lines; brokers sold their clients’ stock without telling them, often at a price far below the bid. So many had jumped into the product (Chase Manhattan Bank; Morgan Stanley; Aetna Life & Casualty; Exxon’s and General Motors’s pension plans) that a record number of S&P 500 index options were traded. The failure of portfolio insurance to deliver as promised was self-fulfilling.
⁸