18 Michael Wolff, Burn Rate: How I Survived the Gold Rush Years on the Internet (New York: Simon and Schuster, 1998), pp. 11–12. “Burn rate” means the need to continually raise more money before a company burns through its earlier funding.
19 Ibid., p. 51.
20 FOMC meeting transcript, December 19, 1995, p. 38.
21 John Cassidy, Dot.con: The Greatest Story Ever Sold (New York: HarperCollins, 2002), pp. 350–351
She rebranded American affluence as Supertanker America.22 The United States was a flagship of such unsinkable construction that the world’s problems were, well, the world’s problems. Ms. Cohen, earnest to the core, could not have understood the irony of designing such a label in the same year that the movie Titanic won 11 Oscar awards. This is not a singular characteristic of Cohen’s: if Wall Street was long on irony, the stock market would be short on exuberance.
Greenspan vs. the FOMC
The FOMC next met on March 31, 1998. Federal Reserve staff economist Michael Prell reviewed current conditions: “[T]he gravitational pull of valuation may no longer be operating. The PE ratio for the S&P 500 recently reached 27 … even as companies were issuing warnings and analysts were lowering their 1998 profit forecast.”23 At the same meeting, Fed Governor Jerry Jordan reminded Greenspan: “I also continue to be concerned that we may never see the effects of monetary excesses in output prices, but rather we will see them in asset prices.”24
Cathy Minehan, president of the Boston Fed, was also worried: “This speculation is fed by financial markets, which are extremely accommodative. From every perspective that we can see in our region and nationally, monetary policy is not tight; it is not even neutral. It is accommodative to an increasingly speculative environment.”25 Nor was board member Susan Phillips attuned to the productivity miracle: “The situation is starting to feel a bit surreal, perhaps even unbelievable. …”26
A case for raising the fed funds rate—or margin requirements—was clear. The S&P 500 had risen 46 percent for the 12-month period ending on March 31, 1998. Greenspan’s response to these comments was mixed. He seemed to understand that the economy was now driven by the stock market: “We have an economic policy that is essentially unsustainable. … There is no credible model of which I am aware that embodies all of this.”27 Since the stock market was beyond his ability to model, the logic of his productivity boom is suspect. Greenspan had hung his hat on stock prices always reflecting correct prices. The variables on the other side of the equation, particularly productivity, changed as need be. Of course, he complained that productivity was not measured properly. In any event, Greenspan did not raise the funds rate.28
22 Patricia Lamiell, “Is the Stock Market a Supertanker or the Titanic?” Associated Press, March 31,1998.
23 FOMC meeting transcript, March 31, 1998, p. 14.
24 Ibid., p. 30.
25 Ibid., p. 46.
Two months later, at the May 1998 meeting, the FOMC was rebellious, or as rebellious as this period piece from the Age of Etiquette dared to be. Jerry Jordan weighed in again by reporting what was happening in his district, in Cleveland: “Bankers complain a lot that pension funds and insurance companies are doing deals that no sensible banker would be willing to consider.”29
Several other members grumbled, to no effect. Greenspan carried the vote, although he felt compelled to say: “I have been giving a lot of thought to the question of whether we are experiencing a stock market bubble, and if we are, what we should do about it. If the market were to fall 40 to 50 percent, I would be willing to stipulate that there had been a bubble!”30 Was this a new model? After the market did fall 50 percent, in 2000–2001, Greenspan did not admit to a bubble—he wouldn’t even discuss it.
At the May 1998 meeting, he gingerly tested the waters for his “can’t see a bubble” act: “[T]he stock market is significantly overvalued. … But”—there had to be a but—“do I really know significantly more than the money managers who effectively determine the prices of these individual stocks? I must say that I, too, feel a degree of humility about my present ability to make such a forecast.” Others would substitute another word for humility. Taking a step back, if he was too humble to venture a stock market forecast, how could he sit at a table where his committee fixed the world’s short-term borrowing rate?
Greenspan closed the argument on whether the Fed would act on Jerry Jordan’s long-running warning when he declared: “I have concluded that in the broader sense we have to stay with our fundamental central bank goal, namely, to stabilize product price levels.”31 This was only four months after he had told the American Economic Association (in January 1998): “The severe economic contraction of the early 1930s, and the associated persistent declines in product prices, could probably not have occurred apart from the steep asset price deflation that started in 1929.”32
27 Ibid., p. 78.
28 He did not think it was “appropriate to move at this stage. Were we to do so, I believe we would create too large a shock for the system, which it would not be able to absorb quickly.” Ibid., p. 79.
29 FOMC meeting transcript, May 19, 1998, p. 58. Ibid., p. 64.
Greenspan’s malleable model, which had broken down at the March 1998 meeting, was once again in tip-top shape. The stock market once again knew all. To justify productivity as the missing variable, Greenspan kept jettisoning unseemly measures. He first ignored his favored price/ book ratio (which he had extolled three years earlier, at the August 1995 FOMC meeting). After such warnings as Michael Prell’s at the March 1998 meeting, the chairman steered clear of price/earnings ratios. His speeches became more emphatic in their propositions—for example, in July 1998: “The implications of today’s relentless technological changes are my subject matter this afternoon”33 [author’s italics]. It seems a good bet that Greenspan was not calculating productivity as much as he was watching the Nasdaq Composite Index, which is heavily weighted with technology darlings. It had risen 21 percent between these two statements, 30 percent over the past year, and 99 percent over the last three years. In July, the Nasdaq burst through the 2,000 level—only three years after first piercing 1,000. More than 50 percent of the Nasdaq 1000-point rise was due to only three stocks: Microsoft, Cisco Systems, and Intel.34
Productivity Gains a Crew Member: Stock
Market Analysts
The chairman’s latest brainstorm was to cite stock analysts’ earnings to justify the stock market. The unveiling was at the FOMC meeting of June 30 and July 1, 1998. At the top of the midyear meeting, Michael Prell presented two profit forecasts: both Wall Street’s and the internal (Federal Reserve) projected rate of earnings growth. Both predicted a profit decline.35 (Prell did not help the chairman by stating, “I won’t take up your time with the umpteenth restatement of our skepticism regarding the sustainability of these valuation levels.”36) Greenspan, in a bubble of his own, thought that “the crucial error in our forecast models has been the productivity numbers.”37 This humble central banker further asserted: “Everyone has been wrong by underestimating domestic demand and wrong in the other direction by overestimating inflation.” Having been wrong, “[t]his has created a major increase in stock prices and a virtuous circle wealth effect.” 38
31 Ibid., p. 85.
32Alan Greenspan, “Problems of Price Measurement,” speech at the Annual Meeting of the American Economic Association and American Finance Association, Chicago, Illinois, January 3, 1998.
33Alan Greenspan, “The Implications of Technological Changes,” speech at the Charlotte Chamber of Commerce, Charlotte, North Carolina, July 10, 1998.
34 Andrew Bary, Barron’s, July 20, 1998, p. mw 4.
This is quite a list of insights, each contingent on either a previous insight (by Greenspan) or a previous flaw by “everyone.” It was the prior meeting when he admitted his humility.
After Prell’s introductory discussion of poor projected earnings growth, this would not seem the time for Greenspan to mention profit forecasts t
o justify the current level of the stock market. He introduced his new diversion by discussing five-year earnings expectations by analysts.39 Prell told the committee projected earnings growth was expected to slow by the end of 1998. So, the chairman discussed only analysts’ predictions for 2003, five years later.
Although the public generally took Wall Street “buy” recommendations at face value, and would pay dearly for its innocence, anyone with the slightest experience knew that the raison d’etre of these ratings was to hock stocks for their employers. Fed Governor Ned Gramlich alluded to their deficiency at the September 1998 meeting by labeling them “socalled stock market analysts.”40 He thought that their forecasts were still “on the high side by all measures”—specifically mentioning their overindulgent longer-term projections.41 Greenspan did not take the bait.
35 FOMC meeting transcript, June 30–July 1, 1998, pp. 13–15. Wall Street earnings are I/B/E/S operating earnings per share; Federal Reserve earnings are NIPA after-tax book profits.
36 Ibid., p. 14.
37 Ibid., p. 35.
38 Ibid.
39 Ibid.
40 FOMC meeting transcript, September 29, 1998, p. 69.
The chairman’s mind may have been elsewhere. LongTerm Capital Management had failed and threatened the financial system. 41 Ibid. This page intentionally left blank
15
LongTerm Capital Management: A Lesson Ignored
1998
It is one thing for one bank to have failed to appreciate what was happening to [LongTerm Capital Management], but this list of institutions is just mind boggling.1
—Alan Greenspan, FOMC meeting, September 29, 1998, upon learning that the counterparties that lent to LongTerm Capital Management did not monitor LTCM’s balance sheet
In the first three weeks of September 1998, LongTerm Capital Management (LTCM), a Greenwich, Connecticut, hedge fund, lost half a billion dollars a week, and everyone knew it.2 Except, possibly, Alan Greenspan. In mid-September, in the midst of the turmoil, he told the House Banking Committee that “hedge funds [are] strongly
1 Alan Greenspan, “Financial Derivatives,” speech at the Futures Industry Association, Boca Raton, Florida, March 19, 1999.
2 Nicholas Dunbar, Inventing Money: The Story of LongTerm Capital Management and the Legends Behind It (New York: Wiley, 2001), p. 210.
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regulated by those who lend the money.”3 He ignored the Federal Reserve’s responsibility, which is to regulate those who lend the money. The central bank had not done its job.
Four and a half months earlier, on May 2, 1998, Greenspan had given a speech in which he emphasized the advantages of “private market regulation.”4 Greenspan explained, “[R]apidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce being pressed to depend increasingly on ever more complex and sophisticated private market regulation. … [O]ne of the key lessons from our banking history [is] that private counterparty supervision is still the first line of regulatory defense.”
“Counterparty” may need an explanation. Banks have counterparty risk to their borrowers: the borrower may not repay a loan. That was a concern when the value of LTCM’s collateral fell below the amount of money it had borrowed. There is also counterparty risk in a derivative contract. A hypothetical example: when Citigroup and J. P. Morgan enter an interest-rate swap, Citigroup will receive floating-rate interest payments every six months, and J. P. Morgan will receive fixed-rate interest payments at the same time.5 The interest-rate payments are computed based on a principal amount upon which the interest is earned: $100 million, for instance. The “counterparty” risk is that one of the participants fails and cannot pay back the $100 million of principal.
In his May speech, the chairman also noted that “[t]he complexity and speed of transactions and the growing complexity of the instruments have required both federal and state examiners to focus more on supervising risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored bank risks (e.g., their modeling techniques, the process used to supervise counterparties) in lieu of examining specific securities. It apparently never occurred to Greenspan, at least in any public statement, that maybe derivative structures should be reined in a bit, since government regulators could no longer understand the holdings in bank portfolios.
3 U.S. General Accounting Office, LongTerm Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk, GAO/GGD-00-3, October 29, 1999, p. 15, quoted in Martin Mayer, The Fed: The Inside Story of How the World’s Most Powerful Financial Institution Drives the Markets (New York: Free Press, 2001), p. 267.
4 Alan Greenspan, “Our Banking History,” speech at the Annual Meeting and Conference of the Conference of State Bank Supervisors, Nashville, Tennessee, May 2, 1998.
5 Citicorp was renamed Citigroup Inc. after it merged with Travelers Group in 1998.
Those Daffy Nobels
There had been plenty of warnings that not much had changed since the derivative failures in 1994. Ignorance was essential to derivative operations. We need look no further than LongTerm Capital Management and two of its employees, Robert Merton and Myron Scholes. The pair received the Nobel Prize in economic sciences in 1997 “for a new method to determine the value of derivatives.” Upon receiving his award in Stockholm, Myron Scholes “singled out two companies—General Electric and Enron—as having the ability to outcompete existing financial firms. He noted, ‘Financial products are becoming so specialized that, for the most part, it would be prohibitively expensive to trade them in organized markets.’ According to Scholes, Enron’s trading of unregulated over-the-counter energy derivatives was a new model that someday would replace the organized [and regulated] securities exchanges.”6 Enron’s specialized derivatives left the company bankrupt in 2001, and General Electric’s financial ventures led it to government life support by 2008. The year after Merton and Scholes received their Nobel Prizes, the firm where they applied their theories collapsed.
John Meriwether had anticipated the derivatives boom by forming his Arbitrage Group at Salomon Brothers in 1977.7 Meriwether left Salomon in 1991. In 1993, he formed LongTerm Capital Management (LTCM). He hired his top Salomon colleagues, including Merton and Scholes. By 1997, LTCM employed 25 Ph.D.s, who manufactured highly quantitative arbitrage trades. The fund rose 59 percent in 1995 and 44 percent in 1996, but then the law of diminishing returns kicked in.8 The firm was managing much more money. The Ph.D.s were finding less opportunity to apply their skills. LTCM produced a 17 percent return in 1997.
6 Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (New York: Times Books, 2003), p. 303.
7 Roger Lowenstein, When Genius Failed: The Rise and Fall of LongTerm Capital Management (New York: Random House, 2000), p. 9.
8 Partnoy, Infectious Greed, pp. 254–255. It is not clear if the 1995 and 1996 returns are gross or net. The 1997 returns are after fees.
Its strategy “moved from highly quantitative arbitrage trades to outright gambling on currencies and stocks.”9
LTCM proved to be too big to fail. The reason for its salvation was the same reason that its fortunes looked so dire: everybody who was anybody had a large stake in its solvency. If LTCM failed, the securities it held would not appeal to a very scared and skeptical market that showed no inclination to buy.
On September 21, 1998, LTCM lost $553 million in a virtuoso rejection of the Nobel laureates’ diversification models: all security prices went down.10 The scientists from the classroom held a loose grip on the human mind. They forgot that “[d]uring a crisis, the correlation always goes to one.”11 This is the normal, time-tested reaction in such circumstances— everyone sells. This correlation never fails. This correlation is never modeled; if it were incorporated, banks would not trade leveraged derivatives.
The Fed Could Have Taken More Regulatory Initiative
>
The FOMC held a meeting on September 29, 1998. The staff and Fed governors briefed Greenspan on LongTerm Capital Management’s counterparties—the banks and brokers that lent to and traded with LTCM. When it became apparent to Greenspan that the risk management apparatus of the institutions he regulated operated at the level he should have expected (that is, expected from their history with loans to less-developed countries in the seventies and to commercial builders in the eighties), he was at a loss: “The question is why it happened in this case. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?”12
From there, it grew worse. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even Bankers Trust’s was “a relatively small piece of the whole action because so much of the latter is off-balance-sheet.”13
9 Ibid., p. 255.
10 Lowenstein, When Genius Failed, p. 191.
11 Martin S. Fridson, “Review of When Genius Failed, by Roger Lowenstein,” Financial
Analysts Journal , March/April 2001, p. 81.
12 FOMC meeting transcript, September 29, 1998, p. 107.
13 Ibid.
The need for supervision of the banks was obvious when a staffer commented: “It was something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.”14 For this reason alone, the Fed should have geared up its watchdogs to monitor the banks. There may be exceptions, but regulators should assume that large banks care more about profit than about risk. Banks chase the hot market until either the government bails them out (Citigroup—again and again) or they fail (Texas banks in the 1980s).
A staff member told the FOMC that LTCM’s counterparties only required the hedge fund to post collateral equal to the amount it had borrowed. Greenspan, a former director of J. P. Morgan, with 50 years of Wall Street experience, shared his perspective on collateral: “If I am a bank lender and I lend $200 million to a hedge fund, ordinarily I would be overcollateralized. I would hold more than $200 million in, say, U.S. Treasury bills.”15 A staffer told the FOMC that LTCM’s collateral included “U.S. Treasuries, Danish government bonds, BBB credits— you name it.”16 With all prices falling, BBB credits were weak collateral. Greenspan was learning how the “private counterparty supervision” actually functioned. It must have been obvious to the chairman that banks took a more casual approach to collateral than they did in his J.P. Morgan days.
Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession Page 20