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

by Frederick Sheehan

  Continuing with Greenspan’s example, suppose the value of LTCM’s collateral had fallen to $180 million, $20 million less than the amount it had borrowed. The counterparties would have demanded the hedge fund post $20 million more. By September 29, LTCM was unable to meet counterparty demands for additional collateral.

  Greenspan was to receive more lessons in this application of modern finance. On September 21, when it seems (interpreting the transcript) the Fed first read LTCM’s balance sheet, its leverage was 55 to 1. A staffer offered more bad news: “The off-balance-sheet leverage was 100 to 1 or 200 to 1—I don’t know how to calculate it.”17 The staffer wasn’t alone.

  14 Ibid., p. 118.

  15 Ibid., pp. 110–111.

  16 Ibid., p. 108.

  17 Ibid., p. 108.

  Greenspan’s “first line of regulatory defense” didn’t know whether LTCM was trading interest-rate swaps or stolen cars.

  Greenspan expressed his exasperation several times during the meeting: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of institutions is just mind boggling.”18 So boggled was the man that Greenspan (and his successor Ben Bernanke) allowed the commercial banking system to leverage as never before, writing over $100 trillion worth of derivatives contracts between then and 2008—without so much as a dollar bill of reserves for these off-balance-sheet structures.

  The FOMC discussed the adequacy of its own bank examinations. It was told that the Fed had not examined the banks since December 1997.19 Vice Chairman McDonough said (at another point in the meeting): “It is not as if we were asleep.”20 But possibly they were dazzled. A Federal Reserve staff member mentioned banks’ risk management processes, but “[t]he question is how effectively the banks were implementing those policies and procedures.”21 To the knowledge of the staffers at the meeting, no one at the Fed had taken the initiative to check.

  In Greenspan’s remaining time at the helm, these gaps were left to fester despite the probability that the banks did have the information. The banks were often buying and selling on the trades made by LTCM. The trading desks of the banks had a good idea what the hedge fund owned.

  The Rescue

  Nicholas Dunbar, physicist, derivatives master, and author, described the atmosphere on the LTCM trading floor in the firm’s final week of independence: “Thirty years of financial theory has proved itself useless. Billion dollar track records and Nobel Prizes are now meaningless. … All that is left is a poker game.”22 As the poker game unfolded, Nobel Prize winner Robert Merton kept breaking into tears. He worried that LTCM’s fall would ruin the standing of modern finance.23 He had no need to worry. Americans worship experts, even when they are dismal failures. The reputations of Merton, Scholes, and the Nobel Prize in economic sciences were not in the least dented.

  18 Ibid.

  19 Ibid., p. 103.

  20 Ibid., p. 114.

  21 Ibid., p. 103–104.

  22 Nicholas Dunbar, Inventing Money: The Story of LongTerm Capital Management and the Legends behind It (New York: Wiley, 2000). p. 214.

  William McDonough coordinated the LTCM bailout. Twelve banks pledged $3.65 billion.24 The firm remained intact, although it was tethered to a short leash. Meriwether remained.

  Greenspan’s decision to ignore what he had learned on September 29 was perplexing. It is common now to ascribe Greenspan’s neglectful regulation to his freemarket principles. But the transcript shows he was amazed that the banks did not monitor the hedge funds. From that moment forward, he knew that no one effectively regulated the hedge funds—not the government, and not the financial counterparties.

  Justifying a Rate Cut? Or Two? Or Three?

  By the end of the September 29 meeting, the FOMC voted to cut the funds rate by 0.25 percent, to 5.25 percent, with little concern for the economy. Greenspan later wrote, “it was highly likely that the U.S. economy would continue expanding at a healthy pace.”25 According to Greenspan’s book, the reason for the rate cuts (there were to be three, each of 0.25 percent) was the “small but real risk that the default might disrupt global financial markets enough to severely affect the United States.”26

  The September 29 rate cut boosted the stock market, although that was not the ostensible reason for the reduction. The stock market had peaked in July and had fallen about 10 percent since. Stocks continued to drift lower. Between September 29 and October 14, 1998, the Nasdaq fell another 10 percent and the S&P 500 by 4 percent.

  Still, this was a gain of 3.5 percent for the year. From the end of 1994 to the high in July 1998, the market had risen 160 percent.27

  23 Lowenstein, When Genius Failed, p. 176.

  24 Ibid., p. 207.

  25 Alan Greenspan, The Age of Turbulence: Adventures in a New World (New York: Penguin, 2007), p. 196.

  26 Ibid.

  27William A. Fleckenstein with Frederick Sheehan, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (New York: McGraw-Hill, 2008), p. 51.

  The FOMC held another conference call on October 15, 1998. At 3:14 p.m., it announced the second 0.25 percent fed funds rate cut. This reduction was a surprise to the markets. Normally, although not always, such announcements are made after meetings of the FOMC. The New York Stock Exchange would close 46 minutes later. The rate cut came the day before October option contracts closed. The bond market had already shut. Holdings of stocks, stock options that hedge those holdings, bond positions, and related options are calibrated with careful precision. Market makers were bewildered. Given the potential for enormous losses, a frenzy of buying pushed the S&P 500 futures up 5 percent in five minutes.28

  There was not a compelling case for cutting the funds rate only 16 days after the previous rate cut. The transcript of the October 15 conference call shows that opinions about the state of the markets from Fed district presidents were mixed.29 The discussion turned to whether the FOMC should act now or wait until the next scheduled meeting in November. The decision was made to cut the funds rate to 5.0 percent. Fed Governor Ned Gramlich summed up the reason: “From the standpoint of the real economy, it probably doesn’t matter too much; four weeks is not that long a period when we consider all the lags in the real economy. But for the financial markets, four weeks could be a long time.”30

  By November of 1999, the Nasdaq Composite had doubled in price.31 Nowhere in the October 15 FOMC transcript does a member mention the timing of a rate-cutting press release. Greenspan states that his own point of view had been formed “after 50 years of looking at the economy on almost a daily basis.”32 He surely had an inkling of how the markets would respond to a surprise announcement. FOMC Secretary Kohn said that the FOMC is “not constrained by the practice followed after regularly scheduled FOMC meetings [when the release time is known by outsiders]. … I would expect [the press release] to be out within the hour.” According to the transcript, Chairman Greenspan next thanked everyone, which is followed by “END OF SESSION.”33

  28 Ibid., p. 56.

  29 Ibid., pp. 53–54, gives the views of the district presidents.

  30 FOMC conference call transcript, October 15, 1998, p. 26.

  31 Fleckenstein and Sheehan, Greenspan’s Bubbles, p. 56.

  32 FOMC conference call transcript, October 15, 1998, p. 29.

  33 Ibid., p. 37.

  There was no question, in most participants’ minds, that Greenspan would always support the stock market. Following the LTCM rescue, the head of the largest hedge funds in the world told Martin Mayer, “If I get into big trouble, the Fed will come and save me.”34 Retail investors, too, were confident the “Greenspan put” was integrated into Federal Reserve policy.

  Pandering to the Money Changers

  In March 1999, Greenspan gave a speech on derivatives. He might have wandered onto the podium from Mars: derivatives “are an increasingly important vehicle for unbundling risk.”35 He also doused post-LTCM regulation reform: “Some may now argue that the periodic emergence of financ
ial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk measurement schemes. In my view, however, this would be a major mistake.” The regulators’ risk models “are much less accurate than banks’ risk measurement models.”36

  In this speech, Greenspan asserted that “notional values are not meaningful measures of the risks associated with derivatives.”37 Notional values (e.g., the $100 million of principal discussed in the “counterparty” explanation earlier) became quite important when investment banks started falling like ducks in a shooting gallery.

  Maybe Greenspan couldn’t distinguish a derivative from a Botticelli, but he did know his audience. This March 1999 speech was before the Futures Industry Association. He congratulated the trade group: “It should come as no surprise that the profitability of derivative products … doubtless is a factor in the significant gain in the overall finance industry’s share of American corporate output during the past decade. In short, the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.”38 This is bureaucratese for: “You are making more money than all of industrial America. The GDP needs you. Keep it up.”

  34 Martin Mayer, The Fed, (New York: The Free Press, 2001) pp. 138–139.

  35Alan Greenspan, “Financial Derivatives,” speech at the Futures Industry Association, Boca Raton, Florida, March 19, 1999.

  36 Ibid.

  37 Ibid.

  38 Ibid.

  Greenspan also stated that “derivatives are mainly a zero sum game.”39 He appeared inattentive to the scandal and joke of Wall Street bookkeeping. This would be expressed by Paul Volcker in 2006. In mock confusion, Volcker asked why it was that derivatives were the only financial instrument with no losers. Everyone wins.40 He was referring to Wall Street earnings reports, which consistently showed banks profiting from derivatives trading quarter after quarter. The banks’ pricing models were bonus generators.

  After 1998, derivatives exploded into more complex and incomprehensible forms. They permitted the world’s financial debt to balloon in a manner that forestalled another financial catastrophe for nine years. LTCM was small in scope compared to the size of the banking system a few years later. That no other similar miscalculation on the part of a hedge fund or bank—large or small—occurred for almost a decade was not because derivative shops had learned from their mistakes. The methodology of derivative construction remained the same. The acronyms compounded, but the models remained flawed.

  LTCM’s models calculated that the likelihood of the actual event— the loss of the firm’s capital—was so remote that it would take several billion times the life of the universe for it to actually transpire.41 However, these once-in-the-history-of-the-universe events were growing in frequency. The 1987 portfolio-insurance implosion, the 1994 derivative failures, and the 1998 LTCM bailout were all miscarriages that fell under the responsibility of the same Federal Reserve chairman. He showed no inclination to rein in derivative excesses. Instead, he gave speeches lauding the derivatives’ virtues and congratulating the practitioners who were making so much money.

  39 Ibid.

  40Paul Volcker, “Central Banker for the World: Challenges Ahead,” speech at Grant’s Interest Rate Observer Conference, St. Regis Hotel, New York City, March 29, 2006.

  41 Joe Kolman, “LTCM Speaks,” Derivatives Strategy, April 1999; http:// www.derivativesstrategy.com/magazine/archive/1999/0499fea1.asp.

  16

  Greenspan Launches His Doctrine

  November 1998–May 1999

  Once the Federal Reserve was set up, Greenspan reasons, the money supply never really got short. With one eye necessarily cocked towards politics, the Fed has always maintained a more than adequate money supply even when speculative booms threaten.1

  —Fortune magazine, March 1959

  The reduction of borrowing costs after the LongTerm Capital Management bailout was instrumental in the repricing of common stocks. From October 8, 1998, to December 31, 1999, the Nasdaq rose 178 percent.

  The Fed’s largesse fired deluded behavior that cannot be captured by market returns alone. On November 13, 1998, TheGlobe.com went public at $9 and closed the day at $63.50. How could an investor make 600 percent returns in less time than it takes to cook a turkey? TheGlobe.com was worth (if that’s the right word) $5 billion.2 Cofounder Stephan Paternot had plenty to celebrate. Soon after the IPO, the 25-year-old entrepreneur was filmed by CNN dancing in leather pants

  1 Gilbert Burck, Fortune, “A New Kind of Stock Market,” March 1959, p. 201

  2William A. Fleckenstein with Frederick Sheehan, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (New York: McGraw-Hill, 2008), pp. 58–59.

  191

  (with his model girlfriend) on top of a nightclub table: “Got the girl. Got the money. Now I’m ready to live a disgusting, frivolous life.” True to his word, on August 8, 2001, TheGlobe.com filed for bankruptcy.3

  Four days after TheGlobe.com’s IPO, Greenspan introduced bubble talk at the FOMC, apparently for the sole purpose of strangling it. The chairman admitted that “concerns about an asset bubble are not without validity, and that is where I have my greatest concerns about easing. Let me first, however, address the inflation issue.”4 He never did return to the asset bubble. Cathy Minehan and Thomas Hoenig, presidents of the Boston and Kansas City Federal Reserve Banks, subsequently tried to rouse the crowd, but to no avail. Greenspan chose a strange way to express his “greatest concern” about easing: he eased once again, another 0.25 percent. This was the last of the post–LongTerm Capital Management Fed funds cuts, a total of 0.75 percent—from 5.50 percent to 4.75 percent.

  Greenspan lived in Neverland. The Financial Times would conclude that 1998 was “a year when it was pretty hard to sustain the belief that markets are perfectly rational.”5 Alan Greenspan may not have suffered doubts since his productivity equation defined the market as always being rational. Even so, the chairman threw a monkey wrench into his hypothesis by suggesting the stock market might be overpriced. He told the FOMC: “I do know that the presumption we have discussed in the last year or so that we can effectively manage a bubble is probably based on a lack of humility. As I’ve said before, a bubble is perceivable only in retrospect”6 (author’s italics).

  As with his “as I noted earlier” productivity claim before Congress (in February 1998), he had never said such a thing to the FOMC, nor anywhere else, on the record. His Uriah Heep act of not knowing the consequences of popping a bubble was, by now, a long-running play.

  3 Andres Pinter, “A Star Is Rebooted,” New York Observer, March 30, 2003; Anita Jain, “Flying at High Attitude,” Crain’s New York Business, May 31, 2004.

  4 FOMC meeting transcript, November 17, 1998, p. 89.

  5Philip Coggan, “Sentiment Shifts to Low Inflation and Low Growth,” Financial Times, January 4, 1999, p. 28.

  6 FOMC meeting transcript, December 22, 1998, p. 61.

  The Fed chairman had test-run his humility at the March 1998 meeting when he said he would know there had been a bubble after the market fell 50 percent. He had now stated what would become known as the Greenspan doctrine.

  His is a contorted form of humility. Greenspan is humble while telling the FOMC that, despite what the members might think, he knew that “a bubble is perceivable only in retrospect.” He might have come to believe this, but it was still only his opinion. It certainly was not the opinion of Cleveland Federal Reserve Bank President Jerry Jordan, who said at the same meeting: “I have seen—probably everyone has now seen—newsletters, advisory letters, talking heads on CNBC, and so on saying that there is no risk that the stock market is going to go down because if it ever started down, the Fed would ease policy to prop it back up. . . . I think there are more and more people coming to that belief and acting on it.”7

  Greenspan may have been prompted into his absolute declaration by his very own hobbyhorse: sto
ck market analysts. Several Federal Reserve staff members and FOMC participants warned earlier in the December meeting of poor corporate earnings predictions. Staff economist Michael Prell spoke of “a continuation of crummy earnings and poor returns.” Cathy Minehan, president of the Boston Fed, said, “[D]eclining corporate profits could cause the stock market to decline sharply.”8

  Falling corporate profits should have diminished Greenspan’s productivity thesis; instead, he found them inspiring. He told the FOMC: “[Although] security analysts have dramatically reduced their earnings expectations for the year 1998, they have not decreased their earnings expectations for the longer run. . . . This effectively explains how the stock market can rise with earnings expectations falling.”9

  It may require a moment to digest Greenspan’s logic. The chairman believed, or, at least said, that since current earnings were falling, and analysts had not changed their estimates for 2003, the rate of growth had to be higher over the next five years to meet the five-year estimate. Greenspan was selling the Brooklyn Bridge. Michael Moskow, president of the Chicago Federal Reserve Bank, stated what anyone with experience knows:

  7 Ibid., p. 38.

  8 Ibid., pp. 13, 30.

  MR. MOSKOW: I also want to make a brief comment about your description of the earnings forecasts by Wall Street analysts, with the short-term earnings forecasts coming down but the longterm forecasts staying where they were before. It reminds me of my years when I was in private industry and looked at many, many business plans, as I am sure you did as well. The head of a business would often come in and say, “Earnings this first year are going down, but wait until two, three, four, and five. They are going to go right up.” We called this the hockeystick approach because we saw it so frequently. So, I would be very skeptical about the forecasts that the Wall Street analysts are making about longterm profits.