Thus, we have the rarest of dichotomies: a Fed chair who appears to be concerned with falling asset prices—cutting interest rates in response to minor market stumbles—and yet who is at the same time a central banker who claims to be comfortable with collapsing bubbles.
These two views are inherently at odds with each other. The only way to reconcile the conflict is to recognize the latter statement as sheer nonsense. It is a dangerous, shameless, foolish rationalization—one that allowed the Fed to look the other way as markets began overheating in the late 1990s.
As we will soon see, each of these changes in emphasis and policy will have dramatic repercussions in the years to come. Not the least of these are in the asset prices themselves: as of March 2009, the S&P 500 was back at levels below where it was when Greenspan gave his 1996 “irrational exuberance” speech. If you bought the broad index the day after the speech, some 13 years later you would have nothing to show for it. What a long, strange trip that’s been.
The end of the 1990s would see the philosophies of the Maestro, as he was known before his impact on markets was more widely understood, in full throat. The Fed chief would be repeatedly tested—by a currency crisis, a major hedge fund collapse, and a technology bubble. He rose to every challenge essentially the same way: increased liquidity and lower rates. Each time, the market would cheer, rallying to new heights.
Ultimately, this would become known as the Greenspan put.
The Greenspan Put
A put is an option contract that gives its owner the right to sell a stock at a specific dollar amount (the strike price). The put holder has total downside protection, regardless of how far a stock or index might fall; in this event, the put holder has the right to sell it at the much higher strike price.
As you might imagine, a put gives any speculator a tremendous degree of comfort. It allows speculators to engage the markets with a high degree of self-confidence. They know they are protected from market turmoil. But there is a dark side to this.
Consider, for example, automotive innovations such as antilock braking systems (ABSs) and supplemental restraint systems. Despite the new technological safety features, automobile fatality rates have hardly improved. It turns out owners of cars with more safety features end up traveling faster and taking more chances than they might in lesser-equipped vehicles. Hence, the gains of ABSs and airbags are offset by overconfidence. Perversely, these safety features can make for less safe drivers.
So, too, it is with financial markets. The moral hazard of the Greenspan put was that it encouraged greater speculation, more aggressive trading, and more use of margin. Once traders figured out Greenspan had their backs, they lost much of their restraint.
The net result was a market with a strong upward bias, and a five-year run of double-digit returns.
In 1997, the Asian contagion struck. The Thai government cut the peg of its currency, the baht, from the U.S. dollar. The decision to let the baht float was disastrous. The currency collapsed, and caused a chain reaction throughout Asia. From Thailand, the so-called Asian flu raced through Indonesia, South Korea, Hong Kong, Malaysia, Laos, and the Philippines. China, India, Taiwan, Singapore, Brunei, and Vietnam were also affected.
The United States was mostly insulated from the Asian problems, but for a one-day wobble in the markets: On October 27, 1997, the Dow Jones Industrial Average fell 554 points, then its biggest-ever one-day point drop, and the New York Stock Exchange briefly suspended trading. But bulls perceived the 7.2 percent sell-off as a buying opportunity. The markets snapped back the very next day. Markets had begun 1997 around 6,400 on the Dow, and finished the year just under 8,000.
The year 1998 saw the last opportunity to avoid moral hazard on a grand scale. A huge opportunity was lost, and the genesis of our current crisis was born.
The missed opportunity in question involved Long-Term Capital Management (LTCM), a hedge fund that specialized in fixed-income arbitrage. Using enormous amounts of leverage—about $100 billion in borrowed money—the fund bought thinly traded assets that were difficult to value. (Gee, why does that sound so familiar?)
Long-Term Capital Management’s investing philosophy and prowess were based on the idea of mean reversion. When spreads—the difference in prices between two bonds—on emerging market debt widened in reaction to the Asian contagion, the hedge fund bet heavily that those instruments would return to normal levels. Because of its early success and the pedigrees of its principals—including former Salomon Brothers bond chief John Meriwether and Nobel Prize-winning economists Myron Scholes and Robert Merton—LTCM was able to use leverage to amplify its bets many times.
Thanks to leverage, LTCM’s exposure was greater than $100 billion. Furthermore, the fund was able to negotiate cut-rate prices for financing from many Wall Street firms, who were enamored of and infatuated by the fund’s mysterious nature. So great was the allure of LTCM that many of its financiers mimicked the fund’s trades (see Figure 6.1).
Thus, many big Wall Street firms were exposed to similar risk throughout 1998. When Russia defaulted on its debt in August of that year, spreads on emerging market bonds not only didn’t revert to normal levels, but continued to widen. The widening credit spreads were taking an unhealthy bite out of LTCM’s portfolio. In less than four months, the fund lost nearly $5 billion.
As LTCM’s losses began to accumulate, the fund had no choice but to liquidate whatever it could to stay afloat. Markets had been digesting its gains since April, but speculation about LTCM’s troubles was starting to make the rounds. As rumors of the fund’s losses spread, the Dow fell from its high near 8,700 in mid-August 1998 to as low as 7,400 in early September—a rapid-fire 15 percent decline.
The Asian flu took place halfway across the world, and required little in the way of a Fed response. LTCM, by contrast, was in Greenwich, Connecticut—much closer to home. Most of the 19 primary dealers—banks and brokerages that directly trade government securities with the Federal Reserve—were involved. They all had lent LTCM much of its leverage, and stood to lose $100 billion if the firm collapsed.
Figure 6.1 1997 Asian Flu, 1998 LTCM
Too Smart for Their Own Good
Long-Term Capital Management (LTCM) used sophisticated trading techniques, but its business model was fairly simple. Using proprietary software, the traders identified price spreads that were wrong according to the quants’ models. However, these price discrepancies were very small on a percentage basis. In order to make money doing this, they had to use leverage to make the price differentials add up to anything significant. This meant LTCM borrowed lots and lots of money against their investors’ cash, and then put that to work following the computer’s algorithms.
Since the bond market is so deeply traded—millions of traders trade trillions of dollars’ worth every day—even with the leverage, their choices were limited. So they took the road less traveled, or in LTCM’s case, the bond less traded. Ordinary Treasuries could not satisfy their itch; instead, their proprietary models found ever rarer and more exotic fixed-income instruments. These were not well followed or understood, nor were they deeply traded. The quants at LTCM thought this gave them an advantage, as they understood these instruments better than many, indeed most. Off they went in search of lesser-known markets. Leaving the main river, they soon found themselves in unknown eddies, trading exotic fixed-income markets—like those soon-to-be defaulting Russian bonds.
This worked well, so long as prices were behaving as the models forecast. Wide spreads were supposed to tighten, and rising prices were supposed to keep rising. Once prices stopped behaving as the models forecast, however, trouble soon followed.
The leverage that so enhanced returns on the way up began to slaughter capital on the way down. For those trading their capital without leverage, a 10 percent loss is a relatively minor inconvenience. If you are leveraged 10 to 1, however, a 10 percent loss wipes you out totally.
And if you’re leveraged 100 to 1 like LTCM was, well, t
hen you’re just begging for trouble.
To someone whose only tool is a hammer, pretty soon everything begins to look like a nail. Greenspan cut rates 25 basis points on September 29, 1998. Two weeks later on October 15—between meetings!—he cut another 25. A scheduled Fed meeting on November 17 brought yet another quarter-point cut. In seven weeks, “Easy Al” lopped off 75 basis points from the federal funds rate.
The statement after the November cut was unusually telling: “Although conditions in financial markets have settled down materially since mid-October, unusual strains remain.”6
Thus, the Greenspan put was born.
About the same time Easy Al was cutting rates that September, William J. McDonough, the president of the New York Federal Reserve Bank, was having a little get-together one Tuesday evening at the Fed’s fortresslike building on Maiden Lane. He called for a meeting of the patresfamilias—the heads of the 16 largest banks, along with the New York Stock Exchange chairman. The discussion was over what to do about the imminent collapse of Long-Term Capital Management.
Roger Lowenstein’s narrative, When Genius Failed (Random House, 2000), is a fascinating read for anyone interested in the grisly details of LTCM. For our purposes, we need only note two facts:1. The Fed was cutting rates.
2. The Fed was using its authority and prestige to help work out the demise of what was a private partnership.
The central bankers jawboned the 14 largest banks—with the notable exception of future bailoutee Bear Stearns—into kicking in $3.65 billion to buy out the assets of LTCM. These included leveraged assets of over $100 billion and derivatives with a notional value of over $1 trillion.
The belief that LTCM had to be bailed out was widely held. It was 1987 redux, and the media accolades poured in. In the aftermath of the LTCM rescue, Time put Alan Greenspan, Robert Rubin, and Larry Summers on the cover as “The committee to save the world.”7
The chaos surrounding a liquidation of LTCM would cause the markets, in Chairman Greenspan’s words, to “seize up.”
But this raises uncomfortable regulatory questions. If this huge leveraged fund presented such systemic risk, then why weren’t there regulations limiting the size and the leverage that hedge funds could use?
Note the ideological quandary this created for the chairman who believed markets could “self-regulate.” Either these funds are too dangerous to be allowed to exist without strict oversight and controls, or this was not a case of systemic risk. There can be no middle ground; he had to either change the rules or change his belief system.
Of course, that’s not how Greenspan saw it. The failure of LTCM would have had a very negative impact on psychology. Woe to the Fed chair who allows traders to become morose! That was how Mr. Atlas Shrugged rationalized the intervention. (Thank goodness Ayn Rand was already dead.)
Whether that would have turned out to be true is a matter of much dispute. The evidence leads me to surmise that not only would LTCM’s demise not have caused the system to collapse, it would have done a world of good. Indeed, the best possible outcome would have been for LTCM to go belly-up and take a big bite out of the investment banks dumb enough to lend all that money to LTCM.
Consider what was at stake: First, LTCM’s portfolio had $100 billion in leveraged paper. But it was the leverage, not the paper, that was the issue. Everything LTCM owned wasn’t Russian debt heading to zero; some of it had real value. The problem wasn’t the quality of the assets; it was using $1 to buy $100 worth of paper. It doesn’t take much spread widening to lose a substantial amount of capital when you are running that much leverage. As we will see in Part IV, that would have been a ripping good lesson for the investment banks to have learned.
What the banks actually learned was that the Fed (and by extension, Uncle Sam) would be there to back them up when they ran into trouble. This is precisely what moral hazard argues against: Encouraging risk-taking to become separated from its consequences.
The other issue was the trillion dollars in derivatives. How did an unregulated, three-year-old, heavily leveraged partnership manage to have so much in “insurance” entrusted to it by counterparties? The only answer I can deduce is that the number of idiots on the planet is greater by several orders of magnitude than previously believed. If you have been paying any attention, that many of them work in finance should come as no surprise.
This was yet another lesson sorely not learned.
What would have happened had this notional amount of derivative paper become worthless? Short answer: not a whole lot.
The loss would have been the premiums paid to LTCM, not the trillion-dollar notional value. If your car insurance company disappeared tomorrow, you wouldn’t lose the value of your vehicle—only the premium payments you made. This is why it’s advisable to do business with firms such as the Government Employees Insurance Company (GEICO) or Allstate, and not Billy Bob’s Bait Shop & Auto Insurance Co.
The penalty for getting into bed with a counterparty that was young, untested, highly leveraged, and reckless should have been expensive. Instead, it was a minor inconvenience. It was yet another lesson not learned from LTCM, and contributed mightily to moral hazard. Future repercussions would be severe.
Had LTCM been allowed to fail naturally, perhaps a lesson might have been learned: Risk and reward are sides of the same coin. Alas, it was a missed opportunity for the traders and risk managers at major banks and brokers to learn this simple truism. The parallels between what doomed LTCM in 1998 and forced Wall Street to run to Washington for a handout in 2008 are all there, and the significance of these missed opportunities is now readily apparent.
In sum, Long-Term Capital Management was the dress rehearsal for the great credit crisis of 2008—and a missed opportunity to prevent the ongoing tragedy.
Chapter 7
The Tech Wreck (2000-2003)
I would not only reappoint Mr. Greenspan—if Mr. Greenspan should happen to die, God forbid . . . I’d prop him up and put a pair of dark glasses on him and keep him as long as we could.
—John McCain, GOP debate, 2000
Up until now, Alan Greenspan had merely been dabbling. Yes, his frequent interventions in markets were worrisome, unprecedented by historical Federal Reserve standards. But as we shall see, they were merely a warm-up for what was to yet come.
In July 1998, the NASDAQ Composite had just cleared the 2,000 mark for the first time. At the time, the tech-heavy index was dominated by active traders, ranging from big momentum funds to small day traders. The prior few years had been good to those NASDAQ traders, with strong gains in 1995 (39.9 percent), 1996 (22.7 percent), and 1997 (21.6 percent). And 1998 was looking like a good year also, until the unpleasantness with Long-Term Capital Management began. At the first inkling of trouble, the so-called momo traders dumped their shares. As the depth of the LTCM hedge fund’s problems became clear, the NASDAQ got pounded. From its July peak of 2,000, the NASDAQ lost nearly one-third of its value, trading down to near 1,350 in less than three months.
To a Fed chair obsessed with asset prices, this was of grave concern.
Hence, the LTCM bailout. If Greenspan hoped the rescue plan would act as a salve to traders, he sure got his wish. Confidence levels recovered just as quickly as they had faltered. Once the threat from Long-Term Capital Management was past, the bull market reasserted itself. The S&P 500 and the Dow Jones Industrial Average each had respectable years in 1998 and 1999. But it was the NASDAQ—heavily weighted with the hot technology, telecom, and Internet IPOs—that exploded. Despite that 30 percent midyear haircut, the NASDAQ cleared its old highs, and by December 31 it was near 2,200—up 39.6 percent for the year. Even more remarkably, from those October lows, the tech index gained 63 percent in less than three months. It was in every way an astonishing performance.
And why not? Traders knew the Fed chief had their back. The Greenspan put was fully operational, interest rates were low, and technology was booming.
It was the new era of rational exub
erance.
NASDAQ Returns
Figure 7.1 NASDAQ, 1994-2003
By 1999, stock trading had become the national pastime. People followed publicly traded companies the way they used to root for sports teams. CNBC was on in every bar, restaurant, and gym. Initial public offerings (IPOs) that merely doubled on the first day of trading were considered disappointments. Stories were rife of lawyers and dentists who gave up their practices for the more lucrative profession of day trading.
A popular discount brokerage TV advertisement of the time featured a tow-truck driver who owned his own island. He told motorists in need of aid there was no charge—he did the job only because he liked helping people. You too, can trade your way to riches was the not-so-subtle message.
The year 1999 began the way 1998 ended: in rally mode. The bias was to the upside, despite the fact that valuations were becoming seriously stretched. Price-earnings (P/E) ratio, a traditional measure of how expensive equities were, indicated tech stocks were wildly overvalued. The P/E of the NASDAQ was near 100, and heading higher. In the so-called new era, however, valuation mattered little. By July 1999, the Nazz was just under 2,900—up 27 percent year-to-date.
The three quick rate cuts from late 1998 were reversed. The Fed tightened a quarter point in June, in August, and again in November. But all that did was return rates to where they were in March 1997. The Wall Street warning “three hikes and a tumble”—meaning three Fed tightenings often lead to a correction—was inoperative. Markets laughed off the increases, and just powered higher.
In this environment, filled with wild speculation and overheating equities, Greenspan did . . . nothing. The Fed chief had any number of tools at his disposal to deal with the rapidly inflating bubble, but the most important was the ability to raise margin requirements for tech stocks. All those day-trading dentists, housewives, and tow-truck drivers were buying and selling stocks using mostly borrowed money. Constraining margin lending would have tamped down some of the mad speculation.
Bailout Nation Page 8