Butier Responds to Greenspan's Latest Attempt to Rewrite History

{Updated, April 9}
At maverecon Willem Butier counters Alan Greenspan's latest claim the he and the US Fed not be held responsible, in large part, for our current mess. Butier's eight policy "tragedies":

1. The Greenspan Fed (August 1987 - January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan's statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan's theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08.

Butier elaborates on each. We will bring forward only one, dealing with possibilities for moral hazard. But before we do, I just found Martin Wolf's counter-balancing position, Ft.com, April 8, still praising Greenspan, while fearing that over-zealous regulatory reform spaned by a Greenspan "blame game" will kill the "good" that free-er (my word, Wolf uses "free) market mechanisms bring. Whereas Butier lists eight "tragedies" of Fed policy/practice, Wolf highlights two: (1) regulators should have been "tougher", in subprime and elsewhere, and (2) monetary policy should have been tigher, not looser — to lean against prevailing winds of excess instead of leaning with them.

David Beckworth, via Macro and Other Musings, adds insight into why Butier's critique is on target:

… [T]he Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom. …

Back To Butier:

The Greenspan Fed: a tragedy of errors, Willem Butier, maverecon:Financial Times, April 8: Mr Greenspan's apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince. …

5. The Greenspan Fed as moral hazard incubator
In 1998, the Federal Reserve System played an important role in orchestrating the private sector bail-out of Long Term Capital Management (LTCM), a hedge fund brought down by hubris, incompetence and bad luck. Although no Fed money, and indeed no public money of any kind, was committed in the rescue, the Federal Reserve System, through the Federal Reserve Bank of New York and its President, William J. McDonough, played a key role in brokering the deal, by offering its good offices and using its not inconsiderable powers of persuasion to achieve agreement among its 14 major creditor banks (ironically, Bear Stearns refused to participate in the rescue). The reputation of the Fed therefore was put at risk.

The reason given by the Fed for its orchestration of this bailout was the fear that, in a final desperate attempt to forestall insolvency, a fire-sale by LTCM of its assets would cause a chain reaction. This rushed liquidation of LTCM's securities to cover its maturing debt obligations would lead to a precipitous drop in the prices of similar securities, which would expose other companies, unable to meet margin calls, to liquidate their own assets. Such positive feedback could create a vicious cycle and a systemic crisis.

This is the same vicious cycle leading to systemic risk story that was trotted out by Timothy F. Geithner, the current President of the New York Fed, to rationalise the bail out of Bear Stearns.

Notable features of the LTCM bailout were (1) that the existing shareholders retained a 10 percent holding, valued at about $400million, and (2) that the existing management of LTCM would retain their jobs for the time being, and with it the opportunity to earn management fees. A rival (rejected) offer by a group consisting of Berkshire Hathaway, Goldman Sachs and American International Group, would have had the shareholders lose everything except for a $250 mln takeover payment and would have had the existing management fired.

One reason given for allowing the existing shareholders to retain a significant share and for keeping the existing managers on board was that only these existing shareholders-managers could comprehend, work out and unwind the immensely complex structures on LTCM's balance sheet. These were the same people, including two academic finance wizards, Myron Scholes and Robert C. Merton, joint winners in 1997 of the Nobel Memorial Prize in Economics, whose ignorance and hubris got LTCM into trouble in the first place.

Any handful of ABD graduate students from a top business school or financial economics programme could have unravelled the mysteries of the LTCM balance sheet in a couple of afternoons. The bail-out of LTCM smacks of crony capitalism of the worst kind. The involvement of the Fed smacks of regulatory capture.

The nature of the bail-out of LTCM meant that there was never any serious effort subsequently to address the potential conflicts of interest arising from simultaneously financing hedge funds, investing in them, and making money executing trades for them, as many investment banks did with Long-Term Capital. Things were even worse because, apart from the inherent potential conflict of interest that is present whenever a party is both a shareholder in and a creditor to a business, the bailout created a serious corporate governance problem because executives of one of the financial institutions that funded the bailout had themselves invested $22 mln in LTCM on their personal accounts. Using shareholder resources for a bail-out of a company to which you have personal exposure is unethical, even where it is legal.

For the Fed to have been involved in this shoddy bailout was a major mistake that soiled its reputation. If the Fed becomes involved (as an 'enabler' and/or by putting its financial resources at risk) in the rescue of a highly leveraged private financial institution, be it a hedge fund, an investment bank or a commercial bank, that private institution should immediately be subject to a special resolution regime, including the appointment of a special public administrator. That is, what is needed is an arrangement for all highly leveraged private financial institutions ddeemed too big and too systemically important to fail, akin to the treatment of (insured) commercial bank insolvencies under the Federal Deposit Insurance Act.

Under the rules established by the FDIC Improvement Act of 1991, a legally closed bank's charter is revoked and the bank is turned over to the FDIC which serves as receiver or conservator. Typically, the old top management are fired and shareholder control rights are terminated. The shareholders do, however, keep a claim on any residual value that remains after all creditors and depositors have been paid off. {footnote in original}

From a longer-run perspective, the LTCM bail-out can be seen as a key enabler of the 2008 bailout of the investment bank Bear Stearns, another type of highly leveraged financial institution deemed too big to fail by the Fed. In the case of Bear Stearns too, shareholders were left with something 'up front' (two dollars per share initially, subsequently revised to ten dollars per share) and the old management is still in situ. In addition, in the Bear Stearns case, Fed money is directly at risk - the Fed is funding the senior $29 bn of a $30 bn off-balance sheet facility created to warehouse Bear Stearns' most toxic assets.

If the "too big and too systemically important to fail" argument for bailing out large deposit-taking commercial banks is now also applied to other highly leveraged private financial institutions, including but not limited to, investment banks and hedge funds, then a similar special resolution regime, including prompt corrective action provisions must be in place if rampant moral hazard is not to be encouraged. The Greenspan Fed failed to make the case for or press for such reforms, even after the LTCM debacle. They bear a heavy responsibility for the moral hazard created in 1998 and in 2008, and for the future financial crises that will be encouraged and exacerbated by these failures. … {emphasis added}