Financial War Games
Mike "Mish" Shedlock
April 21, 2006
Before getting to "War
Games" let's recap some past wisdom from the man formerly
behind the curtain.
1996 - Greenspan warns about
irrational exuberance in the stock market
2000 - Greenspan embraces the "productivity miracle"
and says there is no stock market bubble
2001 - Greenspan said bubbles can only be detected in hindsight
2004 - Greenspan says there is no housing bubble
2005 - Greenspan says there is no national housing bubble even
though he admits we have "froth"
It's Different This Time
Here are some select comments
from just released FOMC
minutes from May 16, 2000 meeting shortly after the Nasdaq
blowoff top:
CHAIRMAN GREENSPAN. My own
judgment, and what I plan to recommend to the Committee, is that
we have an opportunity now to move the funds rate up 50 basis
points, remain asymmetric, and effectively adjust our longer-term
posture to a better position than the one we are in at the moment.
The reason I am not concerned about moving the rate up quickly
at this stage is that I think the evidence indicates that productivity,
indeed perhaps underlying GDP, is still accelerating. I recognize
that the staff's estimate of productivity growth for the first
[quarter] is 1-1/2 percent. I don't believe that estimate for
a fraction of a second. Indeed, using the available data on income
and profits, which essentially reflect the unit cost structure
of nonfinancial corporations, the productivity growth number
that falls out of that system according to staff estimates is
a 6 percent annual rate.
I think we are in a quite
different environment than we have seen in the past. In such an environment real long-term
interest rates have to rise, and indeed they have risen very
significantly in the last several weeks. Real long-term BBB rates
are up over 50 basis points after gradually edging higher for
quite some period of time. This indicates that the markets are
adjusting rapidly to the evidence that overall demand forces
are becoming very strong, driven in large part by the supply
factors themselves.
I think what we have is still
the beginning, or perhaps we are well into it at this stage,
of a significant long-term change in the behavior of the economy.
I believe the risks in moving 50 basis points today are not very
large because I think the underlying momentum in the economy
remains very strong. What is going to happen in the future is
probably going to be dependent on a number of developments that
we can't really forecast.
MR. HOENIG. Mr. Chairman, everything
you said convinced me that a 1/4 point hike seems right. Inflation
is not taking off and in fact a lot of the evidence suggests
some easing off in the expansion. Moreover, I don't think we
should be validating the market necessarily. I think we should
be looking at what is in front of us, and 1/4 point with asymmetric
language seems most appropriate. A year ago when we were at 4-3/4
percent on the funds rate, there was a better case for moving
more aggressively in the sense that we had put in a lot of stimulus.
And yet we were very cautious in moving up.
Is it possible for anyone to
have been more wrong?
In one meeting he was wrong
about productivity, the strength of the economy, where the risks
were, and most importantly right after the start of the Nascrash
came out with one of his most absurd statements ever when he
commented "I think we are in a quite different environment
than we have seen in the past." Hook line and sinker Mr.
Greenspan bought into "It's Different this time" logic,
right as the bubble was bursting in front of his own eyes.
Greenspan on Financial Stability
What should have everyone worried
right now is this Greenspan flashback from May 5th 2005 when
he spoke about Risk
Transfer and Financial Stability.
Perhaps the clearest evidence
of the perceived benefits that derivatives have provided is their
continued spectacular growth. The use of a growing array of derivatives
and the related application of more-sophisticated approaches
to measuring and managing risk are key factors underpinning the
greater resilience of our largest financial institutions, which
was so evident during the credit cycle of 2001-02 and which seems
to have persisted. Derivatives have permitted the unbundling
of financial risks. Because risks can be unbundled, individual
financial instruments now can be analyzed in terms of their common
underlying risk factors, and risks can be managed on a portfolio
basis. Partly because of the proposed Basel II capital requirements,
the sophisticated risk-management approaches that derivatives
have facilitated are being employed more widely and systematically
in the banking and financial services industries.
As is generally acknowledged,
the development of credit derivatives has contributed to the
stability of the banking system by allowing banks, especially
the largest, systemically important banks, to measure and manage
their credit risks more effectively. In particular, the largest
banks have found single-name credit default swaps a highly attractive
mechanism for reducing exposure concentrations in their loan
books while allowing them to meet the needs of their largest
corporate customers.
The greatest evidence of the
benefits of derivatives is spectacular growth? That sounds like
bubble logic to me. There is $17 trillion in derivatives floating
around with $1 trillion bet on GM alone even though GM has a
market cap of $20 billion or so. Is that a sign of a spectacular
success or is that a sign of unbelievable speculative leverage?
Obviously Greenspan learned nothing from the stock market crash
of 2000. He is now claiming that derivatives have permitted the
unbundling of financial risks. Have they? I have a couple of
questions for you Mr. Greenspan that might bring you back to
reality. Is there not a counter party to those trillions of dollars
worth of derivatives? Has that risk been magically offloaded
to Pluto or Mars? If not, who has that risk?
Clearly Greenspan was babbling
nonsense in May of 2005 just as he was in babbling nonsense in
May of 2000 and at nearly every other point in his career as
well.
Liquidity Concerns
On April 11 the IMF
warns over credit derivative liquidity.
Investors in structured credit
products risk not being able to sell or obtain an acceptable
price following a market downturn because buyers may shun the
fast-growing market, the IMF said on Tuesday.
The risk of liquidity disturbances
is "material ... (and) certain products and market segments
are particularly vulnerable," the International Monetary
Fund said in its annual Global Financial Stability Report. The
secondary market, away from the biggest banks, was more likely
to be at risk, it said. In addition, the Fund said, the rapid
growth of the $17.3 trillion market raised concerns over the
potential for operational failures.
The Fund welcomed moves by
regulators to tackle operational issues, but said the industry
should be "encouraged to pursue these efforts expeditiously
in order to avoid potential disputes in the event of a default".
In some cases more credit default
swaps have been written on specific companies than there are
bonds of that company outstanding. After a default there is a
need for a system to settle the contracts without conventional
delivery of a bond.
Still, IMF concern over credit
derivative liquidity was set in the report against a largely
positive overview.
"Credit derivative and
structured credit markets help to improve financial stability
by facilitating the dispersion of credit risks," the Fund
concludes, as "banks, especially systemically important
institutions ... shift credit risk to a broader set of investors."
Leave it to the IMF to ruin
a decent report with "Greenspanesque" talk such as
"Credit derivative and structured credit markets help to
improve financial stability by facilitating the dispersion of
credit risks." There is little evidence of dispersion but
there is mammoth evidence of speculation when hedge funds and
others have massively leveraged bets on whether companies go
bankrupt or not even when they have no vested interest. Even
the mortgage market is insane with everyone attempting to pass
the trash to Fannie Mae while trying to keep the "good loans"
on their books. Even if everyone did miraculously manage to disperse
the risk, will it be a good thing if trillions of dollars in
bets vanish on some sort of blowup?
It seems to me there is some
sort of uncertainty as to what might really happen in a derivatives
meltdown. Back on February 28 The Bond Market Association announced
a "New
Bank" To Provide Crucial Liquidity In Emergencies.
The Bond Market Association
announced that it has accepted an invitation by a private-sector
working group established by the U.S. Federal Reserve Board to
develop and lead the creation of a so-called 'NewBank', a standby
bank that would only be activated if one of two existing clearing
banks in the U.S. government securities markets was suddenly
forced to leave the business. Both government officials and market
participants have long been concerned about the possibility,
even if remote, of one of the banks suddenly exiting the markets
and have agreed the NewBank concept is an appropriate precautionary
measure.
Since the mid-1990's all of
the major participants in the U.S. government securities markets
have depended critically on one of two clearing banks, Bank of
New York and J.P. Morgan Chase, to settle their trades and to
facilitate financing of their securities inventory positions.
Interruption of a clearing bank's services has the potential
to severely disrupt those markets, as was evident in the wake
of the tragic events of 9/11.
"Securities dealers need
a contingency plan in the event one of the clearing banks is
forced to exit the markets," commented Micah S. Green, President
and CEO of the Bond Market Association. "Establishing NewBank
is a prudent market-based initiative aimed at mitigating any
potential problems caused by the sudden involuntary exit of one
of the banks."
Preparation for a Crisis
Over in the Europe, the Times
Online is reporting that EU regulators are told to Be
prepared for a crisis.
Financial regulators in all
EU countries are to be asked today to prepare for the collapse
of a big hedge fund or a similar sudden financial shock. EU finance
ministers and central bankers, meeting in Vienna, were told that
the collapse of a hedge fund could now destabilise European financial
systems as well as the financial markets.
They have equally raised anxieties
about the rapid growth of private equity. They fear that this
could unravel if one of the key sources of funds or markets for
selling on companies dries up. Officials also argue that many
regulators do not understand the risks involved in the £10,000
billion market in credit derivatives, which are traded privately
between banks rather than on public exchanges.
A private report drawn up by
finance ministry officials of EU states says: "Hedge funds
can contribute to market efficiency and sharing of risks but
can also be a source of systems risks." The report urges
the central banks and regulators to monitor banks' exposure to
hedge funds, both as lenders and as counterparties to massive
speculative positions in financial and commodity derivatives.
Banks are also heavy lenders to private equity buyouts, which
provide them with more profitable but riskier business.
War Games
Also in the UK I am pleased
to report that Europe
simulates a financial meltdown.
Europe's financial regulators
have held a "war game" exercise, simulating a continent-wide
financial crisis, amid fears they are ill- prepared to stop a
problem in one country spreading across borders.
The exercise involved simulating
the collapse of a big bank with operations in several large countries
to see whether the European Central Bank, national central banks
and finance ministries could work together to contain the crisis.
It is understood the exercise took place at the headquarters
of the ECB in Frankfurt at the end of last week. One person involved
said: "It is like checking whether a nuclear power plant
can survive a plane crashing into it."
Europe's vulnerability to a
cross-border financial crisis was revealed in a confidential
report prepared by officials for the Ecofin council. Regulators
are particularly worried about the risks to financial stability
posed by the growth in hedge funds and credit derivatives.
It said that "progress
has been insufficient in most of the member states" in putting
in place national structures for crisis management, and urged
national regulators to stage their own crisis simulation exercises.
The EU has rejected the creation
of a single European financial regulator to manage cross-border
risks, and has instead placed its faith in national authorities
working together.
What we are saying vs. What
we are doing
Here is a recap of what Greenspan
said:
- Perhaps the clearest evidence
of the perceived benefits that derivatives have provided is their
continued spectacular growth.
.
- The use of a growing array
of derivatives and the related application of more-sophisticated
approaches to measuring and managing risk are key factors underpinning
the greater resilience of our largest financial institutions.
.
- The development of credit
derivatives has contributed to the stability of the banking system
by allowing banks, especially the largest, systemically important
banks, to measure and manage their credit risks more effectively.
Here is what we are doing:
- Creating a 'NewBank' to provide
liquidity in emergencies.
.
- Simulating financial meltdowns
caused by an explosion in hedge funds and credit derivatives.
I have three questions:
- If the explosion in credit
derivatives is making us safer why do we need to create a new
bank to deal with liquidity issues?
.
- If the explosion in credit
derivatives is making us safer why are we simulating financial
meltdowns based on those very same derivatives blowing up?
.
- How long will it take before
Greenspan is proven spectacularly wrong once again?
April 19, 2006
Mike Shedlock "Mish"
email: Mish
http://globaleconomicanalysis.blogspot.com/
321gold Inc
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