Economic Crisis and Greenspan's Legacy: Part I

science | Sep 22, 2008 | By James Quinn

It has been a momentous year for our country. Absolutely no one on the face of the planet could have predicted on January 1, 2008 the events that would unfold in the next nine months. We are in the midst of an extreme “Black Swan.”

No one saw it coming and no one knows what will happen next. When plans to save the financial world are slapped together every other weekend, the law of unintended consequences is likely to rear its ugly head. It is too early to step back and try to understand what is going on at this point in history. What we do know is that whatever is happening is not good.

“Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall.

The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ….I shiver at the thought.”

It was two years ago that Nicholas Taleb wrote those words in his book The Black Swan. Now the whole world is shivering, as the threat of a global collapse has never been closer. The last global collapse led to the Great Depression which lasted from 1929 until our entry into World War II in 1941.

“They know nothing! They know nothing!” These were the words of Jim Cramer just one short year ago. He was referring to the Federal Reserve, but today those words apply to the Federal Reserve, Treasury, Congress, CEOs, financial gurus, Larry Kudlow, Ben Stein, fund managers, and average Americans. Anyone who tells you confidently what will happen tomorrow, next week, or next year is either a fool or a liar.

The same people who never saw this crisis coming certainly can not be trusted to tell us when it will subside. Our political and financial “leaders” have absolutely no credibility left at this point. No one in government or in the financial community can be trusted to tell the truth at this point, and our financial system needs trust to function. The greed and phenomenally excessive risk-taking by these “Masters of the Universe” at our prestigious financial institutions, and regulators asleep at the switch, led to the possibly of the greatest financial collapse in history. Our worldwide system of finance was on the brink of imploding. 

The world is in the midst of a Black Swan event. People who fail to recognize what is happening, or deny that it is happening, will suffer catastrophic consequences. Nassim Nicholas Taleb, in his brilliant irreverent book The Black Swan, published in 2007, contends that the world only changes during these events. According to Taleb a Black Swan event has three attributes: (1) It is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. (2) It carries an extreme impact. (3) In spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

Taleb makes the case that most “experts” believe we live in a normal distribution world, when the world is really dominated by Black Swan events. These are events that should occur rarely in the long tail of the normal distribution curve. We have experienced five Black Swan events in ten years.

1998 Long Term Capital Management
2000 Dot Com Bubble
2001 9/11 Attack
2005 Housing Bubble
2008 Financial Implosion

These extreme events are interrelated and have built upon each other to leave us in the precarious position that we find ourselves. With five outlier events in ten years, we’ve become the “Black Swan Nation.” 

There are both positive and negative Black Swans. Examples of positive Black Swans are the invention of the Internet, planes, automobiles, and discovery of penicillin. The Dot-Com bubble and the Housing bubble gave people an opportunity to benefit—if you sold at the high. Still, more people have been hurt than helped by these events. You can not stop a Black Swan event but you can position yourself to benefit from a positive Black Swan or to avoid the pain of a negative Black Swan. An example of positioning yourself for a positive Black Swan is investing in venture capital firms that fund biotech or technology firms. If one of these companies discovers a cure for cancer, you will be rich beyond your dreams.

A country can also position itself to bear the brunt of a massive negative Black Swan. Our government’s response to each ensuing Black Swan event insured that the current crisis would be of epic proportions. The common thread and cause of much of the pain today is former Federal Reserve Chairman Alan Greenspan.

Long Term Capital Management

Long Term Capital Management was a hedge fund founded in 1994 by John Meriwether. Myron Scholes and Robert C. Merton, winners of the Nobel Prize in Economics in 1997, developed the “scientific” models that the fund utilized to outsmart the entire financial community. The fund generated 40% annual returns in its first two years. The partners treated other financial institutions with disdain and their hubris grew to epic proportions. Nassim Nicholas Taleb compared LTCM’s strategies to “picking up pennies in front of a steamroller.” They generated many likely small gains, balanced against the unlikely chance of a large loss. The steamroller won in 1998, and Taleb described what happened next.

“Then, during the summer of 1998, a combination of large events triggered by a Russian financial crisis, took place that lay outside their models. It was a Black Swan. LTCM went bust and almost took down the entire financial system with it, as the exposures were massive. Since their models ruled out the possibility of large deviations, they allowed themselves to take a monstrous amount of risk.”

All of their finely modeled bets went bad at the same time. The disdain they had showed to other financial firms was returned in kind. Other banks knew their positions and made them feel the pain. LTCM had so many positions with so many counterparties throughout the world that they became the first firm to be “Too Big To Fail.” They managed to lose $4.6 billion in three months. The Federal Reserve Bank of New York convened a weekend meeting of the CEOs of all the major Wall Street firms. They were heavily pressured to bailout LTCM. Ultimately, fourteen banks contributed $3.625 billion and received a 90% share in the fund and potentially averted a worldwide financial collapse.

Alan Greenspan, supporting this bailout, decreased interest rates twice in late 1998. In front of a Congressional committee in October, Alan Greenspan had this to say: “It was a rare occasion, warranted because of the potential for serious disruptions to markets. Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations including our own.”

These words seem strangely familiar to what we heard from Hank Paulson this past week.

Greenspan ruled out direct regulation of hedge funds, saying it was possible to monitor the fund's activity and act when necessary. Moral hazard was born during this crisis when well-meaning members of the Congressional committee had a different opinion. The rescue raised "troubling questions of financial concentration and antitrust," Mr. Leach said at the hearing. "As a group working together, the new owners can have a greater impact on markets than in competition with one another." Representative Bernard Sanders of Vermont, the House's lone independent, called it a "bailout for billionaires" that rewarded "the gambling practices of the Wall Street elites."

This first Black Swan event should have been a warning to the ruling elite of Wall Street, Congress, Greenspan, and the American people. No one heeded the warning. Firms were allowed to get bigger, the CEOs of the firms took on greater risks, Greenspan and Congress delegated their regulator responsibilities to the free market. Ten years later, the same problems have occurred to a much greater degree. The government is trying to avert worldwide financial collapse on a daily basis.

Dot Com Bubble

The NASDAQ market, consisting of smaller growth companies in January 1995, was at the 750 level. On March 10, 2000 the market peaked at 5,132, an increase of 584 percent in five years. On January 1, 1995, no one predicted this rise. It was an extreme outlier and the reasons for the rise were concocted after the bubble popped. In a speech during 1996, Alan Greenspan warned that the U.S. economy was suffering from “Irrational Exuberance.” The following day, the stock market dropped significantly. Mr. Greenspan never used the term again. As the economy heated up in the late 1990’s and Wall Street started pushing IPOs like, Greenspan did not do what a Federal Reserve Chairman should have done, take away the punch bowl before the party got out of hand. If he had increased margin requirements, day traders wouldn’t have had the money to propel the markets to ridiculous heights.

As a political animal, Greenspan did not increase interest rates leading up to the November 1999 Presidential elections, in support of the then-current Clinton administration. As the year 2000 approached and the fears of computers around the world no longer functioning led people to hoard cash and supplies of water, Mr. Greenspan opened up the spigots and flooded the economy with cash. This cash immediately flowed into stocks and pushed the NASDAQ to its epic peak, a level that not will be seen again for decades.

Robert Shiller, professor at Yale, published his book Irrational Exuberance in early 2000. In this book he poked holes in all of the Wall Street rational for stocks being as high as they were. His contention was that a feedback loop based on emotion led to this dramatic rise in the stock market. He concluded that the “efficient market theory” was worthless. His own words were a little more professorial.

"The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom."

In the real world, people are not the rational machines that Merton and Scholes believed. You can not model human behavior and capture the emotions that drive people to do certain things. This is very disappointing to academics and “scientists” at investment banks. Wall Street gurus declared that it was different this time. The internet era would usher in permanently higher profits and productivity. Once this lie had been perpetuated, Wall Street proceeded to fleece the public by doing initial public offerings of any ridiculous concept with a .com at the end of its name. Many of the IPOs soared by 500 to 1,000 percent on the day they were issued as day traders used margin to pump and dump these stocks. Average people gave up their jobs to day trade. raised $82.5 million in an IPO in February 2000 before collapsing nine months later. Online grocer Webvan raised $375 million in an IPO. Webvan came to be worth $1.2 billion (or $30 per share at its peak). The company closed in July 2001, putting 2,000 out of work. raised $166 million in a May 1999 IPO, but in the course of 16 months, its stock went from a high of $84 per share in October 1999 to a low of just 9 cents per share in February 2001. The event that marked the top was the acquisition of Time Warner by AOL in January 2000.

Professor Shiller’s opening question was: "Are powerful fundamental factors at work to keep the market as high as it is now... or is the market high only because of some irrational exuberance -- wishful thinking on the part of investors that blinds us to the truth of our situation?"

Professor Shiller then proceeded to methodically and convincingly prove that the market was grossly overvalued by every measurement used throughout the history of the stock market. The PE of the market reached 45 in early 2000. At the peak before the 1929 Crash, the PE had reached 35. There was absolutely no doubt that this bubble would pop. S&P earnings had fluctuated in a fairly narrow range throughout history, and have always reverted to the mean. By 2000, a complete disconnect had occurred between earnings and the level of the stock market. Shiller argued that “positive feedback loops” among investors led to herd like behavior and created a “naturally occurring Ponzi process.”

All previous speculative peaks in 1901, 1929, and 1966 had resulted in subpar stock returns for the two decades following the peak. The peak reached in March 2000 far exceeded any previous peak in history. Millions of people piled into the stock market because they saw the media touting the success of others. A sort of collective delusion overcame the country. Shiller concluded that, "The high recent valuations in the stock market have come about for no good reasons." He was right. The Dot-com bubble crash wiped out $5 trillion in market value of technology companies from March 2000 to October 2002. Communications companies, overburdened by massive amounts of debt, filed for bankruptcy. WorldCom, run by Bernie Ebbers, was found to have used illegal accounting practices to overstate its profits by billions of dollars. The company's stock crashed when these irregularities were revealed, and within days it filed the largest corporate bankruptcy in U.S. history. Ebbers went to prison. Wall Street “analysts” were discredited and some were prosecuted for touting worthless stocks as buys.

The trigger for the collapse were the six interest rate increases by Alan Greenspan in late 1999 and early 2000. He continued to increase rates until they reached 6 percent by late 2000. The collapse of the internet bubble, the resulting reduction in business activity, and the increase in interest rates combined to push the country into recession. Alan Greenspan and George Bush have one thing in common, they don’t believe in recessions. Greenspan rapidly decreased the Fed discount rate from 6 to 3.5 percent by September 2001.

9/11 Attack

As Nicholas Taleb points out, human beings always try to rationalize a Black Swan event after the fact. If it was predictable, it wouldn’t happen.

“A vicious black swan has an additional elusive property: Its very unexpectedness helps create the conditions for it to occur. Had a terrorist attack been a conceivable risk on Sept. 10, 2001, it would likely not have happened. Jet fighters would have been on alert to intercept hijacked planes, airplanes would have had locks on their cockpit doors, airports would have carefully checked all passenger luggage. None of that happened, of course, until after 9/11.”

Following the September 11, 2001 attack the Greenspan led Fed voted to reduce the federal funds rate from 3.5 to 3.0 percent. As the Enron scandal and other corporate misdeeds of 2002 developed, the Fed dropped the federal funds rate to 1.0 percent. He then left rates at this level for over a year. Greenspan acknowledged that this drop in rates would have the effect of leading to a surge in home sales and refinancing. He said, "Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years."

The only problem was that Americans extracted $3 trillion in equity from their homes and spent it on BMWs, HDTVs, exotic vacations, and whatever other selfish pursuits that appealed to them.

The national reaction to the 9/11 disaster was one of unity of purpose. Americans wanted to find and punish the terrorists that caused this tragedy. A call for national sacrifice would have been heeded. Instead, George Bush and Alan Greenspan encouraged Americans to teach the terrorists a lesson by spending. In June of 2001, prior to the attacks, a $1.35 trillion tax cut was enacted, including $50 billion in rebate checks. After the attacks, General Motors showed their patriotic spirit by offering 0 percent financing on all cars. Big ticket retailers offered easy credit and extended terms so that everyone could have a flat screen HDTV and worry about paying later. Consumers started a buying frenzy that didn’t stop until credit evaporated in 2008. 

George Bush did his part to stimulate the defense industry by starting an unprovoked war that has already cost the country $700 billion, 4,100 needless deaths, and 30,000 wounded. Estimates of the total cost have risen to $3 trillion. The Bush administration estimated the cost at $50 billion before the war. The lesson is that when the government provides an estimate, multiply it by 10 to get closer to the truth. Trust in the government began to evaporate rapidly after the Iraq debacle. As Alan Greenspan denies causing the housing crisis today, his words from November 2002 come back to haunt him, “our extraordinary housing boom…financed by very large increases in mortgage debt, cannot continue indefinitely into the future.” He then proceeded to reduce interest rates to 1 percent, spurring the biggest bubble in history.

Housing Bubble

Between 1998 and 2006, home values virtually doubled. There is no logical explanation for this occurrence. Previous peaks were 60 percent lower than the peak reached in 2006. Any reasonable person would conclude with absolute certainty that home values would fall steeply for a long time. Too bad the reasonable people didn’t include Alan Greenspan, bank CEOs, mortgage companies, rating agencies, homebuilders, treasury secretaries, Presidents, regulators, or congressmen. They not only didn’t see the fall coming, they spiked the punch bowl and encouraged the party to kick it up a notch. The following words from, former CEO of Citigroup, Charles Prince in July 2007 will be immortalized alongside Gordon Gekko’s “greed is good” speech:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

He is now unemployed, along with James Cayne, Ken Thompson, Angelo Mozilo, Daniel Mudd, Richard Syron, Dick Fuld and Kerry Killinger. And things are now somewhat complicated.

Robert Shiller’s expert opinion regarding the 2005 Black Swan in real estate was: “Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national obsession is poker.”

Much of the housing frenzy can be attributed to homeowners getting caught up in the media hype and the cascade of information about others getting rich buying and selling houses. But, Greenspan's 1 percent interest rates were the fuel for the frenzy. He knew exactly what these rates would do when he said the following words in 2005: "Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission."

The final nail in the coffin of Greenspan’s legacy was his speech in February 2004. Greenspan suggested that more homeowners should consider taking out Adjustable Rate Mortgages. The Fed funds rate was at an all-time-low of 1 percent. A few months after his recommendation, Greenspan began raising interest rates, in a series of rate hikes that would bring the funds rate to 5.25 percent about two years later. Greenspan's advice came at a time when interest rates had bottomed out making it a particularly bad time to take out an ARM. The triggering factor in the current crisis was the many subprime ARMs that reset at much higher interest rates than what the borrower paid during the first few years of the mortgage.

Greenspan gave the bad advice and Wall Street provided the money and derivative products which have created our worldwide meltdown.

James Quinn writes on economics and finance at The Cutting Edge News and is a senior director of university strategic planner, and the Cutting Edge Economic Crisis Analyst. This article reflects the personal views of James Quinn. It does not necessarily represent the views of his employer, and is not sponsored or endorsed by them.


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