The following is an excellent excerpt from the book “THE MAN WHO KNEW: The Life and Times of Alan Greenspan” by Sebastian Mallaby from Chapter Twenty-one: “The Zipswitch Chairman” on page 465 and I quote: “Orange County, California, is the home of Disneyland–and therefore of the Sleeping Beauty Castle. In late 1994 it became notorious for a fantasy castle of the financial variety. The county treasurer, Robert Citron, contrived to lose an astonishing $1.6 billion of taxpayers’ money, and what was more alarming was the manner of his humiliation. The treasurer and his advisers had conjured up a make-believe portfolio, muttering a series of mysterious spells: ratio swap, periodic floor, spread lock, Treasury-linked swap, knockout call option, wedding band. On December 6, these shadowy spells broke–a month after the Fed’s 75 basis point rate hike, Orange County filed the largest municipal bankruptcy in U.S. history. Or was Orange County the only victim of the new dark arts. Around the same time, companies such as Procter & Gamble and Gibson Greeting Cards succumbed to similar enhancements, losing tens of millions of dollars.
In the seven years since [Alan] Greenspan’s arrival at the Fed, a profound change had taken place in the heart of the financial system. Financial derivatives, which had proliferated in the 1970s in response to the new volatility of interest rates and exchange rates, took on a bewildering complexity. Before, banks had traded relatively simple products: futures and options on stocks, interest rates, and currencies. Now Wall Street was hiring armies of young men with physics PhDs to dream up esoteric instruments. The quants delighted in slicing ordinary bonds into strange “strips”; the flows of money they generated were separated into interest-only payments and principal-only payments, creating new securities known as IOs and POs; there were inverse IOs, inverse POs, and even a mind-boggling creature called the forward inverse IO. Firms such as Morgan Stanley assembled teams of scientists to apply ideas like chaos theory to markets, and hedge funds such as Long-Term Capital Management began to bet not on the direction of a market’s move but rather on how far it would move in either direction. The sheer speed with which derivatives proliferated was remarkable. As of the end of 1987, the face value of privately negotiated derivatives–mostly interest-rate swaps–amounted to under $1 trillion. Seven years later, the number had soared more than tenfold, reaching $11 trillion.
In the wake of the disasters at Orange County, Procter & Gamble, and Gibson Greeting Cards, Fortune‘s Carol Loomis did her best to understand what was happening. Loomis was the doyenne of financial journalists, the writer who had exposed the workings of the first ever “hedged fund”–she was not easily bamboozled. Cornering the boss of Bankers Trust, the bank that had sold fancy derivatives to P&G and Gibson, she demanded to know how these instruments functioned: “What is a wedding band?” She asked him. The boss, Charles S. Sanford, Jr., who was himself a former trader, turned out to be hazy: the sorcerers in his kitchen had brewed up their mysterious spells, but he had little idea how they functioned. Sanford suggested that Loomis direct her question to one of his derivatives experts, and the next day a Bankers Trust official called to explain that a wedding band “was a swap containing a series of barrier options. This lurch into barrier options caused Loomis to feel as though her mind was shutting down, as she reported to her readers. In the sheer opacity of its jargon, Bankers Trust anticipated the notorious CDOs-squared that came to light in the 2008 crisis.
Sanford’s fuzzy grasp of his own bank’s products raised a question for Greenspan. The Fed chairman had always believed that private risk management would be superior to oversight by regulators. A decade earlier, after Mexico’s default and the Continental Illinois failure, he had made this point explicitly: bankers were evidently guilty of taking on bad risks, but it was their job to evaluate borrowers, and it was their companies’ capital that was on the line–however fallible they were, they would be less fallible than civil servants. But the losses that bubbled up from the derivatives markets in 1994 might reasonably have prompted a reconsideration of this creed. Finance had grown so complex that private risk takers no longer understood their own portfolios. And Charles Sanford’s confusion was only the start. The really woeful ignorance was to be found among his firm’s clients.
Those wedding-band swaps illustrated the problem nicely. They promised a profit so long as interest rates remained within a narrow range, inflicting losses the moment that rates moved above the band or below it. This sort of arrangement had no obvious risk-management purpose; it was a gamble, pure and simple. It was a gamble, moreover, that the clients were almost bound to lose, precisely because of the derivatives’ complexity. The sorcerers at Bankers had deliberately dreamed up products that their clients could not understand; they were preying on the innocent. In taped conversations that later came to light, Bankers employees referred routinely to the “ROF-factor”–short for “rip-off factor”–in their deals. Celebrating the befuddlement of his clients, one trader looked forward to “a massive, huge fucking gravy train”; “this is a wet dream,” he added. Another Bankers Trust employee mused thoughtfully about the experience of selling complex derivatives. “Funny business, you know?” he said to a fiend. “Lure people into that calm and then just totally fuck ’em.”
The Fed to its credit, dealt with Bankers Trust sternly. The examiners at the New York Fed favored the traditional response of a private rebuke; a public humiliation could undermine a bank’s credibility, perhaps triggering a run and knock-on instabilities. But the Washington Fed favored a tougher approach, and was willing to take the risk of reprimanding Bankers publicly. The dispute resulted in a standoff between the Fed’s two most powerful branches, with the Washingtonians rumbling that the New Yorkers were too soft; eventually the matter was brought before Greenspan and the Fed’s Board of Governors. Generally, Greenspan did not like to clobber the private sector, and he knew Charles Sanford personally. But he did not shrink from a tough line, especially when John LeWare, the governor in charge of regulation, with whom he played golf, came out in favor of a public shaming. An enforcement action was duly brought, requiring Sanford’s firm to hire outside counsel to investigate past abuses. People were impressed. “No matter how you slice it, Bankers Trust has agreed to change its conduct,” one analyst observed. “There is no question that these were bad boys.”
It was one thing to get tough with a bank, another to grapple with the broader challenge posed by newfangled financial instruments. Bankers Trust was not the only abuser of the new products; Orange County had got its fix of poison courtesy of Merrill Lynch, suggesting that the whole business of designer swaps might be a cauldron of trouble. Derivatives, said the former FOMC member Richard Syron, were now “the eleven-letter four-letter word.”; and Senator Byron Dorgan, Democrat of North Dakota, promised a bill barring banks from trading in derivatives for their own accounts–a measure that anticipated the spirit of the “Volcker Rule,” passed after the 2008 crisis. The stage was set for regulatory action, if only the Fed would go along with it.
The day after Orange County’s bankruptcy, at the height of the derivatives panic, Greenspan appeared before the Joint Economic Committee of Congress. Senator Ron Wyden, Democrat of Oregon, gave voice to the nation’s misgivings. The government, he charged, had “not acted as an adequate watchdog over the derivatives market and some of these pretty exotic instruments.”
Greenspan was being invited to lay out a response to the new finance. Instead, he laid the case for doing nothing. Derivatives, he explained firmly, were a zero-sum game. Unlike leverage, they did not magnify risk; they merely redistributed it. Of course, some zero-sum gamblers would be zeroed out. But in a healthy market system, risk takers should be ready to lose their shirts; “I don’t consider it to be something which gives me great concern,” Greenspan lectured. Meanwhile, the risk-shifting properties of derivatives would move financial exposure to the investors who could absorb it best. “I must say we think that’s very helpful,” Greenspan concluded.
Greenspan’s description of derivatives was only half accurate. In theory, if they were managed properly, the new products would have the benign effects that he outlined, shifting risks to institutions that could manage them most safely. But the benign potential of derivatives came bundled with two significant downsides. The complexity of the most exotic contracts made it easy to rip off clients: this lesson emerged from the abusive selling of toxic mortgage securities before the 2008 crash, but the same lesson could have been learned more than a decade earlier, courtesy of the Bankers Trust scandal. Equally, complexity made it possible for crazy risks to build up inside financial enterprises, unbeknownst to their own mangers. This was the lesson taught in 2008 by AIG insurance, a venerable enterprise laid low by derivative sorcerers. But the same lesson might have been absorbed in 1994. Charles Sanford’s fuzziness about his own company’s wedding-band swaps was a portent of the future.
Greenspan ignored these early clues about the danger lurking within finance. In part, he ignored them because regulatory questions failed to engage him intellectually. When it came to the federal funds rate, he would fight his committee doggedly over a difference of 25 basis points; on regulatory issues, he followed the majority. This reflected his sense of his own strengths. Monetary policy hinged on canny economic forecasting, his strong suit. Regulatory policy hinged on a fine understanding of precedent and rule books, and such legalisms bored him. But the main reason why Greenspan glossed over the derivatives danger lay elsewhere. Just as he shrank from using monetary policy to fight bubbles because it was hard, so he understood that getting financial regulation right was virtually impossible. Volcker had failed at it, presiding over the banks’ disastrous lending to Latin America and over the creation of the first too-big-to-fail precedent in the Continental Illinois bailout; now the derivatives mess showed that Greenspan too might fail at it. To a politically astute Fed chairman, the smart course was to avoid entanglement in regulation in the first place–to leave it to lesser colleagues at the Fed, to maintain that markets would manage their own risks, to define financial instability as something other than his problem. The upshot was that Greenspan shrank from deploying both of the tools he might have wielded against financial excess. He would not use monetary policy to target bubbles. He would not use regulatory policy to clamp down on crazy risk taking.
Seven years earlier, at his confirmation hearing in the Senate, Greenspan had previewed one part of his response to the Bankers Trust imbroglio. “History tells us that we become overenthusiastic about certain types of financial arrangements, certain types of ideas, and we overdo it,” he reflected. But then he expressed faith that such errors would be self-correcting: their senses sharpened by salutary losses, financiers would mend their ways and regulatory reform would be superfluous. By way of an example, Greenspan cited Mexico’s default in 1982. Before, Wall Street bankers had lend heedlessly to Mexico; after, they had learned their lesson. “International lending will be significantly more prudent in the years ahead,” Greenspan told the senators. “I don’t think any new policies have to be implemented.”
It was a hope more than a forecast–a hope born of the fact that Greenspan had no appetite for regulatory remedies. But what if the hope turned out to be empty? If financiers committed the same errors, over and over, perhaps it might be time to recognize that the faith in self-correcting prudence was deluded?”
(THE FOLLOWING IS ABOUT THE AUTHOR AND PRAISE FOR THIS BOOK AND I QUOTE:
SEBASTIAN MALLABY is the author of several books, including the bestselling More Money Than God. A former Financial Times contributing editor and two-time Pulitzer Prize finalist, Mallaby is the Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations.”
“Admire him or despise him, Alan Greenspan was the preeminent financial statesman of the postwar era. But Sebastian Mallaby’s magisterial biography casts him as something more (and more intriguing) than that; a masterly and mesmerizing politician. Whether counseling Richard Nixon on the race-freighted Southern strategy, scheming with Watergate felon Charles Colson on a plan to neuter the Federal Reserve’s independence, or waging bureaucratic war against Henry Kissinger (and winning!), Greenspan was cunning, stealthy, and ruthless, neck deep in the political intrigues of his era. In riveting, page-turning fashion, The Man Who Knew reveals the man in full.” —JOHN HEILEMANN, managing editor of Bloomberg Politics; host of With All Due Respect, coauthor of Game Change and Double Down
MY COMMENTS: FED CHM ALAN GREENSPAN, WHO WAS FED CHM FOR A CONSIDERABLE LENGTH OF TIME, DID A REAL BAD JOB OF REGULATING OUR BANKING SYSTEM FOR THE FACT OF RUNNING IT SAFELY. HE WAS A HIGH-RISK TAKER THAT FELL IN LOVE WITH TOXIC DERIVATIVES THAT GOT ORANGE COUNTY CALIFORNIA INTO REAL FINANCIAL PROBLEMS, WHICH ENDED WITH THE LARGEST MUNICIPAL BANKRUPTCY IN HISTORY ON DECEMBER 6, 1994. FED CHM GREENSPAN FAILED TO ENFORCE ANY REGULATIONS, EVEN THOUGH SOME POLITICIANS WANTED TO IMPLEMENT WHAT CAME TO BE KNOWN AS THE VOLCKER RULE, WHICH WAS PASSED AFTER THE 2008 FINANCIAL CRISIS. IF HE WOULD HAVE ACTED EARLIER, WE MIGHT NOT HAVE HAD THE 2008 CRISIS BUT SINCE HE DIDN’T AND RETIRED AND BEN BERNANKE TOOK OVER AS CHM, THEN EVERYTHING WAS SET-UP FOR THE COMING 2008 CRASH AND THE $700 BILLION TARP BANK BAILOUT PASSED BY REPUBLICAN PRESIDENT GEORGE W. BUSH. WHEN DEMOCRAT PRESIDENT BARACK OBAMA TOOK OFFICE, HE DID PASS THE DODD-FRANK BILL WHICH IS IN EFFECT TODAY. THE PROBLEM NOW IS, SINCE REPUBLICAN DONALD TRUMP WAS ELECTED PRESIDENT, THE REPUBLICAN-CONTROLLED CONGRESS REALLY DOESN’T BELIEVE IN HAVING BANKING REGULATIONS, WHICH THEY CALL CUMBERSOME, SO LOOK FOR THE WHOLE BANKING PROBLEM TO GET MUCH WORSE. JUST LIKE SENATOR BERNIE SANDERS HAS BEEN SAYING FOR SOME TIME NOW ABOUT JUST WHY WE DO NEED BANKING REGULATIONS AND A CONSUMER PROTECTION BILL, WHICH SENATOR ELIZABETH WARREN ORIGINATED AND HELPED PASS WHICH IS PART OF DODD-FRANK.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran