An Ode to Alan Greenspan
In his eighteen year term as Fed Chairman, Alan Greenspan orchestrated the greatest expansion of speculative finance in history. Through it all, he presented himself as a disinterested economist, or a scientist quoting the laws of physics. He wasn’t.
In 1998 the The Federal Reserve took the extraordinary step of arranging a bailout of Long Term Capital Management, a prominent Hedge Fund. The firm had used a 3.5 billion dollar investment pool to secure 100 billion dollars in Bank loans. With this line of credit, L.T.C.M. financed over one trillion dollars in derivatives contracts.
Alan Greenspan justified the Fed intervention by saying; ”Had the failure of L.T.C.M. triggered the seizing up of markets, substantial damage could have been inflicted on many market participants… and could have potentially impaired the economies of many nations, including our own.”
In 1999, one year after the collapse of Long Term Capital Management, Congress repealed the keystone of US financial regulation. The Glass-Steagall Act was written in 1933, at the bottom of the Great Depression. Its purpose was to prevent another economic catastrophe by separating commercial banking from securities investment firms and insurance companies.
Alan Greenspan and the financial industry had worked tirelessly to undermine the Glass-Steagall Act. In 1990 the Fed exploited a loophole in the law that allowed banks to underwrite securities provided they were not “engaged principally” in these investments. In 1996 all banks regulated by the Federal Reserve were allowed to operate investment affiliates, with up to 25% of their assets.
By the time Glass-Steagall was repealed, the law had already been rendered useless.
The Fed was instrumental in one more piece of legislation that has created the current financial crisis. In June of 2000, Alan Greenspan again appeared before Congress, this time to lobby for the commodity Futures Modernization Act. According to him: “This bill reflects a remarkable consensus on the need for legal certainty for OTC, (over-the-counter), derivatives and regulatory relief for U.S. futures exchanges, issues that have long eluded resolution.
Mr. Greenspan’s idea of “legal certainty” for derivatives meant keeping them completely deregulated and outside the financial system. Just as “regulatory relief” for commodities futures would create another wide open market for speculators. Congress passed the Commodity Futures Modernization Act on December 21st, 2000.
As leveraged debt in the form of derivatives metastasized through our economy, Alan Greenspan was singing their praises: “The impact of information technology has been keenly felt in the financial sector of the economy. Perhaps the most significant innovation has been the development of financial instruments that enable risk to be reallocated…”
Today our banks and brokerages are swamped with Credit Default Swaps, (CDS), Mortgage Backed Securities (MBSs), and other synthetic assets. Most of these financial instruments are credit derivatives. They are sold “over the counter”, completely unregulated, and in many cases not even listed on balance sheets.
The value of all credit default swaps soared from less than one trillion dollars in 2001 to $62 trillion in 2007. According to the International Swaps and Derivatives Association, the market value of interest rate derivatives reached $465 trillion last year. That’s over 30 times the size of the US economy.
Estimates of losses from the sub-prime mortgage crisis are small potatoes compared to the vast size of these assets. Losses on outstanding loans only account for $225 billion, another $720 billion is due to estimated write-offs on securities. So how has the collapsing housing bubble brought down so many of our banks and brokerages?
Understand this. If not for the repeal of Glass-Steagall, and the wildly speculative growth of derivatives contracts, the “sub-prime mortgage crisis” would have been just that. A correction in housing prices that would have required interest rate cuts and debt re-financing, nothing more.
Alan Greenspan knew the risks. In November of 2002 he addressed the Council on Foreign Relations on the potential for a bailout of the derivatives market:
“Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive.”
The Federal Reserve has become the lender of last resort in an attempt to thwart this “cascading sequence of defaults”. Since the financial crisis began, the Central Bank’s balance sheet has more than doubled, rising from $900 billion to $1.9 trillion. In addition, the Fed has guaranteed the assets of several failing institutions, with a total liability of over seven trillion dollars.
In March of 2008, the New York Fed pledged $29 billion in loans to facilitate the sale of Bear Stearns to another brokerage firm. With $11 billion in net equity, Bear Stearns was a counter-party to $13 trillion in derivatives contracts. This was a repeat of the L.T.C.M. bailout, ten years later and with ten times more money at stake.
borrowing from the fed funds window
Credit markets began to seize up over the summer, by September the financial meltdown had begun in earnest. The US Treasury nationalized Fannie Mae and Freddie Mac, the twins pillars of the US mortgage industry. Leyman Brothers declared bankruptcy with a net worth of 640 billion dollars.
The Federal Reserve came to the rescue of AIG, the nation’s largest insurance company. The insurer had over $400 billion in credit default swap contracts, and was facing $13 billion in collateral calls. This was no bailout. The Fed purchased an 80 percent stake in AIG, and is now liable for those derivatives contracts.
By the end of October the Dow Jones Industrial Average had plummeted below 8,500 points, down from over 14,000 a year earlier. Over fourteen trillion dollars evaporated from the worth of the world’s stock markets. Many of our financial firms were either bankrupt, sold at fire-sale prices, or dependent on the Treasury and Fed to avoid insolvency.
Historically, the Federal Reserve has only allowed banks to borrow from the Discount Window for short-term loans. Last autumn those restrictions were removed and other financial companies were allowed access to Fed Funds. Lending that had averaged $779 million a week skyrocketed as the economy imploded, surpassing 100 billion dollars a week by mid-November.
Since the financial crisis began, the Central Bank has created several new “facilities”, the biggest being the Term Auction Facility. The Federal Reserve is using these auctions to trade treasury bonds and dollars for commercial debt and derivatives contracts. So far the Fed has spent over two trillion dollars, and assumed liability for nine trillion dollars worth of toxic commercial paper.
The Federal Reserve has reduced interest rates to below one percent, and there has been obviously been plenty of borrowing. In addition the Bush administration allocated $700 billion for the Troubled Asset relief Program, (TARP). Liquidity is not a problem, so why are our financial institutions still facing insolvency?
Citigroup has received two cash infusions totaling $45 billion from the Treasury, and a 304 billion dollar “backstop” from the Federal Reserve. In effect the Fed has guaranteed the bank’s toxic assets. And for all this, Citigroup has a market value of less than nine billion dollars today.
AIG has been bailed out four times to the tune of $180 billion, yet the company just reported a $61.7 billion quarterly loss, the largest in history. According to a recently released internal memo, AIG is a counter-party to another $1.5 trillion in derivatives transactions. Since the Fed now owns AIG, the Central Bank will no doubt be forced to pay for them.
Ben Bernanke is trapped, and he knows it. The new Fed Chairman must choose between massive defaults on derivatives contracts, or hyperinflation as he prints the currency to cover the losses. The Fed is in fact monetizing, or creating the money, to purchase derivatives.
On October 23, 2008, Alan Greenspan appeared before Congress for the last time. He was called before the Banking Committee to answer for the collapse of our economy. He refused to take responsibility for the financial debacle, only admitting that, “I made a mistake”.
The Bush administration, CEOs, bankers, and derivatives dealers are being vilified for their role in this economic catastrophe, and rightfully so. The central role of the Federal Reserve in this disaster, and Alan Greenspan in particular, has not been publicized.
At this point, no bailouts, new taxes, or new regulations can save us from the financial reckoning. The Fed can only choose between trillion dollar defaults, or hyperinflation. Either way, this will be the end of the US dollar as a viable currency, and the US economy as we know it.
As for Alan Greenspan, let’s hope he runs out of toilet paper.
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