Tornado Alley (PROG)

[F6]

Black Swan Nation

Fed's legacy one of crisis and collapse.

by James Quinn
Sep 22, 2008

Editor's Note: James Quinn is Senior Director of Strategic Planning at a respected University.

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 hard to step back and try to understand what’s going on at this point in history. What I do know is that whatever’s happening, it isn’t good.

As Nicholas Taleb wrote in The Black Swan, his brilliant, irreverent book of 2006:

“Globalization creates interlocking fragility while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans. We’ve 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…True, we now have fewer failures, but when they occur ….I shiver at the thought.”

Taleb shivered - and now the whole world is shivering. The threat of a global collapse has never been closer. The last global collapse led to the Great Depression, which lasted from 1929 until the US’ entry into World War II in 1941.

The world’s in the midst of a Black Swan event, and people who fail to recognize what’s happening will suffer catastrophic consequences. According to Taleb, a Black Swan event has 3 attributes:

1. It’s 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 - but the world’s really dominated by Black Swan events, which should occur only rarely in the long tail of the normal distribution curve. Based on the last ten years, I would have to agree with Mr. Taleb:

-- 1998: Long Term Capital Management

-- 2000: Dot-com bubble

-- 2001: 9/11 attacks

-- 2005: Housing bubble

-- 2008 : Financial implosion

I believe that these extreme events are interrelated, and have built upon each other to leave us in our current precarious position. We’ve become a “Black Swan Nation.”

You can’t stop a Black Swan event, but you can position yourself to benefit from it - or at least save yourself from harm. Our government’s response to each ensuing Black Swan event ensured 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, founded in 1994, was a hedge fund that remarkably generated 40% annual returns in its first 2 years. Its hubris soon grew to epic proportions - Taleb compares LTCM’s strategies to “picking up pennies in front of a steamroller”. They generated many small gains balanced against the unlikely chance of a large loss. In 1998, the steamroller won:

“During the summer of 1998, a combination of large events, triggered by a Russian financial crisis, took place that lay outside [LTCM’s} 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’d shown to other financial firms was returned in kind. LTCM had so many positions with so many counterparties throughout the world that they became the 1st firm to be “too big to be fail” After LTCM lost $4.6 billion in 3 months, the Federal Reserve Bank of New York heavily pressured the CEOs of all major Wall Street firms to bailout LTCM. Ultimately, 14 banks contributed $3.625 billion, 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. Well-meaning members of the Congressional committee had a different opinion. 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, and, 10 years later, the same problems have occurred to a much greater degree - and the government’s trying to avert worldwide financial collapse on a daily basis.

Dot-Com Bubble

In January 1995, the NASDAQ was at the 750 level. On March 10, 2000, the market peaked at 5,132, an increase of 584% in 5 years.

In a 1996 speech, Greenspan warned that the US 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 1990s and Wall Street started pushing IPOs like Pets.com -- many of which soared by 500% to 1000% on the day they were issued -- Greenspan didn’t take away the punch bowl before the party got out of hand, as he should have done. If he’d increased margin requirements, or interest rates, day traders wouldn’t have had the money to propel the markets to such ridiculous heights.

As the year 2000 approached -- along with ridiculous fears of the “Y2K crash” --Greenspan flooded the economy with cash, which immediately flowed into dot-com stocks and pushed the NASDAQ to its epic peak, a level that won’t be seen again for decades.

The technology-heavy NASDAQ Composite index peaked at 5,048 in March 2000, reflecting the high point of the dot-com bubble.

Robert Shiller, professor at Yale, published Irrational Exuberance in early 2000. The book poked holes in Wall Street’s rationale for stocks being as high as they were, arguing that a complete disconnect had occurred between earnings and the level of the stock market. [F6 note -- and see (items linked in) http://investorshub.advfn.com/boards/read_msg.aspx?message_id=32352721 -- . . .]

Shiller argued that “positive feedback loops” among investors led to herd-like behavior and created a “naturally occurring Ponzi process; furthermore, this feedback loop was based on the “indifferent thinking, emotions, random attentions and perceptions of conventional wisdom" of millions of people. In short, he effectively concluded that the “efficient market theory” was a load of crap.

In the real world, people aren’t rational machines. You can’t model human behavior - very disappointing for academics and “scientists” at investment banks.

All previous speculative peaks in 1901, 1929, and 1966 resulted in subpar stock returns for 2 decades thereafter. The peak reached in March 2000 far exceeded any in history, as millions of people piled into the stock market. A sort of collective delusion overcame the country.

The dot-com 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; some were prosecuted for touting worthless stocks as buys.

The trigger for the collapse were Greenspan’s 6 interest-rate increases, culminating in a rate of 6% 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 W. Bush have one thing in common: They don’t believe in recessions. Greenspan rapidly decreased the Fed discount rate from 6% to 3.5% by September 2001.

9/11 Attack

As Nicholas Taleb points out, human beings always try to rationalize a Black Swan event after the fact. But 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 9/11 attacks, the Fed voted to reduce the federal funds rate from 3.5% to 3.0%. As the Enron and other corporate scandals developed, the Fed dropped the federal funds rate to 1.0%, where they remained for over a year. Greenspan said this drop in rates would cause a surge in home sales and refinancing. But Americans extracted $3 trillion in equity from their homes and spent it on BMWs, HDTVs, exotic vacations and whatever other hedonistic pursuits that appealed to them.

The national reaction to the 9/11 disaster was one of unity of purpose. We wanted to find and punish the terrorists that caused this tragedy. A call for national sacrifice would not have gone unanswered. 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 (GM) showed their patriotic spirit by offering 0% financing on all cars. Big-ticket retailers offered easy credit and extended terms, so that everyone could have a flatscreen HDTV - and worry about paying later. Consumers went into 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 - but when the government provides an estimate, multiply it by 10 to get closer to the truth.

Housing Bubble

Between 1998 and 2006, home values virtually doubled. There's no logical explanation for this occurrence. Previous peaks were 60% lower than the one reached in 2006.

Any reasonable person would conclude that home values would therefore fall steeply after reaching such irrational highs. 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 encouraged the party to kick it up a notch. The following words, from Charles Prince, former CEO of Citigroup (C), 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’s now doing the rumba in the bank-CEO “retirement” home along with James Cayne, Ken Thompson, Angelo Mozilo, Daniel Mudd, Richard Syron, Dick Fuld and Kerry Killinger.

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 about others getting rich “flipping” houses. But, Greenspan's 1% interest rates were fuel for the frenzy.

The final nail in the coffin of Greenspan’s legacy was his speech in February 2004, in which he suggested that more homeowners should consider taking out Adjustable Rate Mortgages. Greenspan's advice came at a time when interest rates had bottomed out, making it a particularly bad time to take out an ARM. A few months thereafter, Greenspan began hiking interest rates, which would reach 5.25% 2 years later.

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.

Financial Implosion

In his 2002 letter to shareholders, Warren Buffett described derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Being the smartest financial mind on the planet, Buffett saw the bleak end of the credit derivative bubble. Another Black Swan was coming, but those Harvard-educated CEOs on Wall Street chose to ignore it, because they knew that the Federal Reserve and the government would come to the rescue if they went too far.

The Greenspan “put” was well-known on Wall Street. Whenever someone did something stupid and risked worldwide financial collapse, the Fed would ride in on its white horse to save the day.

Worldwide sales of CDOs exceeded $500 billion in 2007. A June 2007 Bloomberg article lays out the story of the recklessness and greed surrounding these “financial weapons of mass destruction”:

"Because CDO contents are secretive, fund managers can't easily track the value of the components that go into these bundles. ‘You need to monitor the collateral in your investment and make sure you're comfortable there will be no defaults,’ says Satyajit Das, a [Minyanville professor ( http://www.minyanville.com/gazette/bios.htm?bio=107 )] who has written 10 books on debt analysis.

"Most investors can't do that, because it's extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the US in 2006 were loaded with subprime mortgage debt… Since CDO managers can change the contents of a CDO after it's sold, investors may not know how much subprime risk they face, Das says."

It’s quite interesting that many are now railing against short sellers as the cause of the market meltdown - a smokescreen to cover up the incompetence of others.

Again, Alan Greenspan praised the rise of the subprime mortgage industry and the tools it used to assess credit-worthiness in an April 2005 speech at the very peak of the housing frenzy:

"Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants… With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. …These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s."

The SEC essentially abdicated their role as regulator and protector of individual investors in 2004. An exemption for 5 investment banks (Goldman Sachs (GS), Merrill Lynch (MER), Lehman Brothers, Bear Stearns, and Morgan Stanley (MS)) allowed them to take on the kind of risk which has brought the worldwide financial system to its knees.

Paul de Grauwe, in the Financial Times, indicts Greenspan for failing “to take his responsibility to supervise the financial markets blinded as he, and his colleagues, were by a belief that markets and bankers know better than governments.”

The events of the past year were avoidable. A conscious and willful decision by the SEC to allow these 5 firms to legally violate existing net capital rules in place since 1975, which had limited broker/dealers debt-to-net capital ratio to 12 to 1, is a major cause of the financial collapse. Instead, the 2004 exemption allowed these 5 firms to leverage up 40 to 1. It’s no wonder that 3 out of 5 of these firms have blown up.

The conservative mantra of total deregulation has been catastrophically discredited, having practically brought down the worldwide financial system. Pundits who proclaim that free-market capitalism is the best path to prosperity are now in favor of weekly bailout packages for their buddies on Wall Street. This flip-flop in their regulation mantra has resulted in a total loss of credibility.

In very simplistic terms, this crisis can be summed up in one sentence:

If you loan money to people or companies that cannot pay you back, you will go bankrupt - unless your government bails you out.

What We Know Today

On Wednesday afternoon, Harry Reid, Democratic Senate Majority Leader, spoke the first truthful word from a politician during this entire crisis: "No one knows what to do. We are in new territory here. This is a different game."

I respect him for that. We’ve been listening to Hank Paulson tell us that our banking system was sound for over a year. He was the CEO of Goldman Sachs. He knew the extreme risk taking that was going on. Today, Hank Paulson -- who committed our future generations to trillions in obligations for the sins of his buddies on Wall Street -- is being hailed as a hero. Hank Paulson is no hero.

Nicolas Taleb poses the following questions:

"Why don't we realize that we are not that capable of predicting? Why don't we notice the bias that causes us not to realize that we're not learning from our experiences? Why do we still keep going as if we understand them?"

Wall Street, Alan Greenspan, George Bush’s administration and Congress attempted to put off the pain of recession by encouraging more risk-taking by companies and citizens. We’re now reaping what they have sown.

This has been a remarkable year. The United States has taken actions that will change our country forever - actions taken behind closed doors and in conjunction with the bank CEOs who caused the problems. At least one trillion of our future tax dollars have been committed to bailing out greedy, incompetent, criminal investment bankers:

Bear Stearns rescue : $29 billion

Tax rebates to Americans: $168 billion

Fannie Mae (FNM) and Freddie Mac (FRE) nationalization : $300 billion

AIG (AIG) nationalization : $58 billion

Government taking bad debt off the books: $700 billion

Future Generations' Bill : $1,255,000,000,000

Let’s be perfectly clear: The US government has no money. We entered this week with a national debt of $9.65 trillion. The deficit for next year will surpass $600 billion; the annual interest charge will exceed $60 billion per year, $164 million per day, $6.8 million per hour.

Every dime of these bailouts will have to be borrowed from China, Japan and the Middle East. In an effort to keep our corrupt financial system afloat, we’ve sold another piece of our country. The prestige and status of the US in the eyes of the world have suffered a catastrophic, irreversible decline in the last 9 months. “We The People” had absolutely no say in this decision.

I hate to quote Richard Nixon, but it’s apropos: When he was told that some corporate goliath was “too big to fail,” Nixon responded, “Tell it to get smaller.” I’m tired of hearing that every company that has a problem is too big to fail. The government shouldn’t let any company become too big to fail. Of course, they just encouraged Bank of America to buy Merrill Lynch - thereby making it way too big to fail.

Based on the actions taken to relieve banks of all their bad debt, American citizens may come to the conclusion that they don’t need to honor their own obligations. The moral hazard message from our leaders is that bad decisions do not have bad consequences.

In addition, consumer confidence and trust in government will fall because of the actions taken this week. Our leaders have lied to us. The massive redemptions from money markets weren’t panic; they were a rational response to being misled by bankers that money markets were safe and couldn’t lose money.

We sure could use a positive Black Swan. God help America.

©2008 Minyanville Publishing and Multimedia, LLC. (emphasis in original)

http://www.minyanville.com/articles/Bernanke-Paulson-Greenspan-bush-recession-LTCM/index/a/19113 [Part 1]
http://www.minyanville.com/articles/MER-GS-C-Greenspan-Credit-fre/index/a/19115 [Part 2]
[complete article above]