Thursday, 5. April 2012
Part II of our book review of Frederick Sheehan’s Panderer to Power
Frederick Sheehan’s excellent 2010 book Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession provides us a window into the sources of the worst financial and economic crisis since the Great Depression.
In part I of this two-part review of Sheehan’s valuable book, we discussed Sheehan’s takeaways from Greenspan’s career before becoming Chairman of the Federal Reserve Board of Governors.
In turn, Sheehan’s review of Greenspan’s nearly twenty years with the Fed gets underway with the Senate confirmation hearing in 1987, after Greenspan’s nomination as Fed Chairman by President Ronald Reagan. Sheehan notes with some approval the questioning of Senator William Proxmire of Wisconsin, then the chairman of the Senate Banking Committee. Sheehan praises Proxmire’s willingness to critically examine Greenspan’s forecasting record and his apparent enthusiasm for serving the agenda of large banks. Greenspan was a director of J.P. Morgan at the time of his appointment, which Proxmire noted along with Greenspan’s lobbying activity as a signal his expertise in banking issues might be more attentive to some interests than others.
Further down the road, Greenspan would face critical Congressional reviews from others, including the likes of Representatives Henry Gonzalez and Ron Paul from Texas. But that certainly doesn’t mean Congress as a whole was especially critical, or even responsible, in its oversight of the Fed during Greenspan’s tenure. Just as the Fed went through the motions or even offloaded some critical responsibilities (like capital regulation) to other parties in ways that proved central to our recent economic meltdown, so, too, should Congress as a whole be viewed as an exercise in abdication of responsibility, regarding the Fed and other banking regulators it has created. The Fed serves Congress in a few ways – it serves important Congressional constituents (including special interests), not just banking interests. And the Fed also serves as a convenient way for Congress and the President to blame someone when things go wrong, and to look responsible in their criticism, but without ultimate accountability for Congress, the President or the Fed.
Proxmire’s 1987 inquiry notwithstanding, Alan Greenspan’s first Fed chairman nomination was overwhelmingly confirmed in the Senate, by a vote of 91 to 2. In fact, Greenspan inspired apparently stunning majorities in all five of his confirmation votes from 1987 to 2004. But there is more than meets the eye here. Senate confirmation of Fed chairmen nominations were actually never required by law until the Federal Reserve Reform Act of 1977, and the Senate has been unusually deferential since then. Until Ben Bernanke’s most recent nomination vote, they were never even close. For many years, Paul Volcker had the most nay votes following the bruising early 1980s recessions, on the heels of the Fed’s attempt to stamp out the inflationary flames it had previously inspired, when the vote was 84-16. More recently, in 2010, following the worst financial and economic crisis in history, Bernanke still made it through the Senate, winning renomination 70-30.
Sheehan’s Panderer to Power serves as a wake-up call for all of us, including our representatives in Congress. Sheehan decries the lack of critical review of Fed operations in Congress, and perhaps oversimplifies the efforts of some, like Rep. Henry Gonzalez, who Sheehan reduces to a “grandstanding politician.” But given the evidence compiled by Sheehan and others like him, the days of Congressional deference to Fed nominations, and Fed operations generally, are or should be over.
A few months after becoming Chairman, Greenspan and the Fed were greeted with the 1987 stock market crash. It is hard to blame Greenspan, at least, for that one, and Sheehan doesn’t. But he still draws valuable lessons from that event and the regulatory response to it. The 1987 crash had a variety of influences, including perhaps most importantly the destabilizing influence of a derivative-driven strategy called ‘portfolio insurance.’ The math worked well on the blackboard, but things soured when the students went out in the real world. The real world is a place where good ideas often become fads, get overpopulated, and then, overpriced. Sheehan cites how some of the original designers of portfolio insurance defended themselves after the crash, saying things like “the set of events that led to the breakdown shouldn’t happen once in thousands of years.” Sheehan notes that these “once in a millennium” events were to recur regularly, in subsequent debacles in 1994, 1998, and the Big One in 2008.
Sheehan describes how the Fed liquefied the markets after the 1987 crash, with Greenspan reaping some political capital for that response. But two questions that arise with that response matter more generally, and whenever it appears that people are advertising how the Fed is skillfully guiding us through financial crises. If the Fed is responsible for financial stability, why did things get so unstable in the first place? In turn, what are the longer-term moral hazard implications of Fed ‘stabilization’ efforts for risk-taking and stability down the road? Sheehan’s subsequent discussion of Fed history matters for these questions, and for what we should do about it going forward. And that discussion certainly doesn’t spare Alan Greenspan, who Sheehan thinks should have learned some important lessons about derivatives and their implications for the financial system in 1987, yet remained their champion up to our most recent debacle.
The next challenge of own making — for Greenspan, the Fed, and the Congress — arrived in 1990. Coming on the heels of the savings and loan and deposit insurance crisis (a crisis rooted in the operations of firms like Greenspan’s former client, Lincoln Savings and Loan, whom Greenspan had praised to regulators), the 1990-1991 economic recession prompted a variety of policy responses. The crisis apparently wasn’t preceded by good forecasts, at least at the Fed. In August, 1990, a month after the later-determined ‘official’ onset of the 1990-91 recession, Sheehan reports that Greenspan stated “those who argue that we are already in a recession are reasonably certain to be wrong.” Sheehan takes Greenspan to task not strictly for this statement, but Greenspan’s subsequent characterizations, which included what Sheehan believes to be overstatements about the Fed’s ability to foresee and respond to the downturn.
The deposit insurance crisis underlying the credit market deterioration in the 1990-91 recession was followed by the FDIC Improvement Act of 1991, also known as FDICIA. As a growing number of Americans are becoming aware, when they start calling things PATRIOT Acts, and No Child Left Behind Acts, and Improvement Acts, it’s time to look out for your wallet. FDICIA theoretically dealt with the problem of regulatory ‘forbearance’ (referring to regulators’ habits of allowing banks to stick around and swing for the fences once they approach insolvency, leading to even larger losses) by setting up a system theoretically forcing regulators to resolve failing institutions before they threaten the taxpayers. But as implemented, the Fed and other regulators agreed to rely on credit rating agencies for the capital regulations on banking institutions, and effectively outsourced their responsibilities to ‘the market.’ (the ‘market.’ Hah!) This ended up being central to our latest meltdown, a topic to be discussed below.
The next flare-up arrived in 1994, with a mini-storm (at least, relative to recent events) in the over-the-counter derivatives markets. A number of nonfinancial companies and municipalities, as well as financial firms, proved to have greater exposure to these instruments than they thought or advertised. Sheehan provides a fun if not valuable distinction when he discusses how derivatives originally were developed to serve needs (e.g. risk management and hedging), but had evolved to include a greater role as a way to feed wants and desires (speculation). Congressional hearings in 1994 included testimony from a variety of perspectives, including from Greenspan, who downplayed their risks to the system and emphasized their usefulness and productivity. Derivatives were certainly useful and productive for dealers in the marketplace, and Greenspan and the Fed would go on to continue to promote, defend, and ‘stabilize’ the roles of the major dealers, with longer-term consequences that we are reaping the fruits of today.
Sheehan moves on to a brief treatment of the mid-1990s crisis in Mexico and Chairman Greenspan’s support for the Clinton Administration (including Treasury Secretary Robert Rubin) lobbying the Congress for U.S. taxpayer resources to bail out Mexico (incidentally, in the interest of large U.S. banks exposed to losses there). That was another short-term fix with longer-term moral hazard risk-taking consequences. Then, we had the late-1990s stock market bubble, perhaps in part a consequence of the regulatory signals the markets were receiving as well as Fed monetary policy.
The Internet stock craze in the late 1990s was part of the picture, and related to a seemingly boring story Sheehan tells rather dramatically, if not compellingly. Over a decade had passed since Greenspan’s leadership of the Social Security Commission in 1993, and things had not improved along those lines. Greenspan helped lead one way to fix the issue. He began to champion productivity improvement in the U.S. economy, sparked (as it was, at least in some part) by the advances underway in telecommunications technology. Other things equal, greater productivity growth can (according to some) mean lower inflation threats.
Another element at work, and the fix ultimately sold by the Boskin Commission, was an argument that the CPI was overstating the inflation rate. Productivity and quality improvement, Greenspan and others argued, were not getting captured accurately in the official inflation statistics. After Greenspan testified that the CPI was overstating inflation by 0.5% to 1.5% per year, in late 1996 the Boskin Commission produced a similarly precise 1.1% ‘midpoint’ estimate. Then, the statisticians got to work, ‘improving’ the CPI and lowering the reported inflation rate. Sheehan and others have argued that these efforts overdid things one way, but not in other ways. This remains a matter of some debate, but the likes of John Williams at Shadow Government Statistics certainly bear listening to. The government’s measurement adjustments did help the Social Security problem — by reducing benefit payments tied to the CPI. But Sheehan also tries to make a case that Greenspan’s productivity championing was one element in the Internet stock bubble, soon to burst.
In 1998, two years on the heels of the Mexican crisis, the Fed was again given a lesson in apparently didn’t learn well. The implosion of a firm called “Long Term Capital Management” (another Hah!) combined the derivatives threat with basic issues about concentration, and posed another once-in-a-lifetime set of circumstances threatening ‘systemic risk.’ Even in mid-September 1998, as LTCM was beginning to implode, Greenspan was defending market discipline and bank responsibility in lending to hedge funds to the Congress. By 1999, he was Shocked, Shocked to learn of the extent of the exposure large banks had to this one hedge fund. Just ten years later, the Fed would be shocked again, but the likes of AIG and its friends in the derivatives markets. With disastrous consequences for the overall economy. Speaking of forbearance, when reviewing the record that Sheehan lays out, it is difficult not to think that we as citizens, should not just be wagging fingers at Congress and the regulators. We should be looking in the mirror, as well.
In September 1998, the Fed orchestrated a cooperative approach for lenders to keep LTCM afloat and keep its derivatives book from unwinding. The FOMC then engineered two successive cuts in the Fed funds rate, one a surprise. The markets calmed, and some credited the Fed with a successful resolution. Others, however including Sheehan, date the famous “Greenspan put” assumption to those 1998 LTCM actions. The LTCM episode served as one leg in the unsteady stool propping up massive risk taking at our recent ultimate public expense, partly for this market expectation, and partly, as Sheehan eloquently and passionately identifies, because the Fed and other banking regulators either couldn’t or wouldn’t learn the available lessons. A panderer to power may not just be oblivious to risks, he or she can also rationally help the risk-takers gamble on the public purse, because the panderers are in those positions for that reason, and help the risk-takers survive (and keep a lot of previous ‘winnings’) to gamble another day.
Even after LTCM, the late 1990s were to see more aggressive support for derivatives markets, particularly the New York-centric over-the-counter version. This included lobbying for greater ‘netting protection’ for derivatives agreements. Put simply, if you owe me $100 and I owe you $99, how much do I owe you? Well, back in the late 1990s, the answer was subject to some uncertainty for derivatives counterparties. If one of them failed, say the one who owed me $100, it was unclear whether I owed the dead guy $99 or nothing. The Fed supported the major derivatives dealers looking to cement protection for contractual clauses for netting protection, arguing it reduced systemic risk. This ended up being a key feature of late 1990s regulatory and legislative changes. It certainly reduced the risk of major dealers to one another, but at the possible expense of other counterparties to the dead guy, and only at first blush. Once ‘protected,’ the dealers grew bigger and bigger. And systemic risk in the derivatives markets grew and grew through the next big debacle, the housing market finance/AIG big one we’ve just been through – even though market participants were extolling the benefits of ‘netting protection’ under a growing share of their contracts.
After the LTCM story, Sheehan moves to a lengthy, and perhaps too lengthy, hindsight-driven blow-by-blow description of the rise and ultimate fall of the Internet and broader stock market bubble, and its interplay with monetary policy. But this discussion leads into another good lesson – the rise and fall of Enron – a well connected energy and financial services/derivatives company. In November 2001, Enron announced it had overstated its profits by over half a billion dollars over a five year period. Five days later, Alan Greenspan accepted his award for the Enron Prize for Distinguished Public Service. In December, Enron filed for bankruptcy, providing lessons not only for derivatives markets and their interconnections with banking institutions but the credit rating business as well. Enron continued to ‘earn’ investment grade credit ratings all the way up to four days before it filed for bankruptcy. Here, too, was a lesson unlearned with ramifications for our most recent crisis.
Both Sheehan and Greenspan deserve some credit for the next major step on the journey. In the mid 2000s, Greenspan began to sound warnings about the housing GSEs – Fannie Mae and Freddie Mac. These massive institutions bought up huge volumes of mortgages generated during the housing boom, and had a market advantage in their cost of capital given their ‘government-sponsored’ status. They were among the roots of the massive financial crisis in recent years. Sheehan is fair in crediting Greenspan for his warnings about Fannie and Freddie.
But a fair observer could still criticize, in hindsight, decisions by Greenspan and others at the Fed NOT to do things that they could have done given that Fannie and Freddie existed, and the mortgage boom was in full throttle, making lots of well-connected people lots of money. For example, Greenspan and the Fed were responsible for capital regulation, and chose to continue to outsource much of that responsibility to credit rating companies attached to the mortgage loan securitization boom. The inflated credit ratings helped enable that boom, and also were at the center of reasons for the undercapitalization of much of our banking system when housing prices and mortgage loan quality started heading south. While Sheehan does not capture this angle as tightly as he could, he certainly takes the Fed, Treasury and others to task, effectively, for their approach to derivatives regulation related to the securitization boom.
Bottom line, Sheehan’s book is well worth reading, for a good story as well as important lessons about our financial system. The book perhaps could have benefitted from greater depth on regulatory issues, and less of a focus on its criticism of individual monetary policy decisions. There are other elements of the story that could have been explored. But the book serves the public interest well, in illuminating the sources of financial crisis and widely public pain in recent years. Recommended for any Boiling Frogs that can still read, as our pot grows hotter and hotter.
# # # #Bill Bergman has 10 years of experience as a stock market analyst sandwiched around 13 years as an economist and financial markets policy analyst at the Federal Reserve Bank of Chicago. He earned an M.B.A. as well as an M.A. in Public Policy from the University of Chicago in 1990. Mr. Bergman is currently working with Social Movement Sciences LLC, a new enterprise developing evaluation and funding services for not-for-profit organizations.