Should Greenspan get most of the blame for the housing mess?

There is an interesting article in The New York Times by Peter Goodman entitled "Taking Hard New Look at a Greenspan Legacy" which examines former Federal Reserve Chairman Alan Greenspan's role in being a primary cheerleader for the use of derivatives in the global financial system as it grew dramatically over the past two decades as well as his adamant posture that they not be regulated by the government. Although it is extremely easy to blame Greenspan for the entire mess since, as the article points out, all he really had to do was to step aside and allow others to pursue regulation of derivatives, and it is easy to find lots of people to jump on the anti-derivatives bandwagon as well, but it actually isn't that simple at all.

First and foremost, any number of people have simply stood up and said "wait a minute, I do not understand these things called derivatives, please explain them and their risks", but for whatever reasons, nobody was willing to do so. The crazy thing is that LTCM in 1998 proved that derivatives were a monumental disaster waiting to happen, but even the Fed having to step in and orchestrate a bailout of LTCM was somehow not enough to convince lawmakers and regulators to do something. Maybe it was the Fed's very success with LTCM that convinced people that disaster would never occur.

In truth, we still do not have an absolute disaster since most of the global economy is actually chugging away, albeit at a somewhat sluggish pace. And, once again, the fact that the financial system has not ground to a screeching halt is due in large part to the Fed's ability and willingness to step up and step in and say "wait a minute, the system is not working properly, the government now needs to correct for failures of 'the market'."

I think the main obstacle to regulating derivatives was not Greenspan, but the simple fact that nobody has had a clue as to how to properly do it other than to simply steer clear of derivatives whenever possible (ala Warren Buffett.)

I sat in on a number of congressional hearings in the 1998/1999 timeframe that looked into LTCM and related financial matters, and it was always abundantly clear and clearly articulated that counterparty risk was the 800-pound gorilla that you were chaining yourself to whenever you became dependent on a derivatives contract, either by depending on the other party to pay-up or having the liability to pay-up. I recall Greenspan himself repeatedly emphasizing the need for financial institutions to stress test their assumptions. Supposedly, after LTCM, financial institutions were required to develop and use risk models that would continuously evaluate value at risk to tell them of any looming problems.

So, those are the questions that Congress and other oversight bodies need to examine at great depth:

• Were "value at risk" models developed after LTCM at all the major financial institutions?
• Did the models reflect all relevant risks?
• Were those risk models in use?
• Were the risk models being used properly?
• Did the risk models actually flash warning or danger signals?
• Did management ignore those signals?
• If there were no such signals, why not?
• Did the risk models adequately reflect all counterparty risk?
• Starting a month before Bear Stearns imploded, what signals was management getting from these risk models?
• Was the Federal Reserve and SEC checking to be sure that financial institutions had the models in place and with appropriate management controls for their use?
• Were hedge funds "gaming the system" for derivatives such as credit default swaps (CDS) in such a way that financial institutions were deceived as to true counterparty risk?
• Were "insurance" companies offering counterparty "insurance" without properly reserving for the worst-case risk?
• Were credit-rating agencies deceiving customers as to all risks?
• Wasn't the whole post-Enron/WorldCom Sarbanes-Oxley accounting "reform" supposed to make companies and executives more accountable for fully and accurately reporting the financial state of their businesses? If a business was SOX-compliant, how could their risk models be wrong? The implied answer is that executives either did not know how flawed their risk management was, or they in fact were in violation of SOX for not reporting their true financial state. So, what really happened?
• Did the minutiae of SOX compliance take management's eye off the proper "ball" of understanding the current quantitative risk in their businesses?
• Is there some fatal flaw of interdependence between financial institutions and financial intermediaries such as hedge funds that inevitably leads to flawed assumptions about counterparty risk that will never be reliably detectable until the moment when failures occur near simultaneously on a widespread basis?

Personally, I think Treasury and the Fed will be able to put the financial system back together again, but the question is whether that is what Greenspan and other pro-market enthusiasts really had in mind or in fact is there some super-SOX regulation that is actually needed.

My suspicion is that there is no magic super-SOX regulation that will 100% guarantee that the Fed and Treasury will not have to bail out Wall Street ever again. If somebody cavalierly claims there is some great regulation solution without offering any convincing proof, do as the old Wall Street advice recommends and hang up on them.

Ironically, Wall Street has already significantly reformed itself by letting some firms fail, merging firms, and the last two major investment banks agreeing to be bank holding companies that are under tighter regulation by the Federal Reserve. And all of that is without Congress even lifting a finger.

In short, I suspect that derivatives per se are not the problem but the need to do a much better job with risk models and counterparty risk, and putting hedge funds under some regulations or restrictions so that they cannot be a serious threat to the health of the banking system. Of course, LTCM (a hedge fund) already taught us that lesson, but somehow we needed a little "refresher" to learn the lesson properly, assuming that we have learned the lesson even now.

-- Jack Krupansky