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     Jan 29, 2008
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More than 20 years in the making:
By Doug Noland


It all began innocently enough: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."

The newly appointed Federal Reserve chairman, Alan Greenspan, released this statement prior to the opening of market trading on Tuesday, October 20, 1987. The previous day, "Black Monday", the Dow Jones Industrial Average crashed 508 points, or 22.6%. All the major indices were down in the neighborhood of 20%, with

S&P500 futures ending the historic trading session down 29%.

The 1987 stock market crash was contemporary Wall Street finance’s first serious market dislocation. Stock market speculation had been running rampant, at least partially fostered by new-fangled hedging and "portfolio insurance" trading strategies. When a highly speculative market began to buckle, the forced selling of S&P futures contracts to hedge the rapidly escalating exposure to market insurance ("dynamic trading") played an instrumental role in instigating illiquidity and a market panic.

Following Black Monday, there was of course considerable media attention directed at the event's causes and consequences. Some believed at the time that the stock market was discounting a severe economic downturn. Others recognized the reality that the situation had little to do with underlying economic forces. The economy was in the midst of a robust economic expansion, while credit was flowing (too) freely. Immediately post-crash, however, the financial system was extremely vulnerable and the Greenspan Fed acted decisively to ensure the marketplace understood clearly that the Federal Reserve was a willing and able liquidity provider.

Credit then really began to flow. Greenspan’s assurances came at a critical juncture for the fledging Wall Street securitization marketplace; for Michael Milken, Drexel Burnham and the junk bond market; for private equity, hostile takeovers and the leveraged buyout (LBO) boom; for the fraudulent savings and loan industry and for many banks' commercial lending operations. While it sounds a little silly after what we've witnessed since, there was a time when the eighties were known as the "decade of greed".

When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated an historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system credit growth and fight economic headwinds, the Greenspan Federal Reserve was more than content to garner outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the government-sponsored enterprises such as Fannie Mae and Freddie Mac never looked back - not for a second.

Birth of a 20-year myth
In the guise of "free markets", the Greenspan Fed sold its soul to unfettered and unregulated Wall Street-based credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy’s speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling - alluring - seductive story.

But, as they say, "there's always a catch". In order for New Age Finance to work, the Fed had to make a seemingly simple - yet outrageously dangerous - promise of "liquid and continuous" markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative "insurance" - accommodating the markets’ expanding appetite for hedging - required liquid markets whereby they could short securities to hedge their risk, as necessary.

There were numerous debacles that should have alerted policymakers to some of New Age Finance’s inherent flaws (1994's bond rout, Orange Co, Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron to name a few). Yet the bottom line was that the combination of the Fed’s flexibility to aggressively cut rates on demand; ballooning GSE balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world’s reserve currency all worked in powerful concert to sustain (until recently) the US credit bubble - through thick and thin.

Despite his (inflationist) academic leanings and some regrettable ("Helicopter Ben") speeches as Fed governor, I do believe Dr Bernanke aspired to adapt Fed policymaking. His preference was for a more "rules-based" policy approach of setting rates through some flexible "inflation targeting" regime, while ending Greenspan’s penchant for kowtowing to the markets. Today, it all seems hopelessly naive. Inflation is running above 4%, while the rate-setting Federal Open Market Committee (FOMC) is compelled to quickly slash the funds rate to 3%. And never - I repeat, never - have the financial markets been more convinced that the Federal Reserve fixates on stock prices when it comes to inflationary pressures.

Fed on a limb of its own
Today, the contrast to the European and other central bank could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how it can regain credibility as an inflation fighter or supporter of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.

The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their "risk management" approach.

Repeatedly, monetary policymaking was dictated by the Fed’s focus on what it considered the possibility of adverse consequences from relatively low probability ("tail") developments in the credit system and real economy. In other words, if the markets (certainly inclusive of New Age structured finance) were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through "activist" monetary easing was accepted outright as a patently more attractive proposition compared with the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative ("coin in the fuse box") policy approach is disastrous in bubble environments.

The Fed's complete misconception of the true nature of contemporary "inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary - and greatly unappreciated - risks were part and parcel to the perpetuation of dangerous credit bubble dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater bubble-related distortions and fragilities - deeper structural impairment to both the financial system and real economy. In the end, the Fed’s focus on mitigating tail risk guaranteed a much more certain and problematic tail - a rather fat one at that.

Fundamentally, the Greenspan/Bernanke doctrine totally misconstrued the various risks inherent in their strategy of disregarding bubbles as they expanded - choosing instead the aggressive implementation of post-bubble mopping-up measures as necessary. They were almost as oblivious to the nature of escalating bubble risk as they were to present-day complexities incident to implementing mop up reflationary policies. Mopping up the technology bubble created a greatly more precarious mortgage finance bubble. Aggressively mopping up after the mortgage/housing carnage in an age of a debased and vulnerable dollar, US$90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global bubbles, and a runaway Chinese boom is fraught with extraordinary risk.

Furthermore, the Fed's previously most potent reflationary mechanism - Wall Street-backed finance – is today largely inoperable.

I'm not going to jump on the criticism bandwagon and excoriate Dr Bernanke for his panicked 75 basis point inter-meeting rate cut. From my vantage point, the wheels were coming off and I would expect nothing less from our increasingly impotent central bank. Yet it is silly to blame today’s mess on recent indecisiveness. The Fed has not been behind the curve, unless one is referring to the learning curve. The unfolding financial and economic crisis has been more than 20 years in the making. It’s a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For 20 years now the Fed has basically done everything that Wall Street requested and more.

It is also as ironic as it was predictable that Alan Greenspan - Ayn Rand "disciple" and free-market ideologue - championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our nation’s financial and economic affairs since the New Deal. Articles berating contemporary capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying credit system.

Bears survive squeeze
And, speaking of the credit system, some brief market comments are in order. Stocks generally rallied last week, yet it was a backdrop that provided little comfort that the system has begun to stabilize. Sure, the banks rallied 10%, the homebuilders 20%, the retailers 7%, the transports almost 7%, and the restaurants 5%. One could easily assume that the bears were squeezed and leave it at that.

There are, however, surely more complex and problematic dynamics at work. Notably, many of the favorite sectors were hit this week - the utilities, technology and biotechs all posted notable weakness. Coupled with this week’s extreme volatility, I will assume that the huge "market-neutral" and "quant" components of the leveraged speculating community have suffered even greater losses so far this month than those from last August.
It is also worth noting that some important credit spreads have diverged markedly, most notably many corporate, junk and commercial mortgage-backed securities' spreads have widened as dollar swap spreads have narrowed. The spectacular Treasury melt-up must also be causing havoc for various strategies, ditto the recently strong yen and Swiss franc.

I'll stick with the view that an unfolding breakdown in various trading models and hedging strategies is at risk of precipitating a crisis of confidence for the leveraged speculating community. I suspect hedge fund trading was much more responsible for chaotic global securities markets this week than a rogue French equities trader. There is, unfortunately, little prospect for markets 

Continued 1 2 3 4 5 


1. Going bankrupt: The US's greatest threat

2. Xposed! Norman Podhoretz's boobs

3. Iran sanctions hit the wrong target

4. A salvo at the White House

5. Envoy's belly dancer bares all

6. Troops felled by a 'trust gap'

7. Lies, lies and more lies

8. Crying (Iranian) wolf in Argentina

9. Taliban wield the ax ahead of new battle

10. China: Partner or predator
in Africa?

11. A $4.4bn drop in the bucket

(24 hours to 11:59 pm ET, Jan 24, 2008)



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