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A conservative’s riposte to Prime Minister Rudd and Robert

Manne

The central cause of the global financial crisis was not ideological or
party political. It was caused by Greenspan’s failure to regulate the
Swaps market.

In some ways I enjoyed Prime Minister Rudd’s essay “The Global Financial Crisis”.
National leaders should be encouraged to write. Unfortunately, like a blinkered
juror in a murder trial, Mr Rudd had all the facts before him, but sent the wrong
men to gaol. Squeezing the facts into his political thesis was masterful but
unfortunately mistaken. This is a crisis in financial markets, but he never
addresses the relevant market. His essay strolls through economic history quite
well, but displays the market understanding of a man with a degree in medieval
Chinese poetry.

His main point was that the global financial crisis (GFC) can be attributed to the
neoliberal deregulation mania of George W. Bush’s Republican government. And
that conservative politics everywhere is tainted by this rampant free market
ideology.

In fact, it was former chairman of the US Federal Reserve Alan Greenspan and
Robert Rubin (former Clinton Treasury secretary) who failed to proactively
regulate the relatively new Over-The-Counter (OTC) derivatives market, despite
repeated warnings. Not only did they fail to regulate it, they adamantly opposed
regulation and fostered legislation to enshrine unregulated status.

It is the collapse of the unregulated OTC derivatives market that has destroyed
bank capital and locked up the world’s credit. Alan Greenspan has admitted his
error. We have his confession. What more does Mr Rudd require?

Robert Manne has written an addendum to Mr Rudd’s essay titled “Neo-Liberal


Meltdown”. It is also a defence and apology. I did not enjoy it. To his credit he
has correctly described the OTC derivatives market and Greenspan and Rubin’s
regulatory failure. Mr Rudd missed this. Without Manne’s addendum, the Prime
Minister’s essay is embarrassingly inadequate. Mr Rudd looked at the GFC
through a political lens which pushed the derivatives market into a soft focus
periphery. He missed the important facts. He cannot see the cause of the crisis,
only the neoliberals. Manne however, sees the core material, identifies the cause
and still blames the neoliberals.

Rudd’s error may be unintentional, even understandable. Manne’s is deliberate,


transparent and egregious. Manne knows who the guilty men are and lets them
off, preferring to send his old enemies to gaol.

The first 6 paragraphs of his essay are instructive. He then apologises for and
corrects the Prime Minister’s mistakes. In much of it he plays the oracle. Only
through him can we know the hidden genius in Rudd’s words. Well Mr. Rudd used
7700 of his own words, more than enough to communicate his precise meaning
for himself.

This stirred me from my usual imperturbability towards a mood of pugnacious


defiance. Facts, chronology and common sense should prevail. Not the blindness
in the Prime Minister’s right eye or Robert Manne’s intellectual hall of mirrors.
How very intemperate of me.
I shall address Mr Rudd’s essay and expand Manne’s first six paragraphs,
explaining derivatives and Greenspan’s error in detail.

Mr Rudd mentions Alan Greenspan’s testimony before Congress that his


ideological world view was flawed, but fails to realise that Greenspan’s confession
related specifically to his failure to regulate the over-the counter derivatives
market.

Greenspan was famous for his impenetrable language, so perhaps we shouldn’t


be too harsh with Mr Rudd and the staff in his by-line.

Market professionals would analyse Greenspan’s statements down to the


punctuation in an attempt to divine his meaning. He delighted in this and once
said,

“I know that you think you know what I said. But I’m not sure whether
you understand what you heard is what I meant.”

This sounds more like a football coach than a man steering the American and
world economy. And I still don’t know where the comma should go.

When Mr Rudd quotes George Soros, “...the crisis was caused by the system
itself ”, Mr Rudd fails to grasp that the “system” refers to the explosive growth
of OTC derivatives and their tentacle-like insinuation into every corner of global
finance.

The OTC derivatives, broadly known as swaps, are a relatively new innovation,
essentially only 25 years old. It is OTC derivatives that Warren Buffett referred to
with his famous and prescient remark about “financial weapons of mass
destruction”.

I am aware that many readers will require more explanation, and ask, “what is a
derivative?”

A derivative is a security whose price is dependent upon or derived from one or


more underlying assets. The derivative itself is simply a contract between two or
more counterparties and its value is determined by changes in the value of the
underlying asset. The most common assets include shares, bonds, commodities,
market indices, currencies and interest rates. Most derivatives are characterised
by high leverage.

For the purposes of general understanding there are two broad classes of
derivative: exchange traded and OTC or over-the-counter. (A more advanced
taxonomy would include contingent versus forward claims).

Exchange traded derivatives (futures and options) are highly regulated and by
definition trade on an exchange, the futures exchange.

Over-the-counter (OTC) derivatives or swaps are private performance contracts


between counterparties to exchange certain cash flows. The simplicity of this
definition belies breathtaking complexity. They are privately negotiated and
traded. They deal mostly in debt, currencies and interest rates.

Tragically these swaps were invented to perform a risk management function,


allowing corporations to hedge away risk. Hedge funds use them for investment
and speculation.
Why did Warren Buffett perceive inherent danger? Because they are unregulated,
opaque, highly leveraged and illiquid. They are without standards or financial
guarantees. They are of infinite and ever evolving complexity. When you hear the
term “financial engineering”, this really means innovative OTC derivative creation.

They are valued, not by a market in the real world but by mathematical model.
Mark-to-model not mark-to-market. The mathematical models are full of
assumptions and are imperfect representations of reality. They are valued by
equations in a virtual world. For OTC derivatives there is, by definition, no official
regulated market of exchange such as a stock exchange or a futures exchange
that lets buyers and sellers come to a daily equilibrium. And crucially, swaps are
completely exposed to counterparty risk. The strength of a swap contract is that
of the weakest counterparty. If one counterparty falls over then the "asset"
becomes worthless.

The scale of the market for these instruments and derived products is so vast
that Bill Gross, Chairman of PIMCO, the largest bond manager in the world,
describes the OTC derivatives market as the “shadow banking system.” At a
notional value of around $500 trillion in outstanding derivatives in 2007, it had
grown exponentially to dwarf the real banking system. Credit default swaps alone
totalled $43 trillion, more than half the size of the entire asset base of the global
banking system, according to Mr Gross.

The enormous scale of derivative production produced a global


interconnectedness of financial institutions, far greater than the globalisation of
industry. Mutual dependence was created. Derivative dominoes.

Selling OTC derivatives was also gloriously profitable. These products were
principally created by investment banks, and following the repeal of the Glass-
Steagall Act under President Clinton, the American commercial banks.
Commercial banks could now move into investment banking territory and start
squeezing the golden goose. The upside was cheaper credit fuelling business
expansion. The downside was cheaper credit fuelling asset bubbles and seeking a
home in subprime mortgages and unnecessary private equity leveraged buyouts.

The sell side (banks) was profitable but while the game lasted, so was the buy
side. The buyers of these products were diverse but were principally corporations
and hedge funds. The phenomenal proliferation of hedge funds, chronologically
corresponds to the growth in OTC derivatives.

Enron’s attempts at hedging in the energy market via derivatives went bad,
leading to more bad derivative bets. Like a gambler reduced to theft, eventually
Enron was reduced to corporate malfeasance.

Many other companies have collapsed due to derivatives going wrong.


Paradoxically, most of these companies were seduced by investment banks into
OTC derivative contracts to reduce their risk. AIG, the world’s largest insurer, was
destroyed by its derivative book and the US government is still trying to rescue it
with massive cash injections.

Investment banks charged huge fees and made stratospheric profits. This was the
risk management of the modern era. The sheer complexity did them in.

Paul Volcker, former US Federal Reserve Chairman and now advisor to President
Obama, recently had this to say,
“the sheer complexity, opaqueness and systemic risk embedded in the
new markets, complexities and risks little understood even by most of
those with management responsibilities, has enormously complicated
both official and private responses to this mother of all crises.”

The new markets are the OTC derivative swap markets. Swaps allowed banks to
keep highly profitable, unregulated, and now toxic assets, away from official
balance sheet scrutiny. Reserve requirements were dodged. Again, it is the
collapse of the unregulated swaps market that has destroyed bank capital and
locked up the world’s credit.

It is well known that problems began with default of subprime loans. Officials
believed it was a liquidity issue. New money was created and pumped into the
banks. A rescue was arranged for Bear Stearns via JP Morgan in what has been
described by some as a mutual rescue. Then Lehman Brothers was
uncharacteristically allowed to collapse. This burst into the consciousness of the
market and can be described as “the incident” precipitating this crisis.

Other crises followed such as money market funds “breaking the buck” (trading
under $1 per unit). Not only had property dived, bank capital been destroyed and
hedge funds blown up, but now cash equivalent investments were under threat.
The issue is no longer liquidity but bank solvency.

If Warren Buffet’s warning was insufficient then surely the Enron disaster should
have pushed OTC derivative regulation to the forefront of policy development. In
fact this had already been reviewed in 1998, but Alan Greenspan and Robert
Rubin scuttled it.

Greenspan recently admitted his mistake before the US Congressional House


Oversight and Government Reform Committee:

“I made a mistake in presuming that the self interest of organisations,


specifically banks, is such that they were best capable of protecting
shareholders and equity in the firms.....I discovered a flaw in the
model...”

Greenspan strenuously and repeatedly blocked calls for OTC derivative market
regulation by Brooksley E. Born. As head of the Commodity Futures Trading
Commission (CFTC) she oversaw the futures market.

Futures and options, the so called exchange traded derivatives, are transparent
and highly regulated. They have a market of the bid-ask type. Counterparty risk
is eliminated by the clearinghouse mechanism, requiring the daily stumping up of
cash if the position is in the red. Brooksley Born was the regulator of exchange
traded derivatives. She knew that OTC derivatives have none of these regulatory
merits and are therefore dangerous. She persistently called for OTC derivative
regulation by the CFTC.

Supported by Robert Rubin, Alan Greenspan then chaired a Working Group on


Financial Markets in 1998, specifically to address Born's concerns. He was
adamantly opposed to further regulation. The CFTC concerns were dismissed.
Using Greenspan’s recommendations, President Clinton signed the Commodity
Futures Modernisation Act into law in 2000. This exempted OTC derivatives from
oversight by the CFTC.

Now he has had an epiphany too late.


“Those of us who have looked to the self-interest of lending institutions
to protect shareholders’ equity, myself included, are in a state of shocked
disbelief” he said.

Banks self interest is simply profit. The last twenty years have been a halcyon
age for bank profits. There is nothing inherently wrong with that but banks have
an advantage that most other businesses don’t have. They are deemed essential
to the economy. They are mostly “too big to fail”. It is known clumsily as system
“essentiality”. Bankers knew this. In the United States there is a very long history
of bank bailout. It may come as a surprise but the various recent bailout/rescues
of Bear Stearns, Freddie Mac, Fannie Mae, AIG, Merrill Lynch, Bank of America
and Citibank is not a new phenomenon. Numerous bank and corporate bailouts
are well documented back to at least the early 1970s.

This favoured status reduces the imperative to run a careful prudent enterprise.
Greenspan’s trust was misplaced.

Referring to credit default swaps he said, “This modern risk-management


paradigm held sway for decades…..the whole intellectual edifice
however, collapsed in the summer of last year."

Credit default swaps are an insurance product that banks sold to buyers of other
OTC derivative products such as bundled mortgage debt. The buyers felt
protected. When the underlying debt defaulted, the derived investments lost
money. The hedge funds blew up. The insurance was called upon and banks lost
billions. Combined losses are in the trillions.

Securitisation of poor quality debt was misrated by the ratings agencies because
they believed the banks and Alan Greenspan that credit default swaps provided
satisfactory insurance against failure. Clearly they did not. No regulations were in
place to ensure sufficient collateral provisions, to meet potential liabilities.

The new risk management paradigm of the last 20 years sought to spread the
risk widely, but was brought undone by the global interconnectedness of the
counterparties.

The ratings agencies were wrong. Alan Greenspan was wrong. He has admitted
his mistake. Self-regulation failed.

Banks like all businesses operate to maximise profit through innovation, service
and quality. And they do this within a legislative and regulatory framework.
Australian banks have done rather well and a great deal of the credit for this
should go to our regulatory system that encouraged far more prudent activity.
American banks did nothing illegal. They were no doubt too busy doing business
to reflect on the big picture implications of new product. That was Greenspan’s
job. This is a regulatory failure. Greenspan cannot say he wasn’t warned.

Alan Greenspan “the maestro” independent central banker, had complete


bipartisan political support and Robert Rubin (recently Chairman of Citibank) was
a Clinton appointee. No accusations of extremist right wing ideology with these
men. Except from Kevin Rudd and Robert Manne. There is no party politics
involved in this mess.

Away from New York, in that other great centre of financial innovation, the City of
London, Tony Blair’s Labour Party was in government. No OTC derivative
regulation was proposed by Gordon Brown as Chancellor of the Exchequer. No
conservative ideology here either.
Mr Rudd has missed all this. He is conveniently misguided on this point of central
importance to the origin of the financial crisis.

Alan Greenspan confessed his error last October, yet astonishingly Mr Rudd and
now Mr Manne continue to blame conservative government. This regulatory
failure was not ideological or party political.

Swaps morphed from a sensible and highly flexible risk management product into
a rogue financial virus. Wall Street icons Greenspan and Rubin advised both
Democratic and Republican Presidents that self-regulation was best. No doubt
both Presidents’ eyes glazed over at the arcane nature of these derivatives, if
they had ever asked for a detailed brief on the subject. No doubt they would have
felt secure that Greenspan and Rubin were the best of all men to oversee this
market.

It is Alan Greenspan and former US Treasury Secretary Robert Rubin who bear
prime responsibility, not conservative politics. Government relied on their advice
and oversight.

I propose that the self-admitted failure of Greenspan's ideology speaks more to


the questionable recruitment of regulators from industry. Rubin's easy glide from
Goldman Sachs chief to Treasury Secretary and then to Citibank Chairman is
typical of the US administrative system. This is the flawed model. There is a huge
difference between well regulated free markets and regulators captured by
industry.

Like any ageing public figure concerned with his shattered legacy, Greenspan has
offered a cowardly defence, along the lines of “they made me do it” and “I was
only following orders”. Let’s leave the man to his compounded shame. I would
encourage readers to study only the first six paragraphs of Manne’s essay and
leave him to his shame too.

Now to the free market. Democracy, free speech and free markets. All political
parties in the USA, the UK and Australia support these virtues. Neoliberalism is
best defined as a political philosophy characterised by a belief in free markets and
free trade. I believe all Western democracies have signed up for this. It seems
only Communist countries and Mr. Rudd have not. Mr Rudd cannot have it both
ways. Either he uses neoliberalism in this sense or he uses it in reference to all
political conservatives. Either way he is mistaken.

“Letting the free market rip” however is Mr Rudd’s favourite line as he points
his accusatory finger at the Liberal party and conservatives everywhere.

It may shock him to know that Greenspan and Rubin are not true free
marketeers. True free marketeers oppose bailouts and rescues of imprudent
banks and corporations. Guarantee depositors by all means. Give them a cheque
and let them bank elsewhere. But don’t reward and resuscitate poor
management. The doctrine of essentiality is anti-free market. Greenspan and
Rubin and their organisations are not free marketeers but banking protectionists.
They protected banks from regulation of the swaps market and supported the
simultaneous protection of banks from failure and insolvency. A very happy
insiders arrangement.

Free market philosophy is not anti-regulation. Free markets desire regulation that
promotes their functionality and growth. Regulation is a good thing when
appropriate but like free speech and democracy, problematic and even dangerous
in excess. Regulators need a sense of proportion. Australia seems to have
managed this very well indeed. Although Greenspan did admit to a mistaken
ideology this really refers to his banking protectionist ideology not a free market
ideology.

In early March, current Fed Chairman Ben Bernanke called for broader powers for
the Fed to oversee financial markets. In this climate he will no doubt be given
anything he desires.

I am filled with dread at the prospect of increased powers for the Federal
Reserve.

It was Greenspan and the Fed, who despite many warnings failed to see the
looming crisis, let alone do anything to prevent or soften it. It was Greenspan and
the Fed, who admit their failure to recognise the US housing boom that started in
2002, when house prices began outpacing inflation, having just kept pace with
inflation for the previous one hundred years. It was Greenspan and the Fed, who
in Congressional testimony, encouraged Americans to buy even more property in
2004, on variable rate mortgages, with rates at 40 year lows, before then raising
rates. It was Greenspan and the Fed whose monetary policy created the asset
bubbles of the 1990’s and early 2000’s. And it was Greenspan and the Fed whose
failure to support swaps regulation has killed the credit market.

Now that circumstances are forcing improved regulation, the Fed suggests that
the Fed alone can do it. With the Fed in charge I will not be surprised if the P. C
Vey cartoon from the New Yorker, turns out to be accurate. In it a man says to
his colleague, “These new regulations will fundamentally change the way
we get around them”.

Unlike our own Reserve Bank of Australia, and aside from Paul Volcker’s tenure, I
am yet to be convinced that the Fed has done anything particularly well in its
history. The Fed needs another Paul Volcker. Let’s hope he is listened to in his
advisory role within the Obama camp.

American industry, with its inventiveness, resourcefulness and energy, has been
a creator of our modern world. American finance too has displayed extraordinary
creativity. It is the regulation that needs refining. If done well, a regulatory re-
design will propel us into a future of renewed prosperity. Something good will
have come from all this.

The 7 point plan described by Mr. Rudd in The Australian, to solve the global
financial crisis has merit, but two shortcomings.

His “agreed formula” for toxic asset valuation should involve letting the market
determine the value. This will be essential to avoid prolonging the pain.

Most importantly his plan fails to address the cause. The G20 must design an
international system of OTC derivative regulation.

Gregory Solomons 12th March 2009


Sydney Australia

References:
Greenspan concedes error on regulation

http://www.nytimes.com/2008/10/24/business/economy/24panel.html

What went wrong

http://www.washingtonpost.com/wp-
dyn/content/article/2008/10/14/AR2008101403343.html

Pyramids Crumbling

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/208/IO+Janu
ary+2008.htm

AIG: Where taxpayers’ dollars go to die


http://www.nytimes.com/2009/03/08/business/08gret.html

Greg Solomons is an unaligned conservative with interests in financial markets and in particular,
economic and monetary history.