End of the Greenspan error

HOW THE MASTER OF THE UNIVERSE STRIPPED HIMSELF At least he was sincere about it and that is the only In saying he was "absolutely" wrong about how markets behave, Alan Greenspan has admitted his own ignorance There was a time when investors and members of Congress hung on Alan Greenspan's every nuanced word. Now and then some may have politely suggested that perhaps he should ease up on interest rates, but they would never have dared to think that his encyclopedic view of the economy was in any way flawed or mistaken. Yesterday Greenspan broke that bubble by admitting that he may have been wrong in an appearance before the House oversight and government reform committee: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms," Mr. Greenspan said. The mistake was fundamental. "You found that your view of the world, your ideology was not right, it was not working?" said California congressman Henry A Waxman, the committee chairman. "Absolutely, precisely," Greenspan said. "You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well." To hear Alan Greenspan admit that his way of seeing the world was "absolutely, precisely" wrong is to mark the end of an era. There was a time when Greenspan conferred his blessing on the proliferation of derivatives. He opposed regulating derivatives because they spread the risk and made cheap credit more widely available. The trouble is that the prices of this cheap credit began to lose any connection to reality as derivatives proliferated. As mortgages - which themselves were based on a real estate bubble - were dismembered and repackaged, the resulting derivatives became detached from the value of the underlying assets. Collateralised Debt Obligations, or CDOs, were given triple-A credit ratings and traded by bankers who never saw the properties or looked at the credit profiles of the borrowers. The risk may have been spread, but the price of the risk was badly underestimated. Two weeks ago, Nell Minow of the Corporate Library proposed the Paul Volcker rule (named after the former Federal Reserve chairman) in an appearance before the same House committee: "If Paul Volcker can't understand it, it shouldn't be on the market." Greenspan admitted that he and some other really smart folks didn't understand the derivatives market they had allowed to flourish, despite the "best insights of mathematicians and finance experts," sophisticated computer modeling and at least one Nobel prize in economics: The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. We have seen it over and over again in the Age of Greenspan: hedge funds got their name by hedging risks, but derivatives can be used to double down on risk just as easily. New financial instruments were declared to be so diabolically clever that they couldn't possibly fail. Sophisticated equations allowed bankers and hedge fund managers to price risk to within an inch of their lives, or so they thought; they were actually living far beyond any rational capital requirements. When Long-Term Capital Management, which hired some of those Nobel laureates, failed 10 years ago, Greenspan had to orchestrate a rescue using investment bank funds. LTCM was wound up, but its techniques spread quickly through Wall Street. Investment banks, which before the Age of Greenspan made money by managing money for clients, began trading for their own account. Managers were rewarded for taking on ever larger and more exotic risks that bore little resemblance to the underlying economic reality. One doesn't need a Nobel prize to know what brought about the collapse of this intellectual edifice. Humorist Roy Blount summed it up in a talk before an audience in Philadelphia earlier this week: "Money got too abstract, and that's why it went away"