[editorial note: Some of you saw this post earlier this week; others were foiled by a strange Internet Explorer incompatibility induced by Microsoft Word. Leave it to Microsoft to produce a word processor whose HTML output is incompatible with their own web browser. All fixed now.]
Later this week, I’m going to argue that the Fed’s recent rate cut is at best an exercise in futility and at worst a mistake. [another editorial note: turns out I was wrong, at least on the second part. exercise in futility perhaps, mistake, no. see my next post.] First, it’s time to lay the groundwork:
The Creation of Free Debt1
In the early days of the bail-out debate (way back in the first week of October), Robert Reich gave a talk at the Commonwealth Club in which he, rightly, laid part of the blame for the origins of the current economic crisis at the feet of the Clinton Administration (of which he was a part from 1993 through 1997, as Clinton’s first Secretary of Labor). Regardless of where your politics lie, it’s pretty clear that the roughly 1998-vintage annulment of venerable Glass-Steagall (which among other things created a separation between investment banking and commercial banking activities in the US) was the first in a series of major errors which eventually resulted in today’s crisis.
Add to this something Reich didn’t touch on: the Clinton administration perpetrated the second error later in its watch, when it agreed with numerous Wall Street giants that credit default swaps (the “big bad” CDSs we keep hearing about these days) ought not to be regulated. Why CDOs should have been (and must now be) regulated will be the subject of still another post, but for now let’s stipulate that CDSs are opaque derivative instruments (i.e., not only not transparent but also based on inscrutable “if…then…else” risk structures which, for lack of inspection, can mask huge exposure to global externalities) and that the practice of “netting”2 (in which an investor hedges by purchasing two CDSs with opposite and mutually-exclusive pay-off circumstances, thus “netting to zero” his exposure regardless of which of the two outcomes takes place) has exposed the entire economy to systemic risk of counterparty default. Why? Because netting (offsetting hedges) don’t work if one of the two contracts in the hedge blows up because one of the insurers—think AIG—is suddenly unable to pay. And if everyone is a counterparty to everyone else, well, you get the picture…. (My friend Paul Sheehan, who at one time was in charge of derivatives oversight at money center banks as an examiner for the NY Fed and now runs an Asian event-driven hedge fund, points out that AIG wasn’t actually defaulting; it was merely subjected to an avalanche of “collateral calls” by counterparties who insisted that AIG set first $20 billion, then $40 billion and then $60 billion aside as collateral against their CDS obligations.)
Enter into this brewing perfect storm the High Priest of Economic Growth, Alan Greenspan, who, along with the Bush Administration, feared that the 2000/2001 bubble bursting and the tragedies of 9/11 might conspire to create a Depression. Greenspan’s Fed—amid much aplomb from the neo-supply-siders of the Bush administration—cut the Fed Funds rate so precipitously and so aggressively (down to 1.00% in early 2003) that, as Reich points out, real interest rates were negative for perhaps a year or two. I took a look at the data and produced the chart at the top of this post, and to be specific, real interest rates were negative for nearly 11 quarters (2.75 years) between 2003 and 2005. (see figure above) And, as others have pointed out, the problem wasn’t just negative real interest rates per se, but the fact that such low Treasury rates drove the world of investors who were looking for “safe” fixed income securities to look elsewhere—to CDOs.3
Is it any wonder that everyone and his brother who could support even a moderate credit rating borrowed like there was no tomorrow?(Don’t even get me started about the Ponzi scheme perpetrated by the rating agencies, the bond issuers and their syndicators.)Of course not. If you were a public company CFO from 2003 to 2005, you were crazy not to borrow: it was free! And what did you do with all that money? You couldn’t invest it into real operations because you couldn’t scale that fast, and neither your business nor the economy wouldn’t support it anyway. (That was one of many hints: if your business can’t consume more debt without doing something off the reservation, perhaps you have no business drawing down that debt in the first place!) And so you gamble with it. You create demand for new and interesting securities with which to sate your demand for returns on debt you have no business generating in the first place. So you overheat demand for CDOs, and you create an irresistible temptation for the bankers to create more and more of them. Commercial banks did it. Investment banks did it. Even insurance companies did it.
Thus Clinton Administration policies and Bush Administration policies created the perfect storm:
If you have been thinking about the ramifications of what the Fed did earlier this week, you can see where this is going. But that will have to wait for the next post(s)….
- Inflation data from http://inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx, Fed Funds data from http://www.the-privateer.com/rates.html. Graph by the author. [↩]
- The best explanation of both the system risk from netting and CDSs in general I’ve come across comes from the absolutely super This American Life/NPR News collaboration “Another Frightening Show About the Economy”, itself a follow-up to an earlier and equally excellent collaboration cleverly titled “The Giant Pool of Money” [↩]
- credit to “The Giant Pool of Money” for explaining this so clearly. [↩]