Bailout Nation (12 page)

I
t was in this environment that Alan Greenspan first floated the phrase “irrational exuberance.” In a December 1996 speech, Greenspan raised the exuberance issue—and then nearly as quickly dismissed it.

That speech became infamous for introducing the “irrational exuberance” phrase to the financial lexicon. To the Bailout Nation, there were even more profound reasons the speech was notable. In it we find the basis of not one, but two major Greenspan policies—both of which would emerge to significantly impact markets in the future. They were not recognized as such at the time, but with the benefit of hindsight—and an ensuing decade of Greenspan's Federal Open Market Committee (FOMC) policy—they are readily apparent to us today.

The first policy shift was Greenspan's focus on asset prices. This wasn't a subtle or abstract implication; Greenspan explicitly stated as much in the same speech:

The Fed's previous rate cuts had only
implied
a concern over asset prices; now, the chief explicitly affirmed the fact. The Fed was not concerned just about inflation and employment; asset prices were an “integral part” of its calculus, too.

This was revolutionary. Fed chiefs didn't usually care so much about stock prices; they were more concerned with the bond market. After all, it was the fixed-income traders—known as bond ghouls for their morbid affection for bad economic news—who set interest rates. Worries about deficits, inflation, and trade balances all found a receptive audience among the bond traders.

Once Wall Street figured out Greenspan was concerned about equity prices, it wasn't too long before it learned how to play the Fed like the devil's fiddle. When rate cuts did not materialize, the Street would have itself a hissy fit. It is always ill advised to anthropomorphize markets, but observing the market kick and scream when cuts weren't forthcoming was akin to watching a two-year-old throw a tantrum.
³
It may be illegal to manipulate markets, but no trader will ever get thrown in jail for manipulating Alan Greenspan.

The other policy shift hinted at in the “irrational exuberance” speech was the concept of cleaning up after, rather than preventing, asset bubbles and their aftermath. That was precisely what Greenspan implied when he made the incredible statement that “central bankers need not be concerned” about a bubble collapse, so long as it doesn't leak into the real economy.

Years later Greenspan said: “It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization—the very outcomes we would be seeking to avoid.”
⁴

This is, as any student of market history will tell you, an utterly absurd statement. As we have seen time and again, manias and panics invariably spill over into the real economy. The speech suggests that Greenspan learned precisely the wrong lesson from the 1987 crash. Market bubbles always destroy capital, ruin speculators, and cause all manner of heartache. From the Dutch tulip craze in 1636-1637 and the South Sea bubble in 1720 to the Nifty Fifty stocks in the 1960s, the dot-com bubble in 2000, the housing and credit boom and bust in the 2000s, and the credit and derivatives debacle in 2008, the final results of all investment crazes are lost treasure, blood, and tears.

What the astute student learns from the history of speculative frenzies is that the 1987 crash was a unique aberration, an unusual outcome relative to past collapses. The combination of a hot equity market and the new innovation called portfolio insurance combined with the messy New York Stock Exchange (NYSE) plumbing to create an unusually short-lived, market-driven event in an otherwise robust economy.

The 1987 crash seemed to be the only crash that was (sorry to use a dirty word) “contained.”

Greenspan completely missed this point. The 1987 crash was the rare exception, not the rule. That the chairman of the Federal Reserve failed to recognize this is nothing short of astonishing. Prior to 1987, numerous books had detailed the phenomenon of manias, and the economic fallout that occurs upon their collapse.
⁵
Greenspan was evolving a belief system unsupported by facts or history—and not for the last time, either. That a false premise became the cornerstone of his monetary philosophy goes a long way in explaining what happened next.

But we do not need to theorize to test Chairman Greenspan's hypothesis. We have explicit proof of the falsity of the thesis: The costs of the 2008-2009 credit bubble and collapse have been astronomical. As of December 2008, the United States has rung up over $14 trillion in bailout-related expenses—and counting.

Thus, we have the rarest of dichotomies: a Fed chair who appears to be concerned with falling asset prices—cutting interest rates in response to minor market stumbles—and yet who is at the same time a central banker who claims to be comfortable with collapsing bubbles.

These two views are inherently at odds with each other. The only way to reconcile the conflict is to recognize the latter statement as sheer nonsense. It is a dangerous, shameless, foolish rationalization—one that allowed the Fed to look the other way as markets began overheating in the late 1990s.

As we will soon see, each of these changes in emphasis and policy will have dramatic repercussions in the years to come. Not the least of these are in the asset prices themselves: as of March 2009, the S&P 500 was back at levels below where it was when Greenspan gave his 1996 “irrational exuberance” speech. If you bought the broad index the day after the speech, some 13 years later you would have nothing to show for it. What a long, strange trip that's been.

T
he end of the 1990s would see the philosophies of the Maestro, as he was known before his impact on markets was more widely understood, in full throat. The Fed chief would be repeatedly tested—by a currency crisis, a major hedge fund collapse, and a technology bubble. He rose to every challenge essentially the same way: increased liquidity and lower rates. Each time, the market would cheer, rallying to new heights.

Ultimately, this would become known as the Greenspan put.

In 1997, the Asian contagion struck. The Thai government cut the peg of its currency, the baht, from the U.S. dollar. The decision to let the baht float was disastrous. The currency collapsed, and caused a chain reaction throughout Asia. From Thailand, the so-called Asian flu raced through Indonesia, South Korea, Hong Kong, Malaysia, Laos, and the Philippines. China, India, Taiwan, Singapore, Brunei, and Vietnam were also affected.

The United States was mostly insulated from the Asian problems, but for a one-day wobble in the markets: On October 27, 1997, the Dow Jones Industrial Average fell 554 points, then its biggest-ever one-day point drop, and the New York Stock Exchange briefly suspended trading. But bulls perceived the 7.2 percent sell-off as a buying opportunity. The markets snapped back the very next day. Markets had begun 1997 around 6,400 on the Dow, and finished the year just under 8,000.

The year 1998 saw the last opportunity to avoid moral hazard on a grand scale. A huge opportunity was lost, and the genesis of our current crisis was born.

The missed opportunity in question involved Long-Term Capital Management (LTCM), a hedge fund that specialized in fixed-income arbitrage. Using enormous amounts of leverage—about $100 billion in borrowed money—the fund bought thinly traded assets that were difficult to value. (
Gee, why does that sound so familiar?
)

Long-Term Capital Management's investing philosophy and prowess were based on the idea of mean reversion. When spreads—the difference in prices between two bonds—on emerging market debt widened in reaction to the Asian contagion, the hedge fund bet heavily that those instruments would return to normal levels. Because of its early success and the pedigrees of its principals—including former Salomon Brothers bond chief John Meriwether and Nobel Prize-winning economists Myron Scholes and Robert Merton—LTCM was able to use leverage to amplify its bets many times.

Thanks to leverage, LTCM's exposure was greater than $100 billion. Furthermore, the fund was able to negotiate cut-rate prices for financing from many Wall Street firms, who were enamored of and infatuated by the fund's mysterious nature. So great was the allure of LTCM that many of its financiers mimicked the fund's trades (see
Figure 6.1
).

Thus, many big Wall Street firms were exposed to similar risk throughout 1998. When Russia defaulted on its debt in August of that year, spreads on emerging market bonds not only didn't revert to normal levels, but continued to widen. The widening credit spreads were taking an unhealthy bite out of LTCM's portfolio. In less than four months, the fund lost nearly $5 billion.

As LTCM's losses began to accumulate, the fund had no choice but to liquidate whatever it could to stay afloat. Markets had been digesting its gains since April, but speculation about LTCM's troubles was starting to make the rounds. As rumors of the fund's losses spread, the Dow fell from its high near 8,700 in mid-August 1998 to as low as 7,400 in early September—a rapid-fire 15 percent decline.

The Asian flu took place halfway across the world, and required little in the way of a Fed response. LTCM, by contrast, was in Greenwich, Connecticut—much closer to home. Most of the 19 primary dealers—banks and brokerages that directly trade government securities with the Federal Reserve—were involved. They all had lent LTCM much of its leverage, and stood to lose $100 billion if the firm collapsed.

Figure 6.1
1997 Asian Flu, 1998 LTCM