In some ways I enjoyed Prime Minister Rudd’s essay “The Global Financial Crisis”(February 2009). National leaders should be encouraged to write. Unfortunately, like a blinkered juror in a murder trial, Rudd had all the facts before him but sent the wrong men to jail. Squeezing the facts to fit his political thesis was masterful but mistaken. The current crisis is in financial markets, yet Rudd fails to address the relevant market. His essay strolls quite confidently through economic history but it displays the market understanding of a man with a degree in medieval Chinese poetry.
Rudd’s main contentions are that the global financial crisis (GFC) can be attributed to the neo-liberal deregulation mania of George W Bush’s Republican government, and that conservative politics everywhere is tainted by rampant free-market ideology.
In fact, it was the collapse of the over-the-counter (OTC) derivatives market that destroyed bank capital and locked up the world’s credit. And it is Alan Greenspan, the former chairman of the US Federal Reserve, and Robert Rubin, the Treasury secretary under Clinton, who bear prime responsibility.
These men failed – despite repeated warnings – to regulate the OTC derivatives market. Indeed, not only did they fail to actively regulate this market, they adamantly opposed regulation and fostered legislation designed to enshrine unregulated status.
Alan Greenspan has admitted his error. We have his confession. What more does Rudd require?
Robert Manne has written an addendum to Rudd’s essay (“Neo-Liberal Meltdown”, March 2009) that is also a defence and an apology. I did not enjoy it; although, to his credit, Manne correctly describes the OTC derivatives market and the regulatory failings of Greenspan and Rubin that Rudd missed. Without Manne’s addendum, the prime minister’s essay is embarrassingly inadequate. Rudd looks at the GFC through a political lens, which pushes the derivatives market into a soft-focus periphery. He misses the important facts; he cannot see the cause of the crisis, only the neo-liberals. Manne, however, sees the core material and identifies the cause – and yet he still blames the neo-liberals.
Rudd’s error may be unintentional, even understandable; Manne’s is deliberate, transparent and egregious. Manne knows who the guilty men are but lets them off, preferring to send his old enemies to jail instead. He apologises for and corrects the prime minister’s mistakes. Surely 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. So, let me explain derivatives and Greenspan’s error in detail.
In his essay, Rudd refers to Greenspan’s admission before Congress that his ideological world view was flawed. However, Rudd fails to realise that Greenspan’s confession related specifically to his failure to regulate the OTC derivatives market. Greenspan was famous for his impenetrable language, so perhaps we shouldn’t be too harsh on Rudd. Market professionals would often analyse Greenspan’s statements right 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.”
Moreover, when Rudd quotes George Soros’s statement that “the crisis was caused by the system itself “, he 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.
OTC derivatives, broadly known as ‘swaps’, are a relatively new innovation, essentially only 25 years old. It is OTC derivatives that Warren Buffett was referring to in his prescient, and now famous, remark about “financial weapons of mass destruction”.
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 parties, 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.
There are two broad classes of derivative: exchange-traded derivatives and OTC derivatives. (A more advanced taxonomy would include contingent versus forward claims.) Exchange-traded derivatives (futures and options) are highly regulated and, by definition, trade on the futures exchange. OTC derivatives are performance contracts between counterparties to exchange certain cash flows. They are privately negotiated and traded, and they deal mostly in debt, currencies and interest rates. These OTC derivatives 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 models, full of assumptions and imperfect representations of reality. There is 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, OTC derivatives 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 was so vast that Bill Gross, chairman of PIMCO, the largest bond manager in the world, described the OTC derivatives market as the “shadow banking system”. At a notional value of around US$500 trillion in outstanding derivatives in 2007, it dwarfed 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 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 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, who 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 and, 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.
OTC derivative markets 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.
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, it had already been reviewed in 1998, but Alan Greenspan and Robert Rubin scuttled it.
Greenspan recently admitted his mistake before the US Congressional House Committee on Oversight and Government Reform: “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.”
Brooksley Born, as head of the Commodity Futures Trading Commission (CFTC), oversaw the futures market and was the regulator of exchange-traded derivatives. She knew that OTC derivatives had none of these regulatory merits and persistently called for OTC derivative regulation by the CFTC.
Supported by Robert Rubin, Alan Greenspan chaired a working group on financial markets in 1998, specifically to address Born’s concerns. He was adamantly opposed to further regulation and the CFTC’s 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, Greenspan’s epiphany has come 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.”
Banks’ self-interest is simply profit. Like all businesses, banks 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, which 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 products. That was Greenspan’s job. This is a regulatory failure. Greenspan cannot say he wasn’t warned.
Alan Greenspan had complete bipartisan political support and Robert Rubin (recently chairman of Citibank) was a Clinton appointee. In London, while Tony Blair’s Labour Party was in government, no OTC derivative regulation was proposed by Gordon Brown as Chancellor of the Exchequer. Kevin Rudd has missed all this. And while Alan Greenspan confessed his error last October, Rudd and now Manne continue to blame conservative government. This regulatory failure may have been ideological but was not party political.
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.
’Letting the free market rip’ is Rudd’s favourite line as he points his finger at the Liberal party and at 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. Don’t reward and resuscitate poor management. 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.
In early March, the current federal reserve 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 100 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 1990s and early 2000s. 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 PC 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”.
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.
The seven-point plan described by Prime Minister Rudd in the Australian to solve the global financial crisis has merit, but two shortcomings. Firstly, his “agreed formula” for toxic-asset valuation should involve letting the market determine the value. This will be essential to avoid prolonging the pain. Second, and most importantly, his plan fails to address the cause. The G20 must design an international system of OTC derivative regulation.
