Greenspan in shocked disbelief

[Meadmaker]

Big story today:


http://news.yahoo.com/s/nm/20081023/bs_nm/us_financial_greenspan_2

Greenspan "shocked" at credit system breakdown

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief," he said.


As the news came on about the impending banking system collapse and the heroic measures undertaken by the government of the US, other governments around the world, and of course the taxpayers who are the subjects of those governments, I began to wonder why this all happened. I had heard that deregulation was the culprit, but I wasn’t so sure. I started a thread about that subject, and in the course of participation in that thread researched the reasons as best I could.

One subject kept coming up when I dug down into this mess. It was something called “market discipline”, and a theory that market discipline could be a substitute for regulation.

For those of you who have never heard of it, market discipline refers to the tendency for the market to punish bad business behavior. If a bank makes bad loans, its stock will drop. This is not a radical idea. What was radical was a theory, popular in academic writing and influential on policy makers, that market discipline could act as a substitute for regulation. The theory went that financial institutions did not need regulators telling them what to do, because the market would keep them in line. If they made bad decisions, equity investors would drop them like a hot rock, and they would suffer.

One example that was widely held up in academic circles was an idea of forcing banks to sell something called “subordinated debt”. I’ll let you look it up yourself if it interests you, but basically the idea was to force banks to sell junk bonds. Junk bonds lose their value if there is danger of default. Therefore, if a bank were doing things that could cause default, the market would punish them by making their junk bonds worthless. Bank executives wouldn’t want that, so they would act to prevent it. Reading about subordinated debt at Fannie Mae was what led me to the whole discussion of market discipline.

It was this theory of market discipline to which Greenspan referred. He sat in “shocked disbelief” as it was proven that the theory didn’t work.

I always liked Greenspan, actually, although I didn’t understand the full extent to which he was hoodwinked by this idea. Today’s commentary demonstrated why I liked him. He didn’t mince words. He didn’t make excuses. He said his whole idea was wrong. He was in shocked disbelief because he was certain that the financial institutions would not fail to act in their own self interests to protect shareholder’s equity, the way that this theory of market discipline said they should. Empirical data, actual, results, proved he was wrong, and he said so. A lot of people have tried to blame government, or business, or one political party or another, but Greenspan could see that this was not accurate. His theory was that this collapse should not have happened, but it did.

So, what went wrong? How did Greenspan, a pretty sharp guy, along with so much of the financial community, make such a big mistake? That’s somewhat difficult to answer, but I have my own ideas.

First, I think he failed to realize that the self interest of corporate decision makers, i.e. executives, was not always in line with the interest of shareholders. Those executives acted to protect their own interests, instead of the interests of their shareholders. Traditionally, this kind of conflict of interest was prevented by an independent Board of Directors, who would look out for shareholder interests, and fire any executive who got out of line with what they perceived as shareholder interest. In recent years, we have seen a lot about how boards of directors have become less and less independent. They give huge, fat, salaries and bonuses to the top executives, who in turn recommend huge compensation packages for board members who do very little work.

Sometimes, the shareholders themselves actually demanded, directly or indirectly, the very actions that were against their own self interest. They demanded rising stock prices, and gave tremendous bonuses to executives that delivered. This created a climate where single quarterly numbers were far more important than the long term health of the company.

Another cause of Greenspan’s grievous error was a failure to recognize the changing characteristics of securities markets. There was a time when the average investor was at least marginally savvy. Wall Street was controlled by big money financiers. The “little guy” was just on board for the ride. Today, that situation is reversed. The “average investor” is a fool, like me for the most part, who blindly throws money into a 401(k) plan and lets some high priced mutual fund manager take care of it. Once more, we have investors who will reward short term stock price jumps, instead of long term profits, as they might have in the days when paying dividends was considered the hallmark of a valuable stock. In addition to rewarding the wrong things, this created a situation where market discipline simply couldn’t work. We, the current typical investors, simply aren’t smart enough to apply it, until it’s too late.

I’m glad to see Greenspan admit the failure of his ideas, and I hope that others will recognize that this situation needs to be changed.

 

[Travis]

"First, I think he failed to realize that the self interest of corporate decision makers, i.e. executives, was not always in line with the interest of shareholders. Those executives acted to protect their own interests, instead of the interests of their shareholders. Traditionally, this kind of conflict of interest was prevented by an independent Board of Directors, who would look out for shareholder interests, and fire any executive who got out of line with what they perceived as shareholder interest. In recent years, we have seen a lot about how boards of directors have become less and less independent. They give huge, fat, salaries and bonuses to the top executives, who in turn recommend huge compensation packages for board members who do very little work.

Sometimes, the shareholders themselves actually demanded, directly or indirectly, the very actions that were against their own self interest. They demanded rising stock prices, and gave tremendous bonuses to executives that delivered. This created a climate where single quarterly numbers were far more important than the long term health of the company."


Bingo.

Where's all those Anarcho-Capitalists now?

 

[Confuseling]

Market discipline does work. It works just as well as all the other ideas that share its Libertarian heredity. Poor banks will be eliminated, over time. Unless the poor bankers manage to infect the credit ratings agencies (do Libertarians even have those?) and political institutions (erm...) to such a degree as to create a kleptocracy, in which case there's someone in charge and it isn't the Libertarians' fault any more.

Similarly, violence begets violence, and violent people will eliminate one another. Until someone - let's call him Hitler - comes along and takes over the world, because everyone else is too disorganised to resist, and it's our own fault for not being Libertarian enough.

1... 2... 3...

 

[shadron]

The problem with the maket discipline theory is not that it doesn't work - we're seeing it take action, now, with a vengence. What the problem seems to be is the amount of time that has to pass between the action and its correction. No one understood what the effects of mingling poor debt with other debt and packaging it as securities would have; when it started to become known, it was too late, - there was too much of it out there. With the best communications in the world it still took 10 years to come to grips with the effects.

Regulation may or may not fare better. If the regulators are thoughful and analytic, they might be able to shorten the time, simply because of their ability to effect change very quickly, much faster than the nebulous market discipline can. But they have to be smart and forward looking. Greenspahn admits his training lead him astray - if that's true, then, how would regulators have done better?

 

[egslim]

The problem with the maket discipline theory is not that it doesn't work - we're seeing it take action, now, with a vengence.

Except that it takes the shotgun approach - hurting everyone, almost regardless of guilt.

 

[Francesca R]

Except that it takes the shotgun approach - hurting everyone, almost regardless of guilt.

As such, it has taken the form of a (nasty) market externality, which is a bona-fide reason for government intervention ahead of time, which we now know obviously wasn't done effectively. Tighter restrictions on leverage, and enforcement against excess leverage (none of this needed now but during the next boom in whatever) are the likely primary regulatory changes IMO.

 

[Meadmaker]

The problem with the maket discipline theory is not that it doesn't work - we're seeing it take action, now, with a vengence.

Greenspan's phrase to describe his own state of mind was "shocked disbelief". He was certain that this couldn't happen. He expected market discipline would prevent it. He was wrong, and he admitted it.

If you listened to his testimony, though, you might notice he didn't give up the idea entirely, nor should he, IMHO. His proposed cure was to make sure that financial institutions were even more tightly bound to the fundamentals that ought to drive the market. This would be accomplished by forcing institutions to buy their own securities.

It seems like a good idea, but it won't work unless there is some way to ensure that the personal fortunes of the decision makers, i.e. the CEOs and other executives, are directly tied in to their companies' performance. Sadly, that isn't the case today. I'm willing to bet that the CEOs who drove their companies to ruin still have bigger homes than I have.

 

[The Central Scrutinizer]

Sometimes, the shareholders themselves actually demanded, directly or indirectly, the very actions that were against their own self interest. They demanded rising stock prices, and gave tremendous bonuses to executives that delivered. This created a climate where single quarterly numbers were far more important than the long term health of the company.

Bingo, bingo, bingo.

Mr. Buffett has spoken out about this for many, many years. Which is partly why Berkshire never gives guidance.

 

[Meadmaker]

No one understood what the effects of mingling poor debt with other debt and packaging it as securities would have; when it started to become known, it was too late,

I want to amplify something I said earlier in regard to shadron's quote. I think this fails to see the import of Greenspan's comments. The point of Greenspan's comments was that he thought he did understand what would happen. What should have happened, according to the theory, was that such mingling would have driven down the price of those securities substantially. Financial institutions weren't supposed to purchase them, or if they did, it should have been at a very low price. That's what market discipline was supposed to be all about. It is true that the advocates of the market discipline theory did not understand the effect of such packaging, but they thought they did.

If those high risk mortgage backed securities had been priced as high risk instruments, none of this would have happened. Sadly, that wasn't the case. The market failed to exercise the predicted market discipline.

 

[Tumblehome]

The theory went that financial institutions did not need regulators telling them what to do, because the market would keep them in line. If they made bad decisions, equity investors would drop them like a hot rock, and they would suffer.

I can see that this would work if only one bank operated improperly, but this crisis happened because most, if not all, banks were in on it. If the whole system is rotten, it can't manage itself.

 

[balrog666]

I want to amplify something I said earlier in regard to shadron's quote. I think this fails to see the import of Greenspan's comments. The point of Greenspan's comments was that he thought he did understand what would happen. What should have happened, according to the theory, was that such mingling would have driven down the price of those securities substantially. Financial institutions weren't supposed to purchase them, or if they did, it should have been at a very low price. That's what market discipline was supposed to be all about. It is true that the advocates of the market discipline theory did not understand the effect of such packaging, but they thought they did.

If those high risk mortgage backed securities had been priced as high risk instruments, none of this would have happened. Sadly, that wasn't the case. The market failed to exercise the predicted market discipline.

Except when 1) the mingled debt is given the explicit backing of the US Treasury via GSE's Freddie and Fannie and 2) deliberately overrated by bond insurers, securitizers, and brokers to sell them.

 

[dudalb]

The Classic example of a Board of Directors becoming a rubber stamp for CEO was Disney during the last decade of the Eisner years. Eisner managed to pack the board with what abounted to toadies for him. It was not until Roy Disney resigned from the board that stockholders begun to see what was going on.
To be fair, I don't think Eisner (unlike some CEO's) was out to feather his own nest at Stockholder's expense. I think with him it was a case of pure ego and the idea He Was Always Right.

 

[YoPopa]

Market discipline does work. It works just as well as all the other ideas that share its Libertarian heredity.

Sterling bit of logic there. Makes one wonder how all those Libertarians ever managed to get elected when there were Democrats & Republicans running for office.

 

[SaulOhio]

He shouldn't have been shocked by these events. It is exactly what he said happened in 1929, when he wrote his article Gold and Economic Freedom.

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World Was I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline-argued economic interventionists -- why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely -- it was claimed -- there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks ("paper reserves") could serve as legal tender to pay depositors.

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage.

That is precisely what he did after the collapse of the tech bubble, in order to stimulate the economy, and what Bernanke is doing now.

More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates.

The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market -- triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's.

If he does exactly what he said caused the Great Depresion when he was still an associate of Ayn Rand, why is he shocked that the same kinds of actions are causing the same kind of problems now?

 

[KoihimeNakamura]

Because he could have been wrong then and the cause not what you think it was?

 

[SaulOhio]

I can see that this would work if only one bank operated improperly, but this crisis happened because most, if not all, banks were in on it. If the whole system is rotten, it can't manage itself.

Not all banks.

And this is really interesting: There is a bank, BB&T, whose CEO is an Objectivist. This bank has not failed. In fact, it is doing very well. It minimized its involvement in the subprime market, and they now have plenty of money to lend, and the company's stock is remaining stable, while everyone else's is tanking.

 

[Almo]

The arrival of more gold standard discussion means my departure from the thread. Very interesting points, Meadmaker!