Fundmastery Blog

Kurt Brouwer March 18th, 2008

In a piece written for the Financial Times, former Fed Chairman Alan Greenspan admitted that the Fed does not always know what is going on. And, he acknowledged that ultimately the markets have to deal with financial problems such as the subprime lending mess.

Mr. Greenspan also tacitly acknowledged that he did not have a perfect — or even a good — model of risk in the housing markets. This then is probably the closest we will come to a mea culpa from the former Fed chairman [emphasis added]:

We Will Never Have a Perfect Model of Risk (Financial Times, March 16, 2008, Alan Greenspan)

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes – those belonging to builders and investors – have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

…The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years.

…The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.

I believe he meant something like this: the models we were using failed because the information that went in was of limited value so the output was not reliable. In computer programming, I believe the phrase is GIGO — garbage in/garbage out.

A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

…In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

He favorably mentions market flexibility and open competition. Good thoughts. The problem of course is that every time we have a financial crisis, the cries for more regulation ring loudly on Capitol Hill. And, more regulation leads to less flexibility and less free and open competiton. Now, it is fair to point out that not all government action is negative and, in fact, at times government has to step in. Case in point — Bear Stearns.

Bear Stearns was, in effect bailed out even though it had prospered through competition, leverage and market action. Fair enough. Another relevant and fair point is that Bear Stearns also died as a result of its mistakes and its shareholders, executives and employees suffered nearly a total loss. So, the bailout of Bear Stearns was not a bailout of its investors, but rather of its customers.

The bailout was a move designed to bolster the stability of the financial system. In this case, financial stability has a specific context and it is well within the Fed’s purview to act. As an example of how significant Bear Stearns was, consider that it was one of only 20 or so firms that deals directly with the U.S. Treasury. Also, it holds securities as a custodian for customers including many individuals, but also corporations, retirement plans, charities and other similar organizations. It is also the prime broker for many hedge funds. In short, the counterparty risk (that is the risk to other entities that Bear Stearns would default on contracts it had guaranteed) was far too high to allow it to fold. There are not many firms whose failure would have a similar impact, so I think the Fed did the right thing.

During Mr. Greenspan’s tenure, he successfully helped the financial markets recover from the Long-Term Capital Management hedge fund’s demise. We owe him a debt of gratitude for that one. So, it is probably a bit unfair to think he should apologize for missing the housing bubble. In any case, this piece is probably as close as we will come to a mea culpa from Alan Greenspan.

Via: Rita Lee

• Economy , Geopolitics , Hedge Funds , Investing , Money , Personal Finance
• Comments(4)

Did you enjoy this article?

• Subscribe to Fundmastery Blog by e-mail »
• Subscribe to Fundmastery Blog's RSS feed