Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (20 page)

The investment banks had gone beyond underwriting and now acted as an alternative source of credit. They expanded their balance sheets, leveraging the capital that stood behind their solvency. They were extending more credit to the brokers and hedge funds that were buying the profitable derivative products created by the investment banks.

Bear Stearns was one investment bank that lent to speculating hedge funds. William Michaelcheck, a senior managing director of the firm, analyzed the market: “We think that there has got to be $100 billion to $200 billion of this right now, of investment partnerships, going from the biggest to the smallest, buying one-, two-and three-year Treasuries and financing them day to day, speculating on interest rates. And the people who have done this over the past year have made a fortune.”
¹⁷

Michaelcheck was quoted in October 1991, when the funds rate was 5¼ percent. Fortune making grew in magnitude, and apparent ease, as the Fed lowered the funds rate to 3.0 percent a year later. It would sit at 3.0 percent until February 1994, when it was raised to 3¼ percent.

There are no margin requirements in the government bond market.
¹⁸
If the lender is willing, the borrower’s leverage is unlimited. In
The Trouble with Prosperity
, James Grant tells of meeting with an investor who had earned $300,000 over the previous weekend. Every dollar contributing to this return had been borrowed—all $769 million of them.
¹⁹
This was to be known as the “carry trade.” Speculators borrowed at a cheap rate—such as a Treasury bill, yielding 3 percent. They bought higher-yielding securities, such as Japanese government bonds that yielded around 6 percent. They expected (or hoped) that the borrowed asset would not rise in price. They leveraged the 3 percent spread at 10:1 or 100:1. Up to the present, the carry trade has funded fortunes in New York, London, Tokyo, and Shanghai. The securities that were borrowed and lent would change, but the strategy did not. This was another reason that central banks had less influence than they had during the chairmanship of William McChesney Martin. Financial flows were channeled away from funding potentially profitable enterprises. The FOMC’s calibration of interest rates could not keep pace with the evolving motivations of borrowers.

¹⁵
Federal Reserve Flow of Funds Accounts Z.1, http://www.federalreserve.gov/releases/
z1/Current/data.htm.
¹⁶
Federal Reserve Flow of Funds Accounts Z.1
¹⁷
Grant,
The Trouble with Prosperity
, p.191.
¹⁸
Ibid., p.187.
¹⁹
Ibid.

Congress did not quibble. Maybe it did not understand the economy was bound together with leveraged finance. In any case, it had reason to keep quiet: the federal deficit rose from $155 billion in Ronald Reagan’s final year of service to $290 billion in 1991.
²⁰
Demand for Treasuries from speculators held the cost of government borrowing down. (In 1991, longterm Treasury yields fell from 8.3 percent to 7.3 percent.)

How Can One Save?

Americans are admonished for not saving, but it was difficult to save when being propelled along the roller coaster of volatile interest rates, inflation, and the stock market. During the 1970s, the middle class had been jarred by inflation. As the Federal Reserve loosened its monetary policy in the early 1990s, interest rates fell across the spectrum of maturities. An investor might have been too frightened to step into the stock market during the 1980s (memories of the 1966–1982 swoon remained vivid) but could earn 13 percent on a certificate of deposit.
²¹
By 1992, CDs yielded only 4 percent. In 1990, food prices rose at the fastest rate since 1980.
²²
Saving looked more and more like the losing proposition of the 1970s.

²⁰
research/stlouisfed.org/fred2/data/FYFSD.txt.
²¹
Maggie Mahar,
Bull! A History of the Boom, 1982–1999
(New York: HarperBusiness,

2003), p. 114.
²²
Food and beverage inflation was 4.6 percent in 1990; www.bls.Gov/opub/ted/1999/
Jun/wk5/art01.txt.

This does not seem like the time the population at large would embrace the stock market. The recession led to a slowing of consumer borrowing, yet net cash flows into stock mutual funds rose from $8 billion in 1985 to $13 billion in 1990 to $79 billion in 1992 and to $127 billion in 1993. In 1992 and 1993, money market funds suffered net outflows.
²³
The stock market was about to replace the bank deposit system (and money market funds) as the backbone of household wealth.

The Recovery: Cutting Workers and Investment

The economists declared the recession was over in March 1991, but there was little evidence of a recovery. Moreover, the large layoffs that followed were different from previous recessions; now, management was dismissed en masse. When 70,000 workers were laid off from General Motors in December 1991, CEO Robert Stempel announced that GM’s salaried workforce (that is, management) was being cut from 140,000 in 1985 to 70,000 by 1995.
²⁴

The median household income fell from $46,670 in 1989 to $44,665 in 1994. It would start to rise again, but this was not much above the $43,677 median income in 1973.
²⁵
More important than the data were the mass firings that made a “career” seem more a wish than a pursuit.

Layoffs and capital spending reductions had a salutary effect on companies that had bulked up on debt in the 1980s. Squeezing costs to raise profits may be just what any one company needs. When applied across the economy, however, the capacity for real economic growth withers. This recovery lacked investment in capital equipment.

On December 19, 1991, GM announced that it would cut $1.1 billion from its previous 1992 capital spending plans. Coincidentally or not, Chairman Greenspan spoke on the same day. He declared that “the essential shortcomings of this economy is [
sic
] the lack of savings and investment… . Investment is the key to enhanced productivity and higher living standards.”
²⁶

²³
Investment Company Institute, “Mutual Fund Assets and Flows in 2000,”
Perspective
, February 2001.
²⁴
Levin, “General Motors to Cut 70,000 Jobs; 21 Plants to Shut.”
²⁵
U.S. Census Bureau,
Current Population Reports, Consumer Income
, p. 41, Table A-3.

That depends on where you sit. “Shareholder value” was paying off. Corporate profits fell 21 percent during 1991, a year in which the S&P 500 rose 31 percent.
²⁷
The winnings were rising to the top. The CEOs of the largest 100 companies in America received an average of $2.63 million from grants and options in 1991 when their companies were losing money as if it was 1932.
²⁸
In 1976, a CEO had been paid 36 times the average worker’s salary. In 1993, average CEO pay was 131 times that of the average worker.
²⁹

The Cock Crows: Greenspan Pricks the Bubble

Alan Greenspan gave a clear warning that the carry trade was coming to an end. On January 31, 1994, before the Joint Economic Committee, he stated “Short-term interest rates are abnormally low in real terms”
³⁰
It was no secret that the borrow short and lend long strategy had refinanced the banking system. By early 1994, banks were liquid and lending.

The Fed raised the funds rate from 3.0 percent to 3.25 percent on February 4. This was the first of several increases, the consequence of which was the most traumatic financial convulsion since the 1987 crash. Margin calls drove prices lower, prompting more margin calls and more selling. Longterm Treasury yields rose from 6.3 percent in January to 8.0 percent in December 1994.

Greenspan may not have anticipated how derivatives had leveraged the financial system. Still, he could not have been completely surprised by the deleveraging. At the December 1993 FOMC meeting, Federal Reserve Governor Lawrence Lindsey warned: “[W]e all agree that the 3 percent [funds] rate is unsustainable. We all know we always act too late.”
³¹
Lindsey talked about a rush into $1 million home mortgages since, at current interest rates and forthcoming tax rates, this was “like borrowing money free for 30 years.”
³²

²⁶
“Excerpts from the Fed Chief ’s Testimony,”
New York Times
, December 19, 1991.
²⁷
Steve Lohr, “Recession Puts a Harsh Spotlight on Hefty Pay of Top Executives,”
New York Times
, January 20, 1992.
²⁸
Ibid.
²⁹
Joann S. Lublin and Scott Thurm, “Behind Soaring Executive Pay—Decades of Failed Restraints,”
Wall Street Journal
, October 12, 2006.
³⁰
Beckner,
Back from the Brink
, p. 348. Greenspan was testifying before the Joint Economic Committee, January 31, 1994.

On a February 28, 1994, FOMC conference call, Chairman Greenspan declared: “I think we partially broke the back of an emerging speculation in equities. … We pricked that bubble [in the bond market] as well. … We also have created a degree of uncertainty; if we were looking at the emergence of speculative forces, which clearly were evident in very early stages, then I think we had a desirable effect.”
³³

The Fed raised the funds rate from 3.25 percent to 3.5 percent on March 22. On an April 18 FOMC conference call, the chairman ventured: “[T]he sharp declines in stock and bond prices since our last meeting, I think, have defused a significant part of the bubble which had previously built up. We let a lot of air out of the tire, so to speak.”
³⁴
The Fed, Greenspan believed, could not stop here: “While we have defused a goodly part of the bubble, we have an awful lot left in there.”
³⁵
The need to defuse was so compelling that the FOMC decided to raise the funds rate from 3.50 percent to 3.75 percent during the call, rather than wait until the next meeting.

At the May 17 FOMC meeting, the chairman decided to tighten again: “[W]e have taken a very significant amount of air out of the bubble. … I think there’s still a lot of bubble around; we have not completely eliminated it… . [T]he only way we’re going to pierce it is essentially to create a degree of uncertainty… . [W]e have the capability I would say at this stage to move more strongly than we usually do.”
³⁶
The FOMC voted to raise the funds rate from 3.75 percent to 4.25 percent.

³¹
FOMC meeting transcript, December 21, 1993, p. 28.
³²
Ibid., p. 27.
³³
FOMC meeting transcript, February 28, 1994, p. 3.
³⁴
FOMC meeting transcript, April 18, 1994, p. 7.
³⁵
Ibid., p. 9.
³⁶
FOMC meeting transcript, May 17, 1994, p. 32.

At the August 16 meeting, Greenspan expressed satisfaction: “I think we clearly demonstrated that the bubble for all practical purposes has been defused.”
³⁷
The FOMC raised the funds rate another 0.50 percent at this meeting, to 4.75 percent. (It would follow with two more rate increases, to 6.0 percent, by February 1, 1995.)

Greenspan was also forthright in public. On May 27, 1994, he told Congress that depositors had shifted their money out of banks and from money market funds into stocks and bonds, “and some of those buying the funds perhaps did not fully appreciate the exposure of their new investments to the usual fluctuations in bond and stock prices.”
³⁸
The Federal Reserve chairman was obviously well versed in the novice investor’s exposure to unfamiliar territory.

Derivative Lessons

Greenspan witnessed derivative mayhem when he raised the funds rate from 3.00 percent to 3.25 percent. Askin Capital Management was a $600 million hedge fund that lost all of its money by April 7, 1994.
³⁹
The Piper Jaffrey Institutional Government Income Portfolio lost 28 percent of its principal.
⁴⁰
It happened that 93 percent of the Piper Jaffrey fund was invested in mortgage derivatives called collateralized mortgage obligations (CMOs). The mortgages were all rated AAA because the government backed them.
⁴¹
This would not be the last time derivative strategists and their models sank the ship by misestimating the risks of AAA rated mortgage securities.

Companies groping for shareholder value included Air Products and Chemicals (which lost $113 million) and Dell Computer (which lost $35 million).
⁴²
Securities and funds sold by NationsBank, Fidelity Investments, the Vanguard Group, Fleet Financial, and United Services Advisors suffered unexpected losses.
⁴³

³⁷
FOMC meeting transcript, August 16, 1994, p. 32.
³⁸
Beckner,
Back from the Brink
, p. 365.
³⁹
Frank Partnoy,
Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
(New York: Henry Holt, 2003), p. 128.
⁴⁰
Ibid., p. 130.
⁴¹
Ibid., p. 122.
⁴²
Ibid., pp. 114, 136.

Financial derivatives were born to serve a need—to hedge the currency and interest-rate risks of companies. As the market grew, they served desires. Instead of hedging, companies often speculated. Banks were willing to help. Derivative sales were very profitable. Between 1990 and 1993, Merrill Lynch earned more than $3.1 billion, topping the total profits of its previous 18 years as a public company. Over $100 million of its 1993 earnings were from derivative sales to a single client: Orange County, California, which lost $1.7 billion on the trades and filed for bankruptcy.
⁴⁴

Congress Trusts Greenspan, Ignores Soros

Congress held hearings on the derivatives maelstrom in April 1994. George Soros appeared before the House Banking Committee on April 13. Soros was the one hedge fund manager who was famous, and would have been known to Congress. He told the legislators: “There are so many [new financial instruments], and some of them are so esoteric, that the risks involved may not be understood even by the most sophisticated investors.”
⁴⁵