Way before the potential for a credit crisis was on anyone’s radar, American investment guru Warren Buffet dubbed derivatives, the complex financial contracts that are claimed to be the culprit of the collapse, “financial weapons of mass destruction.” Felix Rohatyn, a former U.S. ambassador and a central player in the 1975 plan that saved New York City from bankruptcy, described derivatives as potential “hydrogen bombs.”
One economic titan, however, felt differently. And as head of the world’s most influential economic institution, his views carried a lot of weight. I am talking about Alan Greenspan, Chairman of the Federal Reserve from 1987 to 2006. Greenspan had deep affection for deregulation. To him, the powerful financial institutions that (used to) populate Wall Street had a very large interest in ensuring that all of their assets were protected and that they had the resources in place to make sure all the investments they made were sound. While defending derivatives during a hearing in 2003, Greenspan said: “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.”
In 2000, after years of pushing and shoving, Greenspan persuaded Congress to pass the Commodity Futures Modernization Act, the bill that removed derivatives from the purview of federal oversight. The derivatives market thereafter grew from $100 billion to more than $50 trillion. Although the housing collapse is often cited as the culprit of the current credit crisis, derivatives are what actually made our financial system vulnerable. Originally intended to reduce risk and spread prosperity, derivatives instead magnified the impact of bad mortgages. When homeowners began defaulting on their mortgages, the investment houses did not have enough capital to cover the derivative settlement claims and, as a result, are now in great peril.
In essence, the great debt that the world economy has to now face is the result of an experiment by Greenspan to let the market forces run free. Investment bankers, who collected billions of dollars in bonuses, were selling mortgage securities they thought were safe and derivatives that they thought would never have to be paid off. On the other side of the spectrum were the investors, who were buying credit default swaps that would pay off big when other people’s mortgage investments went south. And with the multitrillion-dollar market in place – no one was there to regulate. No one was keeping track of how many derivatives sold. No one knew who owned them. No one was making sure that the investment houses were setting aside the money needed to pay off their obligations if the mortgages went sour.
On Thursday, while testifying at a Congressional hearing, Greenspan admitted that he had “put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.” Hailed three years ago as “the greatest central banker who ever lived,” the retired Chairman’s legacy will likely be quite the opposite: the man who paved the way to a global credit crisis.