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Thursday, October 9, 2008

Derivatives and the Greenspan legacy

In light of the recent tumultuous events, the NYT has a "hard new look" at the Greenspan legacy. One of the most appropriate testimony to the legacy comes from this graphic capturing the five fold increase in the global market for derivates, an instrument that Frank Partnoy describes as the "centerpiece of the crisis". Greenspan, with an almost missionary belief in the ability of financial markets to self-regulate, had fierecely opposed any regulation of these instruments, variously described as "hydrogen bombs" by Felix Rohatyn and "financial weapons of mass destruction" by Warren Buffet, even when it became clear that they were capable of causing uncontrollable damage. Derivatives were created as a risk management tool, to hedge against investment losses.



The moral of the story, in financial markets, there cannot be any "oracles"!

Update 1
Finally, the "oracle" himself admits to a judgement error in regulation, wherein 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. Mr Greenspan, who presided over the Fed for 18 years till he stepped down in January 2006, noted that the immense and largely unregulated business of spreading financial risk widely, through the use of exotic financial instruments called derivatives, had gotten out of control and had added to the havoc of today’s crisis. Mr. Greenspan’s critics say that he encouraged the bubble in housing prices by keeping interest rates too low for too long (Fed slashed interest rates to nearly record lows from 2001 until mid-2004) and that he failed to rein in the explosive growth of risky and often fraudulent mortgage lending.

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