Ms. Watkins, why does Charlie have lit dynamite?

You are a teacher at a local primary school. Each school day you and some of your colleagues watch over the children at the school playground to make sure all of the children follow the rules and keep their hands to themselves. Your role is to keep the children safe. Mind you, this is a Montessori School where the philosophy is to let children explore within set boundaries.  But, if a child hurts another or a child’s behavior poses an immediate risk to others, you always step in.

In fact, one child, Charlie has been a bit of a problem recently. Charlie is one of the biggest kids at the school, a boisterous sixth grader who likes to push and play with matches. Last July 4th, it seems he got a hold of a video on the Internet blog Credit Writedowns on how not to use fireworks.  Contrary to the video’s intention, he rather liked seeing things blow up and courting danger. You see Charlie is a bit of a pyromaniac. You have repeatedly had to stop Charlie from bringing matches to the playground and lighting things on fire. But, recently you have had to confiscate firecrackers and suspend him from school.

But, one day a new headmaster comes to the school. He doesn’t believe much in the need for teachers to monitor the children. The children can monitor themselves. Unfortunately, Charlie has a bit of a following at school and before you know a lot of the kids are lighting firecrackers on the schoolyard. No one gets seriously hurt – just a few minor burns here and there. So Charlie ups the ante to M-80s like he saw in the video. There was a serious close call when he put the frog in a jar with the M-80, but self-monitoring has worked pretty well and there have still been no major casualties.

That’s when little John comes up to you and asks, “Ms. Watkins, why does Charlie have lit dynamite?”

In case it’s not obvious:

  • Charlie is a too big to fail bank.
  • The matches are debt, the firecrackers are derivatives, the M-80s are asset-backed securities and the dynamite is OTC derivatives.
  • You (Ms. Watkins) are Brooksley Born
  • The headmaster is Alan Greenspan
  • Little John is another smaller community bank
  • The other children are banks and citizens of the broader economy
  • The frog-glass incident was LTCM’s collapse
  • The lit dynamite incident was Lehman Brothers

In the past, I have likened regulators to referees or playground monitors to illustrate why the concept that markets are self-regulating is absurd. In the last post, “Frontline – The Warning: Who Knew About the Looming Financial Crisis?” Alan Greenspan was at war with regulator Brooksley Born over this concept of self-regulation. Born believed that regulation was a necessity in any financial market. Greenspan believed that markets are inherently self-regulating. Even fraud was self-regulating through market discipline in his view. I believe he has now repudiated this. However, Born lost that battle with ugly consequences when the market she wanted regulated, OTC derivatives, blew up via AIG.

Self-regulation is to regulation as self-importance is to importance.

Note: Even though, I am pointing to Buiter’s piece here, I am not a believer in regulation-heavy in the least. Nevertheless, his ideas do merit consideration.

Print Friendly
Tweet about this on TwitterDigg thisShare on Reddit0Share on StumbleUpon0Share on Facebook0Share on LinkedIn0Share on Google+0Buffer this pageEmail this to someone
This entry was posted in Banking industry, Derivatives, Doomsday scenarios, Federal Reserve, Free markets and their discontents, Guest Post, Regulations and regulators on by .

About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com

18 comments

  1. Observer

    Great post! I think the old version of Headmaster Alan Greenspan, before his recent enlightment, might have reasoned as follows, “But Teacher Brooksley, don’t you see? If Charlie were doing something dangerous, he would already have blown himself up by now. So logically, it’s impossible that he is doing something dangerous.” This kind of reasoning flows from the assumption that we are already at an equilibrium state.

  2. Frank T.

    One point I would disagree on. Greenspan was not the headmaster — he was head of another school, and improperly interfered with Ms. Watkins efforts to supervise the children. On top of that, he allowed the schoolyard bullies to steal the other childrens’ lunch money. He has since gone on the lecture circuit shere he commands handsome speaking fees regaling audiences with fond reminiscences of bullies in the schoolyard and their clever antics/

    1. Edward Harrison Post author

      Good point; the analogy only works so far. Also, Greenspan was headmaster before Ms. Watkins arrived on the scene. But, for the most part it fits well. What I didn’t mention but a commenter on the last post did is that Greenspan felt even fraud could be self-regulated. That is fairly stunning.

  3. gruntled

    One of the most amazing parts of that Frontline piece on Brooksley Born comes near the beginning. Greenspan was against regulations even when it’s apparent that there is outright fraud involved. And now he comes and tells us he was wrong!

  4. Jesse

    They are trying to paint Greenspan as some ideological crank. He was just a tool.

    What about the hundreds of millions the banks spent in lobbying to have Glass Steagall repealed, led by Sandy Weill?

    Where was Robert Rubin while Charlie was playing the dynamite? Oh yea, it was Bob’s backers that sold it to him.

  5. Frank T,

    Further question. A grownup (Greenspan) has it brought to his attention that children are bringing explosives to the school. He does not pick up the phone and call the police, or even school security. Instead, he has a long lunch and discusses the free market.

  6. mock turtle

    greenspan saying the free market could self regulate and deal with fraud…executive action not required

    is kinda like saying the free market can deal with bank robbery…police not required

    (ie investors ( and depositors) will note the banks that experience more heists and move their investments and deposits to safer banks…just let the bank robbers go on)

  7. csissoko

    Another issue that Frontline and many others fail to note is that Born’s Concept Release did not actually propose regulating over the counter derivatives. All it proposed was that regulators gather enough information about the market to determine whether or not regulation was necessary.

    The opposition she faced under these circumstances was simply inexcusable. The “regulators” took the position that didn’t even want to gather enough information to understand what it was they were supposed to be regulating. They wanted to fly blind.

    The concept release is available here: http://www.cftc.gov/opa/press98/opamntn.htm

  8. vlade

    I’m curious. Can OTC derivative opponents specify why exactly are ALL OTC derivatives wrong? I’d like to point out that lots of FX options (and even some futures) trade OTC (they do trade on exchanges, but are highly illiquid). IR swaps I’d classify are relatively harmless despite the recent post about Jefferson county- were they really vanilla IR swaps? These don’t tend to blow up just because your credit rating does. I suspect either non-govt repos (ala Orange County) or total return swaps.
    The former is margin lending, the latter should be banned outright (the only purpose TRS can server is balance sheet/funding arbitrage, neither of which I consider that great).
    There is a number of dangerous derivatives – CDSes, TRSes, quantos (used by funds which are contractually obliged not to have exposure to some currency to get exposure to the “forbidden” market) etc.. But even exchange traded FX futures can be extremely dangerous to the SMB clients – the margin calls can kill them (due to cashflow problems), even if their hedge is theoretically (if you fill all margin calls) perfectly ok.

    But there are perfectly valid OTC derivatives which, even with extreme events, are unlikely to generate huge losses.
    Say the IR swaps. If someone got 1bn notional 5 year swap at say 5% as fixed payer, the maximum they can lose is 250mil – if the rates go suddenly to 0 (1bn*5%*5yr*1 – 1 is for discount factor). If they are floating payer, and fixed at 5%, the LIBOR rates would have to go to 25% for them to lose the equivalent of notional. If the rates are that high, the fact that they have this huge swap is the last of their problems (and likely inflation is going to erode it pretty quick). So yes, you can ramp up big losses, but not catastrophic (unless, of course, you went to the bank with say only 250mil in assets in the first place. But how is that different from geting a NINJA loan for 500k on income of 20k?).

  9. Big Guy

    Actually, you can make a pretty solid case that Greenspan actually did have it right. And despite the current Potemkim village stock market, the real economy is just getting started in correcting all the excesses that ‘regulation lite’ policies gave rise to. Doesn’t make him wrong, just arrogant and most especially, evil.

  10. fresno dan

    Just to be the turd in the punchbowl, while I no doubt Greenspan was a big problem, there is that little problem that while he was keeping rates low and on the “committee to save the world” and was the “maestro” everybody was rooting him on.

    It seems to me that there is still the desire to believe that low interest rates solve everything – soon we will giving everyone a thousand, than 100 thousand, than a million. But funny thing, a beer will cost 1,720$.

  11. Siggy

    “Warning”, which appeared on Frontline last night is an infromative piece of journalism. I was generally aware that Born was stymied by Greenspan, Rubin and Summers. I was unaware the Greenspan was of the view that financial fraud did not have to be prosecuted.

    I see that view as a propensity to favor financial anarchy. It also helps me to understand how the several bubbles have come and gone and where the core of the problem lies. It is a confluence of greed, an abandonment of social responsibility, an abandonment of personal responsibility and the complete corruption of the political system that have brought about this great recession. The factors of greed and irresponsibility flow out of a fiat currency and a fractional reserve banking system that have worked to destroy the purchasing power of the currency. A 1914 dollar has, today, the purchasing power of a nickel. That’s compound rate of loss in purchasing power of slightly more than 3%. Or, the price of everything effectively doubles in 24 years. I bot a car in 1965 for $6,000. I bot a comparable car this year for $24,000. That’s also an approximate compound rate of loss in purchasing power of slightly more thatn 3%. Both cars were and are comfortable and represent equal utility to me. Hedonic price adjustments don’t have application. The percent of income required to support my purchases is about equal. Any adjustment that might apply would do little to alter the fact that the purchasing power of a Dollar today is substantially less than it was in 1965.

    Given that experience, is it not reasonable for the body politic to spend or invest every dollar of income as rapidly as possible? Is it not reasonable for some of the body politic to borrow today, consume and pay tomorrow in dollars that have less purchasing power?

    All of this leads me to the very depressing conclusion that we have lost the Republic to the kleptocrats of the financial services industry. This is a synchronized world recession entirely because the Dollar is a fiat currency and every other currency is a fiat currency. While the government has effectively taken over AIG, it has apparently done nothing about prosecuting what apears to me to have been a massive fraud.

    At the end of the Warning piece there came a very sad moment when Arthur Leavitt made a mea culpa and admitted that he could have done better, he could have made a difference. Mr Leavitt appeared to be near tears and so was I!

Comments are closed.