Did the lesson of 1994 lead to the Credit Bubble of 2004-2007 and the subsequent Credit Crunch?

Alan Greenspan, the Fed Chairman in 1994, was a completely different persona than Alan Greenspan, the Fed Chairman in 2004.

Greenspan raised rates several times in 1994. He raised them unpredictably and in large increments. The financial markets, especially the bond markets, were totally unprepared for the decisiveness and the ferocity of the rate hikes. Treasury yields exploded upwards and Nasdaq stocks got creamed. For example, Cisco, the premier technology stock of that era, collapsed from 37 to 19 in one quarter. Later in 1994, James Carville, adviser to President Clinton moaned  that he wanted to reborn as the Bond Market in his next life.

I remember buying a Two Year Federal Home Loan Bank Structured Note in February 1994 because it paid 75 basis points (0.75%) above the rolling Three-Month Treasury Bill rate. Understand that this note was supposed to benefit me as Greenspan raised interest rates, because, every quarter, I would receive 75 basis points over the new and higher Three-Month T-Bill Rate.

Suppose, Shmapose! This note, issued at 100 in February 1994, traded at 90 in December 1994. This was because the speed with which Greenspan raised interest rates was far higher than what the structure of the note had envisaged.

This is exactly the sort of investment that led to the bankruptcy of Orange County, California in late1994. I survived because I had bought the notes with cash, while Orange County did not because it had bought these notes with substantial leverage (borrowed money).

Greenspan had not intended to cause the financial carnage that resulted from his fast and unpredictable rate hikes. He learned what happens when you surprise financial markets.

Greenspan remembered this lesson of 1994 when he began raising rates in 2004. The economy was emerging from a tech-telecom bust and most experts expected a tepid recovery at best. Greenspan did not want his rate hikes to cause market turmoil and so he decided to become predictable. Alas! He became totally predictable.

The markets understood that Greenspan was going to raise 25 basis points at every fed meeting. Such predictability can be easily modeled. Predictable models are basis of leverage. The greater the predictability, greater the leverage (borrowed money) that can be used.

Thus began the credit explosion in 2004. It went up and up in 2005, 2006 an into early 2007 when lenders lent and investors borrowed against any and every asset of any and every quality (or lack thereof) they could find. Structured Notes proliferated first, then came CDOs (packages of Notes, Loans and Mortgages) and finally came CDO-Squared (packages of CDOs). The party was on and in President Bush’s words “Wall Street got drunk”. Actually, homeowners, investors, mortgage brokers, insurance companies and banks, they all got drunk. America is now living through the hangover and it is very painful.

In 2004, Greenspan re-fought the battle of 1994.  The results were just as long-term in nature. Thanks to the strong medicine of 1994,  an era of sustained disinflationary prosperity began in 1994 and lasted until 1998. The weak, mellow and soft policy of 2004 led to the formation of the credit bubble in 2006-2007. We are living through the bursting of this bubble via a severe credit crunch.

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