Who predicted the credit crunch abyss?

One year ago, Ben Bernanke got it wrong. But even earlier, another Federal Reserve official was signaling the alarm.


Andrew Leonard
March 18, 2008 9:18PM (UTC)

This is just the kind of thing you love to hear from a senator who sits on both the Senate Finance Committee and the Senate Committee on Banking, Housing, and Urban Affairs.

From the Wall Street Journal, in reference to the quick pace of the Bear-Stearns buyout:

Advertisement:

"When you're looking into the abyss, you don't quibble over details," said New York Democratic Senator Charles Schumer.

That Schumer, he's sure got a way with words. And although he was speaking specifically about just one Wall Street investment bank, the sentiment can easily be expanded to encompass the entire federal response to the ongoing financial crisis. There is a very strong sense that events are forcing the hands of policymakers at this point, and we're all being swept along, if not into an abyss, then very close to the edge. Maybe we should return to Schumer's quote a year from now, and see how well it holds up.

Because, gosh, it's fun looking backward in time to see what some of the key players in the Bear-Stearns drama over the weekend said back in the day.

Almost a year ago, Federal Reserve chairman Ben Bernanke testified to Congress about the state of the economy.

"At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

Ow. Ow. Ow.

But what about the New York Federal Reserve Bank president, Timothy Geithner, who has also been very active in handling the crisis. On Sept. 15, 2006, Geithner gave a long speech titled "Hedge Funds and Derivatives and Their Implications for the Financial System." How the World Works noted it at the time, but it bears revisiting, especially by those who would like to believe that no one could possibly have seen this mess coming.

Some excerpts:

Advertisement:

But probably more important is the fact that even as we have pushed forward on regulatory, supervisory and risk-management efforts, financial markets, instruments and institutions have continued to evolve as well. Among the most notable of these changes has been the rapid growth and innovation in derivatives and the greater relative importance of private leveraged financial institutions, such as hedge funds...

The changes in credit markets that have accompanied the latest wave of innovation in derivatives and the large role played by leveraged financial institutions in those markets may exacerbate some of the traditional sources of challenges in financial markets...

The effectiveness of market discipline in constraining the risk-taking behavior of financial firms, however, may be compromised by the presence of market failures of the type mentioned above. While this issue is at the heart of risk management challenges for the provision of credit more broadly, the rise in the relative size of the private leveraged fund sector and the rise in the importance of new derivative financial instruments may complicate the design of policies and risk-management practices to counteract these traditional frictions...

Understanding and evaluating "tail events" -- low probability, high severity instances of stress -- is a principal, and extraordinarily difficult, aspect of risk management. These challenges have likely increased with the complexity of financial instruments, the opacity of some counterparties, the rapidity with which large positions can change, and the potential feedback effects associated with leveraged positions...

The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by and complicate the management of very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the large ones.

A long speech and a subtle one, full of nuance. And unlike many other analyses of the economy over the past few years, it has not suffered one whit from the passage of time.


Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

MORE FROM Andrew LeonardFOLLOW koxinga21LIKE Andrew Leonard

Related Topics ------------------------------------------

Ben Bernanke Globalization How The World Works U.s. Economy

BROWSE SALON.COM
COMPLETELY AD FREE,
FOR THE NEXT HOUR

Read Now, Pay Later - no upfront
registration for 1-Hour Access

Click Here
7-Day Access and Monthly
Subscriptions also available
No tracking or personal data collection
beyond name and email address

•••






Fearless journalism
in your inbox every day

Sign up for our free newsletter

• • •