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For those of you that repeated the Bill Gross' (PIMCO) assertion that the
markets believe Greenspan has effectively created a floor underneath it
(sort of a government guaranteed put option) and for those of us that
believed it (including me), AG would like to dissuade us of that notion:
Greenspan: Fed is not a rescuing angel
MARKET SELL-OFF
Saturday, April 15, 2000
Washington -- Financial institutions shouldn't rely too heavily on
risk-management tools to avoid losses, and the Federal Reserve isn't
prepared to always bail out lenders when investors panic and markets
collapse, Fed Chairman Alan Greenspan said.
While the Fed can be expected to help stabilize markets, it can't be
expected to ''protect against all potential adverse loss outcomes,''
Greenspan said Friday in a speech to an American Enterprise Institute
conference. ''Financial institutions should expect to look to the central
bank only in extremely rare situations.''
Improved and more complex risk-management devices by banks and other
financial companies aren't likely to avoid panic-driven losses, he said. As
a consequence, financial companies should boost their reserves to weather
market declines, he said. Reserves may seem a poor use of available cash,
but ''so do fire insurance premiums --- until there is a fire,'' he said.
Financial panics will occur because diversification, while it can reduce
risks, ''cannot alter the more deep-seated uncertainties inherent in the
human evaluation process. There is little in our historical annals that
suggests that human nature has changed much over the generations,''
Greenspan said.
That's why financial institutions and regulators must be prepared for
extreme situations.
''We have chosen capital standards that by any stretch of the imagination
cannot protect against all potential adverse loss outcomes,'' he said.
''There is implicit in this exercise the admission that, in certain
episodes, problems at commercial banks and other financial institutions,
when their risk-management systems prove inadequate, will be handled by
central banks.''
Stocks plunged Friday, with the Dow Jones industrial average falling 5.7
percent and the Nasdaq composite index falling 9.7 percent. Economists said
Greenspan probably wasn't speaking directly about stock prices.
''I would suspect this is just a coincidence,'' said Pierre Ellis, senior
economist at Primark Decision Economics in New York. ''This doesn't seem to
be a new theme for him. I suspect he's very reluctant to comment on stocks
in this environment.''
Greenspan said risk-management systems must account for the sheer panic of
investors in highly volatile markets. In such scenarios, ''disengagement is
the normal protective reaction,'' and investors will stop differentiating
between investments carrying varying degrees of risk and choose, instead, to
invest in low-risk securities, such as U.S. government bonds, he said.
The implications of that behavior for risk management tools are
''significant,'' Greenspan said. Portfolio diversification, a frequently
used risk-management strategy, will lose its effectiveness. ''At a minimum,
risk managers need to stress test the assumptions underlying their models
and consider portfolio dynamics under a variety of alternative scenarios,''
Greenspan said.
''Although information technology by its very nature has lowered risk, it
has also engendered a far more complex international financial system that
will doubtless bedevil central bankers and other financial regulators for
decades to come,'' he said. ''Clearly, to choose the distribution of
risk-bearing between private finance and government is to choose the degree
of moral hazard.''
IMHO:
While Greenspan has moved to save the markets from cataclysmic crashes in
the past and will do so in the future, I don't know and I don't believe that
anyone including Greenspan know what the "floor" under the market is. It
definitely isn't the value of a particular index.
I believe this is what Greenspan means when he says he will only move to
stop a market crash "in certain episodes". In previous speeches, he has
said that these episodes occur when the markets are "disorderly".
Disorderly to him seems to mean when market supply grossly exceeds demand
(due to panic) AND that imbalance causes normal markets to fail (since
buyers effectively remove themselves from the market).
Is there anything of value in this opinion to a Real Trader? For me, it
means last weeks action is nothing that Greenspan is losing sleep over. In
fact, I believe that Greenspan will continue to raise interest rates until
unemployment rises. Greenspan's biggest focus recently has been the
shortage of labor in the US. He will allow the markets to go to hell as
long as it is an "orderly" going to hell. He will only pause in raising
interest rates
1. when the elections get near (hey, even the Fed Chairman has to be
politically aware), but then continue raising them after the elections
OR
2. when it appears that unemployment is rising.
My question for any RTs that have made it this far and are willing to
respond:
What does Greenspan mean when he says "Portfolio diversification, a
frequently used risk-management strategy, will lose its effectiveness."
Diversification has been a central theme of my strategy. This one has got
me stumped.
PS: No disrespect intended to those who repeated Bill Gross' assertion.
Bill Gross and the people who repeated his assertion have far more
experience and success in the markets than I have. However, as we sometimes
forget, not every trade that we make or every opinion that we believe is
accurate or profitable.
My two cents (at least I got one of them by shorting last week)
Ross Kovacs
rossrk@xxxxxxxxxxxxxx
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