The Man Who Knew: The Life and Times of Alan Greenspan by Sebastian Mallaby

Author:Sebastian Mallaby [Mallaby, Sebastian]
Language: eng
Format: epub
Publisher: Penguin Publishing Group
Published: 2016-10-11T07:00:00+00:00

Twenty-one

THE ZIPSWITCH CHAIRMAN

Orange County, California, is the home of Disneyland—and therefore of the Sleeping Beauty Castle. In late 1994 it became notorious for a fantasy castle of the financial variety. The county treasurer, Robert Citron, contrived to lose an astonishing $1.6 billion of taxpayers’ money, and what was more alarming was the manner of his humiliation. The treasurer and his advisers had conjured up a make-believe portfolio, muttering a series of mysterious spells: ratio swap, periodic floor, spread lock, Treasury-linked swap, knockout call option, wedding band. On December 6, these shadowy spells broke—a month after the Fed’s 75 basis point rate hike, Orange County filed the largest municipal bankruptcy in U.S. history. Nor was Orange County the only victim of the new dark arts. Around the same time, companies such as Procter & Gamble and Gibson Greeting Cards succumbed to similar enchantments, losing tens of millions of dollars.

In the seven years since Greenspan’s arrival at the Fed, a profound change had taken place in the heart of the financial system. Financial derivatives, which had proliferated in the 1970s in response to the new volatility of interest rates and exchange rates, took on a bewildering complexity. Before, banks had traded relatively simple products: futures and options on stocks, interest rates, and currencies. Now Wall Street was hiring armies of young men with physics PhDs to dream up esoteric instruments. The quants delighted in slicing ordinary bonds into strange “strips”; the flows of money they generated were separated into interest-only payments and principal-only repayments, creating new securities known as IOs and POs; there were inverse IOs, inverse POs, and even a mind-boggling creature called the forward inverse IO. Firms such as Morgan Stanley assembled teams of scientists to apply ideas like chaos theory to markets, and hedge funds such as Long-Term Capital Management began to bet not on the direction of a market’s move but rather on how far it would move in either direction. The sheer speed with which derivatives proliferated was remarkable. As of the end of 1987, the face value of privately negotiated derivatives—mostly interest-rate swaps—amounted to under $1 trillion. Seven years later, the number had soared more than tenfold, reaching $11 trillion.1

In the wake of the disasters at Orange County, Procter & Gamble, and Gibson Greeting Cards, Fortune’s Carol Loomis did her best to understand what was happening. Loomis was the doyenne of financial journalists, the writer who had exposed the workings of the first ever “hedged fund”—she was not easily bamboozled. Cornering the boss of Bankers Trust, the bank that had sold fancy derivatives to P&G and Gibson, she demanded to know how these instruments functioned: “What is a wedding band?” she asked him. The boss, Charles S. Sanford Jr., who was himself a former trader, turned out to be hazy: the sorcerers in his kitchen had brewed up their mysterious spells, but he had little idea how they functioned. Sanford suggested that Loomis direct her question to one of his derivatives experts, and the next day

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.