In October 2008, within weeks of the collapse of Lehman Brothers, Alan Greenspan testified before the US congress on whether his emphasis on deregulation had failed. He said yes, but then added caveats to his admission. In the end, he contradicted himself. He said: “Whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets." He added: “Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime."
Then, in 2014, in a conversation with Gillian Tett of the Financial Times, he conceded that non-financial parts of the economy behaved rationally, that the financial parts of the economy did not, and that animal spirits dominated this part of the economy. Why is all this important now? We will be “celebrating" the 10th anniversary of the collapse of Lehman Brothers this September. Some of the derivative products that brought about the downfall of Lehman Brothers and almost brought the world economy to a halt may no longer be as dangerous as they were then. But the machinery of complex financial engineering that conjured up such products remains intact. The ethical issues that dogged Wall Street then remain alive. In the last few years, exchange-traded funds (ETFs) have become all the rage. Just as credit default swaps, a derivative product, took off prior to the crisis, ETFs have taken off in the last decade and a half. Combined assets under management (AUM) of ETFs and exchange-traded products (ETPs) have risen to over $5.1 trillion, from a meagre $319 billion in 2004. It is difficult to come up with a definitive answer on the AUM in volatility ETFs. The top 14 volatility ETFs have a combined AUM of around $1.6 trillion. They are complex. An article in Reuters (Meltdown Raises Fears Of ‘Financial Innovation The Planet Doesn’t Really Need’) manages to give us a sense of the complexity that is inserted into these products. “The VIX (volatility index) measures market expectations of how choppy the S&P 500 might be over the coming month. With the US index becoming the most widely-traded in the world, the VIX is seen by many as a key barometer of investment sentiment.... Inverse exchange-traded products based on the VIX add another element of complexity, allowing investors to take short positions on volatility futures, hence betting on fading volatility.... Add in leveraged products, which enable the buyer to multiply the scale of their bet many times over, and the possibility for market havoc becomes clear." To round off the discussion, we have information that regulators suspect that the prices linked to VIX—the stock market’s widely watched “fear index"—might have been manipulated (“Regulator Looks Into Alleged Manipulation Of VIX, Wall Street’s ‘Fear Index’", The Wall Street Journal, 13 February, goo.gl/zc7D7r). Two professors from the University of Texas wrote a paper on it in May last year but the Chicago Board of Options Exchange, which owns the franchise for VIX and trades a slew of products around it, said that their work had misunderstood VIX. So, what do we have now? Post-2008, Greenspan blamed lack of regulation but still maintained that markets would self-regulate. That has not happened. The industry has replaced one set of derivatives products (credit default swaps) with another (ETF). These products have enjoyed exponential growth. Not all ETFs are alike. Some of them hold illiquid assets and yet promise daily liquidity to ETF holders. Volatility is now traded; derivative products have been launched on volatility and they are spiced with leverage (debt). Despite strong growth, investors expect interest rates to stay on hold or stay low. To round it off, regulators now suspect manipulation after having watched these products being launched and leverage piled on top of them. So, what has changed since 2008? Two things have changed. One is that we have a new chairperson of the Federal Reserve. There are tentative signs—based on his past public comments—that he does not set as much store by asset prices as three of his predecessors had done. As I had noted in my piece on his testimony to the US congress two weeks ago, he is willing to take into consideration the overheating, as evident in financial market prices, even if consumer prices are rising at a slower pace. Gavyn Davies argued in his regular blog in the Financial Times that not just the Federal Reserve chairperson but six of the seven board members would be nominated by the current administration when the process is completed next year. Davies thinks the new Federal Reserve board might be inclined to confront rising asset prices, and might be less gradual in raising interest rates. Both might be welcome departures from the monetary policy framework of the last one or two decades. The second thing that has changed is that the US 10-year government bond yield appears to have ended its long-run trend of declining. It now stands at 2.90%. In July 2016, it had reached a low of 1.38%. If it breaches 3%, it could create big losses for leveraged investors. On Friday, American stocks greeted the employment report showing strong job gains and tame wage gains with glee. James Montier calls this a cynical bull market. I am not sure if providence is known to be kind to cynics.