Bernanke will inherit all the problems created by Greenspan's 18-year legacy of loose money, problems that are finally building toward some kind of crisis. But what he won't inherit is Wall Street's overwhelming faith that Greenspan will defuse any potential market bomb before it blows up. The financial markets, while wishing Bernanke success, will be nervously waiting for him to foul up. Nervous markets, of course, have a tendency to turn a minor blip into a major crisis of confidence.
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The Greenspan put
There is another way of looking at this record. Greenspan is handing over to Bernanke a problem that the financial markets jokingly call the Greenspan put. In the options market, a put is the right to sell a stock or other financial instrument at a specific price. It has a value if the current price of that asset falls below the selling price guaranteed by the put. And when the current price falls through the floor, a put can suddenly become very valuable. Think how much you'd pay for the right to sell a stock at $75 when it has fallen to $40.
The Greenspan put is the market's name for a belief, based on all those market interventions by Greenspan's Fed, that the Federal Reserve will always act as the buyer of last resort. If prices fall fast and hard enough, the Fed will supply cash to prop up the market.
The Greenspan put has two long-term effects. First, in the short term, it calms the markets; there's less need to panic if Wall Street and its counterparts around the globe believe the Fed will ride to the rescue. And, second, it encourages careless risk taking. If the Fed will bail out the market, why worry about the consequences of very risky financial behavior? If the Federal Reserve will intervene to prevent the failure of Long-Term Capital Management, why not make risky bets in very volatile markets? If the Federal Reserve will intervene to limit the exposure of other financial companies to the bankruptcy of commodities brokerage Refco, why bother to perform careful due diligence on the companies that you do business with?
The increase in risky behavior as a result of the Greenspan put would be dangerous enough by itself. But its effects are exacerbated by the growth of the derivatives markets. Much of the explosive growth of the derivatives market -- and the market for credit derivatives had grown, as of June 2005, by 128% in 12 months -- is a result of banks, pension funds, insurance companies, hedge funds and other financial institutions seeking a way to insure themselves against the riskier investments that they've been making. Like the Greenspan put, the derivatives market encourages investors not to worry about risk. Instead of avoiding credit-quality problems, for instance, by not buying the bundles of riskier interest-only mortgages now flooding the market, insurance companies and pension funds can load up on the higher yields of these mortgages and insure themselves against the risk by buying a derivative insurance product.
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A looming crisis
As we learned earlier this year when the downgrades of General Motors (GM, news, msgs) and Ford Motor (F, news, msgs) took the bond markets by surprise, derivatives work just fine until they don't. And the more volatile the financial markets are, the higher chance that some asset class will zig when the financial models used to create derivatives are predicting they zag. And then Bernanke will be facing his first financial crisis. All of Wall Street will, of course, be watching to see if he's really up to filling Greenspan's shoes.
I think the odds are that this crisis isn't too far down the road.
I think we'll see the turning point of three long-term trends in the next 12 to 18 months:
* The era of rapidly rising housing prices that sustain consumer spending and economic growth seems to be ending, either with a whimper or a bang.
* The era of cheap money is ending: Not only the Federal Reserve, but also the Bank of Japan and the European Central Bank are likely to raise rates in 2006.
* And the era of controlled inflation seems to be ending: The annual inflation rate isn't really 4.7%, because September's numbers reflect a post-hurricane spike in oil, but higher energy prices are spilling over into higher prices for just about everything.