If Alan Greenspan lived on a flood plain, would he buy insurance?
When the former Federal Reserve chairman testified before Congress recently, he kicked off his remarks by announcing that "we are in the midst of a once-in-a-century credit tsunami." Those once-in-a-century analogies are usually used to explain away something that's so rare you can't possibly be blamed if you fail to prepare for it. Plan for every hundred-year disaster and there's little time or money left to invest in the good life.
Greenspan's shrug-off brought to mind Warren Buffett, who's made news lately by snapping up big chunks of Goldman Sachs and General Electric at depressed prices and by generally being the only living person expressing any optimism at all about stock markets. There's also a new book about Buffett, The Snowball by Alice Schroeder, who spent hundreds of hours talking with the Oracle of Omaha. Buffett is famous for his ability to calculate risk—and avoid it—which is the very thing that banks and consumers catastrophically failed to do over the past couple of years. "He always thinks through what's the worst possible thing that could happen," Schroeder told me during an interview. "What we're seeing now is a lot of people who said, 'This kind of calamity has never happened before, so it probably won't happen to me.' But that doesn't mean the calamity will never happen."
Contrast that with Greenspan's Panglossian perspective. By way of explaining the housing boom and subprime lending explosion he presided over—which caused the housing bust and recession we're enduring now—Greenspan described the "best insights of mathematicians and finance experts" whose job was to make sure that that credit tsunami didn't happen. But instead, he testified, "the whole intellectual edifice...collapsed in the summer of last year because the data inputted into the risk management models covered only the past two decades, a period of euphoria." Bad data. Bad outcome. Tsunami.
The solution, Greenspan pointed out, would have been mathematical models "fitted more appropriately to historic periods of stress." In other words, the long view.
But there was at least one finance expert whose risk-management models predicted a chance of catastrophe. In his Berkshire Hathaway shareholder letter from 2002, Buffett wrote that derivatives—such as credit-default swaps, now causing tremors in world markets—were "toxic" investments, "time bombs" that could wreck the financial system. In his 2003 shareholder letter, Buffett famously called derivatives "financial weapons of mass destruction." At around the same time, Greenspan was lowering interest rates to historically low levels, fueling a lending binge, a housing bubble, and the mass securitization of mortgages good and bad. He was also extolling the virtues of derivatives, arguing that the benefits outweighed the costs and that more regulation was unnecessary.
The Snowball also details how Greenspan and Buffett both played a role in cataclysms that might not have been once-a-century events but were certainly dramatic contretemps during Greenspan's "period of euphoria." One of them was the 1991 bond-trading scandal at Salomon Brothers, which mushroomed into a kind of bank run that nearly sank one of Wall Street's mightiest investment banks. Buffett, a big Solomon shareholder, saw the risks of collateral damage up close and engineered a rescue effort that helped prevent turmoil at other banks. Greenspan, as Fed chairman, also had a front-row seat, and called Buffett at one point to offer his encouragement.
Then, in 1998, the huge hedge fund Long-Term Capital Management nearly collapsed, threatening another global run on the financial system. The fund's proprietors lobbied Buffett for a big capital infusion, but he demurred. Instead, it was Greenspan who engineered an unprecedented bailout of the private firm, lest its problems infect dozens of other institutions.
Buffett has since preached about the lessons of those incidents, while more euphoric investors apparently forgot them. Buffett's message of prudence was unwelcome during the housing boom, when he seemed like a financial fuddy-duddy. Newsweek even called him "the alarmist of Omaha."
But after the first domino fell in the current crisis—when the government bailed out a rump Bear Stearns earlier this year—Buffett put the pieces together in an interview with Schroeder. "It's a version of what I went through at Salomon," he said, "where you were just inches away all the time from, in effect, an electronic run on the bank."
Greenspan was there too, but he seems to have drawn different lessons. If it wasn't a hundred-year calamity, it didn't seem to count. Who needs insurance when you have exuberance?