Big Trends Will Haunt Fed's Bernanke

Good luck, Ben. You're going to need it.

After all, there's nothing you can really do about the biggest problem you'll face when you take over as chairman of the Federal Reserve in January 2006. That problem: You're not Alan Greenspan.

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.

Market commentator Bill Fleckenstein isn't a big Greenspan fan. In fact, he called him "the worst Fed chairman, ever."

Unfortunately for the stock and bond markets, for investors and for Ben Bernanke, Wall Street doesn't agree. Think how much easier Bernanke's job would be if everyone on Wall Street thought like Fleckenstein. The investment bankers, the brokers and the traders would still be out cheering President Bush's announcement of Bernanke's nomination. Thank God, the market would be saying, we're getting rid of that Greenspan turkey.

Forget about the 170-point rally that occurred as news of Bernanke's nomination leaked to the press on Monday morning. We'd be looking at 500 points up on the Dow Jones Industrial Average, no sweat.

But the prevailing opinion on Wall Street is exactly the opposite from Fleckenstein's. According to the majority view, Alan Greenspan is the best Fed chairman, ever.

Greenspan to the Rescue

His fans point to Greenspan's record since he took over as Fed chairman in August 1987. Start with the recession and inflation records. There's been only one recession (defined by many economists as two consecutive quarters of negative economic growth), when the economy shrank by 3% in the fourth quarter of 1990 and 2% in the first quarter of 1991.

There was also a soft patch from 2000 through 2001 with three down quarters out of five, although they weren't consecutive. Contrast that with the record of the prior 18 years, when the U.S. economy went through four deeper recessions. The recession of the fourth quarter of 1981 through the first quarter of 1982, for example, showed back-to-back economic declines of 4.9% and 6.4%.

And Greenspan has built this growth record while keeping inflation below 3.5% every year since 1991.

But it's really Greenspan's record of intervening in the financial markets to stave off panic or collapse that has earned him his godlike status on Wall Street.

Just a few months after he took over as Fed chairman, he supplied the liquidity that prevented the stock market crash of 1987 from turning into a prolonged financial crisis. Greenspan and the Fed stepped in to stabilize global financial markets in amid the Asian currency crisis of 1997, in 1998 after the failure of the hedge fund Long Term Capital Management, and again in 2000 after the market bubble burst.

Add in Greenspan's role in providing liquidity during the savings-and-loan meltdown and in preparation for a Y2K crisis that never appeared, and you can see why the financial markets believe so deeply in the powers of the Federal Reserve and its chairman.

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 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.

A Looming Crisis

As we learned earlier this year when the downgrades of General Motors ( GM) and Ford Motor ( F) took the bond markets by surprise, derivatives work just fine until they don't. And the more volatile the financial markets are, the higher the chance that some asset class will zig when the financial models used to create derivatives are predicting they'll 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.

    The timing of the end of these trends couldn't be much worse. The new guy at the Fed will be looking at an economy that has lost its growth driver: If the growth in housing prices simply tapers off with the gradual end of cheap money, that will cut consumers' ability to increase spending.

    The Maestro would have his hands full finding the right balance between growth and inflation. Raise rates too high to fight inflation, for example, and the Fed can tip the economy into recession. But in his juggling act, Greenspan would be able to draw upon almost two decades of respect and faith, invaluable commodities when the Fed is trying to keep consumers spending and CEOs investing.

    Bernanke not only doesn't have that reservoir of faith, he will take over Greenspan's chair with doubts about his inflation-fighting zeal circulating on Wall Street. The one major knock on Bernanke's nomination, amid otherwise favorable reviews from Wall Street, is that he was among the most dovish Federal Reserve governors on fighting inflation during his three years at the Federal Reserve. Bernanke stood out during that time for his advocacy of lowering interest rates to fight deflation.

    A Hike Too Far?

    So Bernanke, unlike Greenspan, will have something to prove on inflation when he takes over as Fed chairman. He'll be under pressure to prove that he's not soft on inflation at a time when inflation looks like it's making a comeback. And he'll have to be even tougher than Greenspan would have been on raising rates to prove his inflation-fighting chops.

    All this raises the odds that Bernanke will overstep next year and raise interest rates one or two times too many. That has the potential to stall the economy, and any stumble by the economy will raise fears of a recession.

    And of course, Bernanke won't want to start off his tenure with a recession, especially not in a midterm election year. All that, in turn, raises the odds that we'll see the Fed reverse course and actually start cutting interest rates again by the middle of 2006. (For a full discussion of the why the Fed could cut interest rates in 2006, see bond guru Bill Gross's October investment outlook on the Pimco Web site.

    And that effort to control inflation and then avert a recession would turn 2006 into exactly the kind of high-volatility year, with unexpected zigs and zags in the prices of important asset classes, that could give the derivatives markets and the risk-takers a nasty surprise. That would be enough to burn institutional investors who have gotten lackadaisical about doing the hard work that controls risk. Burn enough institutions, and you've got a full-scale financial crisis to manage.

    You sure you really want this job, Ben?

    At the time of publication, Jim Jubak did not own or control any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.

    Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York.

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