The Worst of the Credit Crisis May Not Be Over - Scholes

Scholes, Nobel Laureate, Says Credit Crisis May Not Be Over
By Vivien Lou Chen and Thomas R. Keene

May 16 (Bloomberg) -- Myron Scholes, chairman of Platinum Grove Asset Management LP and 1997 winner of the Nobel Prize in economics, said the worst of the crisis in credit markets may not be over.

``From my perspective, I think that we don't know if the storm has passed or if we are still in the eye of the storm,'' Scholes said in an interview with Bloomberg Radio yesterday. ``Are there other shoes to drop and new events or new shocks that will come to the fore?''

Scholes's warning reflects financial markets that Federal Reserve Chairman Ben S. Bernanke this week said remain ``far from normal.'' Financial institutions have been reluctant to lend to each other, driving up bank borrowing costs, since a flight from risk in August sparked by defaults on subprime mortgages.

``In my view, this is probably as bad or worse than the 1989-1990 crisis and may even rival the worst crisis we've seen since the end of the Second World War,'' Scholes said. Former Fed Chairman Alan Greenspan has also said the turmoil is the most ``wrenching'' since the war.

Scholes, 66, and Robert Merton won the Nobel Prize for economics in 1997 for their work in valuing options. His firm, Platinum Grove, is based in Rye Brook, New York.

To contact the reporters on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net; Thomas Keene in New York at tkeene@bloomberg.net

The Roots of Our Financial Crisis: False Stewards and Careless Greed

Critics of derivatives often raise the specter of the failure of one dealer imposing debilitating losses on its counterparties, including other dealers, yielding a chain of defaults. However, derivatives market participants seem keenly aware of the counterparty credit risks associated with derivatives and take various measures to mitigate those risks."

"The use of a growing array of derivatives and the related application of more-sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries."

"…the success [of derivatives] to date clearly could not have been achieved were it not for counterparties' substantial freedom from regulatory constraints on the terms of OTC contracts. This freedom allows derivatives counterparties to craft contracts that transfer risks in the most effective way to those most willing and financially capable of absorbing them." Alan Greenspan, 2003

So, Sir Alan just was not aware of the potential for a single counterparty to inflict systemic risk on the broader markets? How could he have known this. This is why he opposed the imposition of almost any regulatory oversight on the derivatives markets and hedge funds. He just didn't know, right?

Is this why he could argue with a straight face that a lack of margin requirements or minimum capital rules on derivatives positions would "promote the safety and soundness of broker-dealers, by permitting more financing alternatives and hence, more effective liquidity management."

Or one might ask, did he know of the danger, but just did not care for whatever reason?

"Had the failure of LTCM triggered seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own." Alan Greenspan in 1998 Fallen Star: Greenspan's Testimony Before Congress on the Fed's involvement with LTCM

As Charles R. Morris observes in his brilliantly entertaining and informative book "The Trillion Dollar Meltdown"

"In other words, counterparty surveillance works fine, so long as you're willing to accept the occasional crash of the economies of many nations. But given the enormous rewards that accrue to top-of-the-food-chain players... true market-believers may find that a cheap enough price."

In other words if you are counting the profits as enormous personal riches to your own small elite class, and accruing the losses to Other People's Money (OPM), the public trust, and all holders of US dollars, its a reasonable arrangement to promote if you are a dishonorable pigman or a willing servant to same.

Financial Relativism: Fraud by Any Other Name....

Let's speak plainly for once, Chairman Bernanke.

The US financial system degenerated under the collateralized debt origination model in which super-compensated bankers and brokers used unreliable mathematical models to create complex and opaque packages of dubious quality debt which they sold to most of the major institutions in the world.

Our words to be sure, but a paraphrase of Paul Volcker's testimony to Congress yesterday, as he deviated from his prepared text.'

More simply put, it is a Ponzi scheme.

Now that the game is collapsing, the bankers that gained enormous, fantastic wealth while it was running are now looking for their shareholders, the public, and in many cases their victims to bear the losses and repair the financial system and the banks themselves while they safely hold their personal gains.

All up and down the line, from the loan originators to the bankers who created the bundles to the broker salespeople to the regulators and the Fed, everyone turned a 'blind eye' to the fraud as it occurred. Time and the justice system may sort out the degrees of guilt. We will see the spectacle of highly paid very experienced businessmen claiming utter ignorance of their own companies as we did with the role model for the neo-capitalists - Enron.

The banks were central to the scheme from the inception as they spent years and many hundreds of millions of dollars to overturn Glass-Steagall to allow this coup de grâce to be delivered to all holders of US dollars. PBS Frontline: The Long Demise of Glass-Steagal