Timothy Geithner, President and CEO of the New York Fed and President-Elect Obama’s choice to be the next Treasury Secretary, is being given credit for predicting the current financial crisis. But is this true? The principal evidence that people point to that he did comes from a lecture he gave on September 15, 2006. It was sponsored by the Hong Kong Monetary Authority and Hong Kong Association of Banks and was entitled Hedge Funds and Derivatives and Their Implications for the Financial System.

What Geithner talks about in this lecture is mostly how new financial products and entities, like hedge funds, can pose challenges to the financial system. And some of the things he says do, in fact, sound prescient.

The foundations of modern risk measurement rest on a framework that uses past returns to measure or estimate the distribution of future returns. The stability of the recent past, even if much of it proves durable, probably understates potential risk.


and

We should focus more attention on parts of the risk-management process where uncertainty is greatest and materiality of the risks that we can’t readily quantify is highest. This means more attention on the risk factors where the measurement challenges are most complex. It means more attention on assessing potential exposure in extreme events that lie outside past experience, not just those outside of the recent past.

and

The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by and complicate the management of very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the large ones.

I mean this certainly describes what happened. Ratings agencies used bad models based on traditional lending practices to describe expected default rates on mortgages that were very different from traditional mortgages and were being sold in an inflated market. These mortgages were then sliced and diced in various ways into succeeding generations of a new type of financial instrument the CDO or collateralized debt obligation. By chopping up groups or tranches of mortgages and selling them as CDOs and then chopping up and reselling the CDOs, risk was effectively spread throughout the world financial market. Risk could be even further diluted by purchasing insurance in the form of CDSs, the credit default swaps. Geithner is on to this aspect to:

Although assets under management in hedge funds still represent a relatively small share of total financial assets, their relative share has increased significantly and their ability to take on substantial leverage magnifies their potential impact on financial market conditions. These private leveraged funds have become an important source of protection to regulated institutions by being large sellers of credit insurance in the rapidly growing market for credit default swaps.

And Geithner correctly describes what we have seen happen both in the housing and stock markets.

In market conditions where initial margin may be low relative to potential future exposure, the self-preserving behavior of leveraged funds and their counterparties may be more likely to exacerbate rather than mitigate an unexpected deterioration in asset prices and market liquidity. As financial firms demand more collateral, funds are forced to liquidate positions, adding to volatility and pushing down asset prices, leading to more margin calls and efforts by the major firms to reduce their exposure to future losses.

All in all I would say Geithner nailed the present crisis, except for one thing. He is describing potential problems, not those which actually happened and which were, in fact, happening even as he spoke and right under his nose. By 2006, we had a fully mature housing bubble with huge downstream liabilities both in terms of CDOs and CDSs. Throughout 2006, mortgage writing companies like Ameriquest, Mortgage Lenders Network USA, and Ownit were struggling unsuccessfully to stave off bankruptcy. Geithner references none of this. Instead he praises the strength of the US economy,

The U.S. economy appears to have become more resilient to financial shocks. Over the past two decades, the U.S. economy has experienced several episodes of significant financial market strain. These episodes were associated with spikes in risk perception and significant market volatility within financial markets, but none proved exceptionally damaging in terms of the overall macroeconomic impact.

and

The resiliency we have observed over the past decade or so is not just good luck. It is the consequence of efforts by regulatory, supervisory and private financial institutions to address previous sources of systemic instability. Risk management has improved significantly, and the major firms have made substantial progress toward more sophisticated measurement and control of concentration to specific risk factors.

and

The available evidence is consistent with the view that the changes in the core of supervised institutions, growth of the leveraged sector and rapid financial innovation have strengthened the efficiency and resiliency of the overall financial system. As I mentioned at the start, a broad range of recent financial shocks do not seem to have adversely impacted the real economy. The international financial crisis that began in 1997 did not spillover to the nonfinancial sector in the United States. The equity price collapse and deterioration in credit in 2000 did not cause significant damage to the core institutions in the U.S. market.

Geithner did not see the current collapse coming. And if you think about it, the idea that he did makes no sense. He foresees this huge economic mess and his reaction is to give a speech in Hong Kong, not actually do anything about it here at home–although he runs one of the Fed’s most important branches. Like so many others in positions of power and trust, Geithner was eminently well placed to see the developing crisis and avoid or mitigate its worst effects. He should have known, but he didn’t. His view was much more conventional. He saw no shocks that the financial system couldn’t handle. He could not have been more wrong, but this is the guy that Obama wants for his Treasury Secretary.