Have No Fear… the PPT is Here; But Beware of Ongoing Market Shocks!

I had a good healthy chuckle the other day while reading a blog post from my colleague Jack Crooks who conjured up fond memories by mentioning that the Plunge Protection Team (PPT) was back on the job on Wall Street!

To refresh your memory, the Plunge Protection Team was the affectionate term given to the Fed back in the good-old “irrational exuberance” days of the late1990’s. During this halcyon period, the Alan Greenspan-led Fed repeatedly rode to the rescue of global financial markets.

This gave rise to another charming phrase that’s been back in vogue in recent days: the “Greenspan Put”, which refers to the fact that the former Maestro of the Federal Reserve always stood ready to backstop troubled financial markets anytime Wall Street got in over its head with speculative excess.

Today, we’re in a new era – with Ben Bernanke conducting the Fed’s rag-time band. Well, you can change the Chairman, but it seems like the Fed is still playing the same old tune.

A Brief History of the “Greenspan Put”

Way back in 1996 – four years before the technology/internet bubble imploded – Alan Greenspan warned in a very public speech about “irrational exuberance” and the role it played in “escalated asset values.” But the Maestro didn’t put his money where his mouth was at the time, continuing an easy money policy that had persisted since late 1994.

A year later came the Asian financial crisis, followed the next year by the Russian debt default and devaluation of the ruble. This series of events led to the collapse of giant hedge fund Long Term Capital Management (LTCM) in late 1998.

Greenspan responded by rounding up Wall Street banks to bailout the insolvent hedge fund and stem a credit crunch. And in return, the Greenspan Fed aggressively cut lending rates in order to pull Wall Street’s fat out of the proverbial fire – quid pro quo!

How to Buy Fed Issued Put Options…

Thus was born the era of the “Greenspan Put”. This refers to a popular trading strategy of purchasing protective put options as an insurance policy (or hedge) against unexpected market risk. If the market or index falls in value, your put options should soar in price so that some – if not all of your losses in the market are offset with option profits.

If you were well informed enough to buy put options on the Standard & Poor’s financial sector index, or the S&P homebuilder’s index – prior to the recent credit crunch correction – then you probably suffered no pain (or at least reduced pain) as global markets sold off. And if you owned enough put option contracts on select indexes or ETFs, you probably even profited from the sell off.

But oh those Greenspan Puts… they have magical powers indeed, but can’t be purchased on the major listed options exchanges. No, these put options are issued only by the Fed and are made available to a select club of Wall Street insiders; we’ll call them the “irrational exuberators!”

The Power of the Greenspan Put at Work

In 1998, when the Fed rode to Wall Street’s rescue by cutting rates swiftly during the LTCM crisis, Greenspan was essentially giving big banks and brokerage firms a free put option as insurance against their “irrational speculative exuberance.”

Wall Street soon realized that “greed (excess speculation) is good”, and if anything bad were to happened, the Maestro would just ride to the rescue all over again issuing more Fed put options as he rode on into the sunset.

In fact, the Greenspan Put issuance of ’98 handed Wall Street lots of cheap and easy money with which they could speculate, apparently without risk, thanks to the existence of these special Fed put options.

And Wall Street saw that it was good… and promptly speculated some more – in the internet sector. This easy money led directly to the most speculative phase of irrational exuberance in the tech-bubble market, which not coincidently took place from 1998 to March 2000. During this period the tech-heavy Nasdaq 100 Index doubled in 1999 alone!

The Greenspan Put saved financial markets from gridlock in 1998, but led to even more recless speculation by Wall Street in the years that followed leading to the tech/internet bubble.

Tune in to my blog tomorrow when I explain how the Greenspan Put was soon used again -- this time inflated the housing bubble -- and why new Fed Chief Ben Bernanke is about to call out the PPT now.

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