So markets rallied with president-elect Obama selecting New York Federal Reserve Bank chief Timothy Geithner to head the Treasury.
It's a significant choice because Geithner warned years ago that trouble was ahead. Three years ago, he warned about the risks in hedge funds and derivatives: "The substantial increase in the role of hedge funds in our financial system also complicates the challenge of risk management. Although hedge funds help improve the efficiency of our system and may also contribute to greater stability over time by absorbing risks that other institutions would not absorb, they may also introduce some uncertainty into market dynamics in conditions of stress. The rapid growth in instruments for risk transfer, most recently in the credit world, has produced a large universe of exposures in complex products, whose future value is uncertain and difficult to model. The risk-reducing benefits of these innovations, for individual institutions and for the system as a whole, are substantial, but these benefits are to some extent qualified by the limits of our knowledge of how they will perform in conditions of stress … The increased stability in macroeconomic outcomes that has characterized the last two decades, the relative ease with which the U.S. financial system weathered the stress of the equity market shock and September 11, the increased mobility of the world's savings and the optimism produced by the acceleration in productivity growth, have all worked to lower expected future volatility and risk premia. The reduction in credit losses and in realized volatility has created room for institutions to take greater risk without showing deteriorating risk-based capital measures. But the macroeconomic environment may not prove to be as benign in the future as it has in the recent past."
And then two years ago, there came another warning: "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."
In other words, the likelihood of smaller crises was reduced, but if the large ones hit, it will be even more severe. And we are discovering that now.
Jim Cramer has slammed Geithner for letting Lehman Brothers go bust, claiming with his typical moderation that he prefers Ken Lay, Jeff Skilling or Bernie Ebbers.
But as The Wall Street Journal suggests, Geithner is the kind of person who thrives on crises. former Clinton economic adviser Jeffery Frankel says it's a good choice. "Tim Geithner is refreshingly straightforward and personable, and doesn't "stand on ceremony." At the same time, he is cool and unflappable."
Whichever way you look at it, he has inherited one hell of a mess. How he fixes it is anyone's guess.