Monday, October 22, 2007


His Fault - Blame Greenspan for the credit bubble.

His Fault

Blame Greenspan for the credit bubble.
Alan Greenspan

Alan Greenspan’s just-released memoir, The Age of Turbulence, is aptly titled. In his two decades as chairman of the Federal Reserve Board, Greenspan presided over Black Monday, the stock market collapse that occurred 20 years ago this month; the Asian financial crisis; the demise of Long-Term Capital Management; and the dotcom bubble.

Greenspan’s book will make headlines over the next few weeks, in part because of his surprisingly downbeat assessment of the economy and financial markets. But even though he left the Fed more than a year and a half ago, his recollections aren’t of merely historical interest. The current turmoil on Wall Street is largely a result of policy decisions he made during his final years. By keeping interest rates too low for too long, he encouraged a borrowing-fueled speculative binge, which has now given way to a credit squeeze. By failing to crack down on the mortgage industry, he allowed subprime hucksters to peddle dubious loans, which the financial industry’s math whizzes packaged for investors. Coming on top of his role in creating the internet-stock mania a decade ago, the mistakes Greenspan made—now playing out in home foreclosures and hedge fund collapses—will surely color historians’ views of his long tenure, if not his own account of it.

The 81-year-old New Yorker has lived a remarkable life. From Washington Heights, where he was born; to Times Square, where in his youth he played the clarinet in a swing band; to Wall Street, where he made his name; to Richard Nixon’s 1968 campaign, when he entered politics; to Gerald Ford’s White House, where he chaired the Council of Economic Advisers; to Foggy Bottom, where for 18 years he occupied a big office overlooking Constitution Avenue, he proved to be a brilliant survivor—the best that Washington has seen since J. Edgar Hoover.

Since leaving the Fed, he has continued to make news, if not always in ways he would like. Within weeks, he started making off-the-record appearances before select audiences: hedge fund managers, investment bankers, and the like. Inevitably, some of his remarks slipped out, causing disruptions in the markets. In February, he said a recession was possible before the end of 2007—a comment that contributed to a 416-point fall in the Dow. In May, he put the chances of a recession at one in three. Two weeks later, he rattled international bourses by saying that a bubble had developed in the Chinese stock market and a “dramatic contraction” was inevitable.

When Greenspan was chairman of the Fed, his public statements were famously delphic. While he is entitled to make a living—he reportedly charges $150,000 a speech and received an $8.5 million advance for the book—there is something jarring about his late-life discovery of clear, declaratory English. His predecessor, Paul Volcker, was barely heard from for years after he retired, and Greenspan’s failure to follow that example has perplexed some of his former colleagues. In January, the governor of the Bank of England, Mervyn King, who heads the panel that sets British interest rates, made an indirect but well-aimed swipe at Greenspan when he remarked about his own predecessor, “I’ll say only that I am very grateful to Eddie George that he has not been in the newspapers or on the radio commenting on what the committee is doing.”

Greenspan may have been acting strategically. His appearances in the headlines haven’t harmed the commercial prospects of his book, and they may have attracted some clients to Greenspan Associates, the consulting firm that he founded upon leaving the Fed. It was noticeable that shortly after he started using the R-word, Pacific Investment Management, which oversees the world’s largest bond fund, hired him as a consultant. Pimco’s chief investment officer, Bill Gross, is well-known for his bearish views on the economy and the stock market.

In his book, Greenspan, historically one of the economy’s biggest boosters, is remarkably pessimistic about the prospects facing the United States, and not just because a recession might be in the cards. In addition to one of the grave fiscal challenges facing the country—the retirement of the baby boomers—he expresses concern that the rate of technological innovation is slowing down.

Really? In the 1990s, Greenspan famously espoused the view that advances in information technology, such as the development of ever more powerful computer chips and the building out of the internet, had permanently increased the economy’s growth capacity. Granted, the Labor Department’s productivity figures didn’t initially provide much evidence to support this argument. Nonetheless, Greenspan kept interest rates low so that the economy could reach its enhanced potential. In 1996, productivity figures started rising steadily, and Greenspan was vindicated.

Unfortunately, his repeated expressions of optimism helped stoke the bubble in internet stocks, as did his decision in the fall of 1998 to lower ­interest rates by another three-quarters of a percentage point following the crisis at Long-Term Capital Management, a giant hedge fund that had made some bad bets. Rightly or wrongly, many people on Wall Street concluded that should the stock market get into serious trouble, the Fed would come to its rescue. This was the famous “Greenspan put.” During the ensuing 18 months, the Nasdaq jumped 3,000 points, and names like Webvan, eToys, and entered the national lexicon via initial public offerings.

As the speculative fever raged, some old-timers and sticks-in-the-mud, myself included, urged Greenspan to raise interest rates and tighten margin requirements. He refused, on the grounds that bubbles are impossible to identify definitively. Pricking them is by no means easy, and even if you succeed, the consequences are far from certain. The best course of action, Greenspan argued, was to let a bubble deflate of its own accord. Then, and only then, you take remedial action by cutting interest rates. That was what he did. Following the stock market slump and the events of September 11, 2001, he cut the federal funds rate to 1.75 percent, a level that had not been seen since the early 1960s. Then, in June 2003, he reduced the rate even further, to 1 percent.

Now, when managing an economy, emergency action is sometimes called for. A market collapse twinned with a large-scale terrorist attack was something new and frightening. By the middle of 2002, however, it was clear that for whatever reason—low interest rates, the Bush tax cuts, increased military spending—the economy was staging an amazingly robust recovery. At that point, history and economic orthodoxy suggested that the Fed should have been tightening policy rather than loosening it.

Again, Greenspan went his own way. Citing fears (which proved to be misplaced) of Japanese-style deflation spreading to the United States, he kept the federal funds rate at 1 percent until June 2004, by which point the economy had been growing steadily for more than two years. By failing to tighten monetary policy, Greenspan created an apparently limitless supply of cheap credit.

After adjusting for inflation, the cost of cash was close to zero. Investment banks, hedge funds, and other financial operators were able to obtain money at minimal cost and use it to finance risky investments. To a lesser extent, so could ordinary Americans. In a feat of levitation almost without precedent, the prices of nearly all speculative assets moved in the same direction: U.S. stocks went up; foreign stocks went up; residential real estate went up; commercial real estate went up; oil went up; gold went up; sugar went up; coffee went up; Treasury bonds went up; junk bonds went up. To make money, all you had to do was suit up, buy something, and sit back and watch it grow.

In the real estate market, lenders competed frantically to make loans, and speculators flipped condos like burgers. With so much cheap money sloshing around, lenders had to work hard to find enough borrowers to mop it all up. At any one point, there is a limited population of folks who (a) need a new mortgage and (b) are capable of servicing one. So the lenders extended their attention to people who wanted loans but couldn’t afford them; hence the rapid growth of interest-only mortgages, no-doc loans, and even “ninja” mortgages (no income, no job or assets). In the beginning, money-center banks like Citigroup and Bank of America shied away from issuing loans to low-grade borrowers. But as specialist mortgage providers, including Washington Mutual and New Century Financial, started to eat away at their market shares, the respectable bankers became convinced that they had no choice but to compete with them. On Wall Street, meanwhile, a parallel race to the bottom was under way. Firms like TCW Group and BlackRock were busy packaging subprime loans into mortgage-backed securities, credit-default obligations, and other exotic instruments, which were then unloaded on gullible investors searching for a higher yield than Treasury bonds were providing. As the innovative newcomers started to make hefty profits, established investment banks like Bear Stearns, Goldman Sachs, and Lehman Brothers raced to catch up. Eventually, even firms that had shunned the risky new field of structured credit, such as Morgan Stanley, joined the fray.

Once a speculative mania gets going, it rapidly becomes self-reinforcing. Rising asset values draw more players to the table and provide collateral, which allows for additional borrowing. Before long, the process of speculation itself becomes a driving force in the economy, at which point bringing it to an end is politically problematic and economically costly.

Greenspan’s experience in the dotcom era should have demonstrated to him that the best way to control a speculative boom is to prevent it from developing in the first place. But rather than putting the brakes on what was happening in the credit markets, he celebrated it in a spirit reminiscent of Ayn Rand, the author he idolized and befriended as a young man. In 2004, as the subprime boom was cranking up, he advised homeowners to switch from fixed-rate mortgages to adjustable-rate loans. And in April 2005, in a speech that probably now haunts him, he said, “Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial-services industry throughout the history of our country…. Where, once, more-marginal applicants would simply have been ­denied credit, lenders are now able to quite efficiently judge the risks posed by individual applicants and to price that risk appropriately.”

For far too long, Greenspan denied the evidence before his eyes, insisting there was neither a real estate bubble nor any sign of problems emerging in the financial sector. Now that delinquency rates on subprime loans are running at 40 percent in badly affected areas—including the Inland Empire, east of Los Angeles—and some of the biggest mortgage providers, such as New Century Financial and American Home Mortgage Investment Corp., have gone bankrupt, Greenspan has come up with a new argument. “These adverse periods are very painful, but they’re inevitable if we choose to maintain a system in which people are free to take risks,” he said in August.

Because of his Randian view of the world, there is no reason to doubt that Greenspan believes what he said, but it raises the question of whether he was ever a suitable choice for Fed chairman, given his understanding of the job. The reason the Fed was set up, in 1913, was to preserve financial stability—to break the historical pattern of ruinous boom-and-bust cycles. Central banks maintain stability by limiting the types of risks people can take, either by raising the cost of borrowed money or by enforcing regulations. If all else fails and panic breaks out, they inject liquidity into the system by acting as a bank of last resort, which is what the Fed and other central banks were forced to do over the summer.

Given Greenspan’s inaction during his final years in office, our current crunch was pretty much inevitable. In addition to reducing interest rates to 1 percent, he rejected calls for more vigorous oversight of the mortgage industry. Instead of outlawing such dubious practices as the provision of “2-28” loans—which lure borrowers by offering them cheap rates for two years and then sock them with enormous increases in their monthly payments—the Fed issued vague “guidance” letters that most lenders ignored.

Greenspan’s reluctance to act as a ­financial cop was nothing new. During the ’90s, in addition to ruling out higher margin requirements for stock trading, he championed the repeal of the Glass-Steagall Act, the New Deal legislation that prevented commercial banks and investment banks from competing with each other. Alan Blinder, who served as Greenspan’s deputy from 1994 to 1996, described his former boss as “the great anti-regulator.”

Other past colleagues of Greenspan’s have admitted that serious policy errors were made. In a speech last November, Richard Fisher, the president of the Dallas Fed, said that the federal funds rate “was held lower longer than it should have been,” which “amplified speculative activity in the housing and other markets.” Asked at one of his public appearances about Fisher’s comment, Greenspan replied, “In retrospect, I know of nothing we would have done differently.” The closest he has come to a mea culpa was when he told the Wall Street Journal, “We tried in 2004 to move long-term interest rates higher in order to get mortgage interest rates up and take some fizz out of the housing market. But we failed.”

He certainly did, and the fact that the Chinese government and other foreign investors were making his job harder by pouring money into Treasury bonds is no excuse. Rather than ruminating over the conundrum of why long-term interest rates were so low, he should have been taking vigorous action to burst the credit bubble. For a Fed chairman to have one speculative bubble inflate during his tenure is an indictment; to have two of them qualifies him as a serial bubble blower.

Greenspan did get one thing right, though: his retirement date. Were he still at the Fed, he would be responsible for cleaning up the mess he helped create. While his successor, Ben Bernanke, watches anxiously to see who the next casualty of the credit squeeze will be—a Wall Street investment bank? a big hedge fund? a private equity firm?—Greenspan will be busy signing autographs at Borders and Barnes & Noble. If you want to question him about all of this, get there early. The lines will be long. © 2007 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.

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