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March 11, 2009

Greenspan A Glutton For (His Own) Punishment
by Brady Willett

Why Greenspan continues to try and defend his deplorable record as Fed Chairman is unknown. What is known is that the once powerful Sir Alan has seen his reputation steadily deteriorate to a level not much higher than laughing-stock. Here is what Greenspan had to say in his most recent commentary:

"There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess...The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria....

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble." March 10, 2009

Greenspan is absolutely correct that the decline in long-term interest rates played a role in stoking the global housing price bubble. Moreover, he is right that there was a "disconnect between monetary policy and mortgage rates". To get an idea of how consistent Mr. Greenspan has been on this 'disconnect' consider the following:

March 10, 2009: "The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004..."

September 25, 2005: "...the thirty-year fixed-rate mortgage, currently around 5-3/4 percent, is about 1/2 percentage point below its level of late spring 2004, just before the Federal Open Market Committee (FOMC) embarked on the current cycle of policy tightening. This decline in mortgage rates and other long-term interest rates in the context of a concurrent rise in the federal funds rate is without precedent in recent U.S. experience."

But while Greenspan aptly points to "the disconnect" as contributing to the housing bubble, he myopically attempts to end the discussion here.

"I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis."

Wrong. What Greenspan conveniently neglects to mention is that another, and arguably more important cause of the housing bubble, was regulatory neglect. To get an idea of just how important lack of regulation was during the bubble days consider what Greenspan had to say only a few months ago:

"The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of the crisis) would have been far smaller and defaults accordingly far lower." Greenspan. October 23, 2008.

Who was/is in charge of regulating the subprime manufacturing complex? Who was/is in charge of scrutinizing the practices of the securitizers? Finally, who did former Fed Governor, Edward Gramlich, visit in 2000 to warn that immediate action was required to slow widespread predatory lending in the mortgage market? You got it - Greenspan! And how did Greenspan, a long-time proponent of self (or non)-regulation, respond to Gramlich's request?

"For us to go in and audit how they act on their mortgage applications would have been a huge effort, and it's not clear to me we would have found anything that would have been worthwhile without undermining the desired availability of subprime credits." Greenspan. June 9, 2007

Perhaps it is time that Mr. Greenspan stops trying to quarantine discussion of the bubble and, at minimum, acknowledge that undermining the desired availability of subprime credits would have been an excellent idea (an idea Greenspan ignored). Astonishingly, and after yet another 'don't blame me for the bubble' rant, Greenspan - almost - admits exactly this:

"The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities."

No matter how many times you read the above line you can not help but chuckle. To be sure, with this single sentence Greenspan unwittingly and decisively attacks his legacy, not to mention common sense. Think about it: when Greenspan wants to paint his horrific tenure as Fed boss in a better light he says that the Fed wasn't in control of mortgage rates, but when compelled to offer a solution to preventing a similar crisis in the future Greenspan argues that "The solutions...are higher capital requirements and a wider prosecution of fraud...". Mr. Greenspan, is the Fed not charged with setting capital requirements? Does the Fed not have the broadest of powers when it comes to investigating and regulating banking institutions? Finally Mr. Greenspan, does it not stand to reason that if the next financial crisis can be prevented with enhanced regulations that a lack of regulation helped spark the current crisis?

With this in mind, the revision should be as follows:

There are at least three broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Fed, the second is the interest rate 'disconnect', and the third is that Greenspan didn't do a damn thing to stop it.

Thank you Greenspan, for setting that fool Greenspan straight.

And Now For Something Completely Different

Incidentally, Greenspan was right about the housing bubble artificially supporting consumer demand for more than a decade. Moreover, he acknowledged this fact well before the housing bubble popped:

Survey data suggest that approximately a fourth to a third of the value of home equity loans and cash-outs finances personal consumption expenditures directly. Another fourth funds repayment of nonmortgage debt that had been used, in effect, as bridge financing, predominantly of personal consumption expenditures. Home mortgage debt is thus the final source of funding of some consumer outlays originally financed by extensions of credit card and other consumer debt. Although there are no comparable surveys of the disposition of equity extracted by sellers of homes beyond amounts applied as a down payment on a subsequent home purchase or outright cash purchases, plausibly they would exhibit similar propensities.

If indeed this is the case, the implied increase over the past decade in consumption expenditures financed by home equity extraction, rather than by income and other assets, would account for much of the decline in the personal saving rate since 1995.* September 25, 2005

In other words, Greenspan knew the housing mania was supporting an unsustainable increase in consumption**, he knew that the subprime complex was ridden with fraud, and he knew that the Federal Funds rate was no longer dictating mortgage rates. But even with this knowledge Greenspan still did absolutely nothing because, in his words, it "would have been a huge effort". Surely the exhausted Fed Chairman Bernanke, who has adopted innumerable new policy efforts since taking over, can not be impressed as Greenspan inexplicably reminisces about his effortless tenure as Fed boss.

* Last week the U.S. personal savings rate busted above levels not seen since 1995.
** It is obvious that Greenspan knew consumption expenditures were being supported by an unsustainable increase in housing prices, although exactly when Greenspan was aware of this remains unclear.

Brady Willett
FallStreet.com

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