Thursday, October 23, 2008

The Maestro Testifies


Alan Greenspan testified today before the House Committee on Oversight and Government Reform. Here are some excerpts from his prepared remarks (

“In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences. This crisis, however, has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount………

“What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer………….

“It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology……….

“When in August 2007 markets eventually trashed the credit agencies’ rosy ratings, a blanket of uncertainty descended on the investment community. Doubt was indiscriminately cast on the pricing of securities that had any taint of subprime backing. As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty surveillance.

“There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitization. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime……….

“This crisis will pass, and America will reemerge with a far sounder financial system.”

These quotations summarize The Maestro’s views on the causes of the crisis and its consequences for mortgage markets as well as his belief that “…America will reemerge with a far sounder financial system.”

Four questions:

1. What about The Maestro’s role in pumping up the real-estate bubble? The Fed drove interest rates into the basement in 2001 and held them there despite a robust housing market. This was the root cause of the 100-year flood of real-estate speculation in 2002 through 2006. No root cause, no bubble.

2. What about The Maestro’s rejection of pleas by federal regulators that the Fed support enhanced regulation, supervision and oversight of mortgage markets in the face of the unfolding sub-prime abuses? Adequate regulation, supervision and oversight of mortgage markets could have restrained the bubble.

3. Didn’t The Maestro say that goods-and-services price inflation is the Fed’s concern, but asset inflation is not? If the Fed had registered sufficient concern, perhaps the real-estate bubble could have been restrained.

4. Didn’t The Maestro say that real-estate bubble’s can’t occur because people live in their homes – unlike stocks - and home prices always rise? So much for those points of view.

There may be additional issues, but these are a good start.

© 2008 Michael B. Lehmann

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