March 23, 2010 | Comments (81)
Former Federal Reserve Chairman Alan Greenspan just published a 66-page letter on the causes of the financial meltdown and how to avoid a repeat. He presents some great points, and several ridiculous ones as well. Here are a few of each.
"The firms accounted for an estimated 40% of all subprime mortgage securities … during 2003 and 2004. That was an estimated five times their share of newly purchased and retained in 2002, implying that a significant proportion of the increased demand for subprime mortgage-backed securities during the years 2003-2004 was effectively politically mandated ..."
Wall Street gets vilified for blowing up the financial system. As it should. But a big part of the mortgage mess had nothing to do with Wall Street. It started with commercial banks making shady loans and ended with Fannie and Freddie's political obligation to buy up these loans in bulk. What's scary is there isn't a plan on what to do with these two rascals. Functionally,nothing has changed since they collapsed.
2. On the role of the rating agencies:
"[A]n inordinately large part of investment management subcontracted to the 'safe harbor' risk designations of the credit rating agencies. No further judgment was required of investment officers who believed they were effectively held harmless by the judgments of government-sanctioned rating organizations."
It's easy to have no sympathy for those who bought collateralized debt obligations only to learn they were filled with packing peanuts. And I don't. But stupidity wasn't these people's shortfall, to their credit. It was relying on the word of the ratings agencies -- Moody's (NYSE:MCO), Standard & Poor's, and Fitch -- that told them everything was fine and well. And as Greenspan points out, ratings agencies are government-sanctioned entities, so competition for good, high-quality analysis gets stifled.
3. On regulating financial markets:
"In dealing with nonbanks that come in all varieties under the label of 'shadow banking,' it is probably best to regulate financial products rather than institutions."
Bingo. Don't simply regulate Goldman Sachs (NYSE: GS). Its bankers will throw up smokescreens all day around regulators trying to decode its balance sheet. Start at the bottom and regulate (or ban) things like credit default swaps. The only way you'll outsmart these guys is to regulate from the bottom up, not the top down.
4. On "too big to fail":
"Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution."
Hear that, JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon? Now quit acting like civilization will be forced back into hunting and gathering if four banks don't control the economy.
5. On crisis forecasting:
"Forecasters as a group will almost certainly miss the onset of the next financial crisis, as they have so often in the past and I presume any newly designated 'systemic regulator' will also."
I'm like my colleague Matt Koppenheffer on this one: The thought of risk-regulation committees and advisory boards makes me nauseated. Most regulators didn't even acknowledge anything was wrong until chaos was everywhere. And once you realize a bank such as Citigroup (NYSE: C) or Bank of America (NYSE: BAC) is in deep water, it's too late. You've got to install firm rules that prevent insanity in the first place, rather than rely on crisis committees or reactionary policies the way we did in 2008.
Ridiculous points
1. On the Fed's role in the housing boom:
1. On the Fed's role in the housing boom:
"The global house price bubble was a consequence of lower interest rates, but it was long-term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom. … No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate ..."
If you assume everyone uses a 30-year fixed-rate mortgage, he's right. But how about the roughly one-third of borrowers in 2005 who used adjustable-rate mortgages linked to short-term interest rates set by the Fed? These borrowers represent some of the most egregious excesses of the housing boom, and they couldn't have done it without you, Al.
2. On the impracticality of controlling bubbles:
"At some rate, monetary policy can crush any bubble. If not 6 1/2%, try 20%, or 50% for that matter. Any bubble can be crushed, but the state of prosperity will be an inevitable victim."
Let's look at how this has played out in the past. Facing an inflation bubble in the early 1980s, Greenspan's predecessor, Paul Volcker, raised interest rates to 20%. That hurt for a while, but he's now considered an economic hero for doing it. Inflation collapsed, and real growth boomed. He looked past the short run to save the long run. Greenspan, on the other hand, let this bubble burn itself out. The result, in his own words, was "the most virulent global financial crisis ever." But we preserved prosperity in 2006, people, so apparently it was all worth it.
3. On choices:
"Unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible. Assuaging their aftermath seems the best we can hope for."
It's a bit dramatic to assume we can pick either crippling bubbles or central planning, but nothing else. You can simultaneously have dynamic free markets and common-sense rules that prevent pizza delivery guys from living like they're on MTV Cribs. We had something close to this from the end of World War II up until the late '90s. And it was awesome. Bubbles are a natural part of human behavior. That's a given. But it's pretty weak to just roll over and accept their wrath as inevitable.
What do you think? How responsible is Greenspan for the financial meltdown, and what should he have done differently?
