Thursday, April 8, 2010

Greenspan deflects blame for crisis

Patrice Hill

Former Federal Reserve Chairman Alan Greenspan on Wednesday testified that mortgage giants Fannie Mae and Freddie Mac played a critical role in fostering an explosion of growth in the subprime-mortgage market that led to the global financial crisis.

In his first appearance officially defending his own role in the crisis before the Financial Crisis Inquiry Commission, Mr. Greenspan deflected the blame from himself and the central bank – which had broad but largely unused authority to regulate banks and the mortgage market – while giving voice to long-standing charges by Republicans that congressional meddling with Fannie Mae and Freddie Mac was a critical factor in the run-up to the crisis that brought down the global economy in the fall of 2008.

Fannie and Freddie, while under strict federal control since a government takeover in September 2008, have escaped efforts at reform in Congress, though they are fast becoming the biggest beneficiaries of taxpayer bailouts with $125 billion in cash infusions so far. Moreover, their growing and potentially unlimited liabilities are not likely to be recovered through repayments like those from big banks and Wall Street firms in the past year.

In detailing the role of the mortgage monoliths in the crisis, Mr. Greenspan pointed to the mandates Fannie and Freddie received in 2000 from Congress and the Clinton-era Housing and Urban Development Department to make housing more affordable to minorities and people with blemished credit by using their vast resources to purchase more subprime-mortgage securities.

As the mortgage giants started to scarf up the subprime securities, much of which had been engineered by Wall Street firms to earn AAA ratings, the subprime market grew rapidly. It burgeoned from less than 2.5 percent of the mortgage market in 2000 to encompass 40 percent of Fannie’s and Freddie’s more than $5 trillion mortgage portfolios by 2004, Mr. Greenspan said.

The enormous appetite for subprime mortgages that Fannie and Freddie brought to the market is the reason that interest rates on mortgages fell so dramatically in the mid-2000s and many exotic and risky loans were created to satisfy the heightened demand for mortgage investments, Mr. Greenspan said. That, in turn, gave birth to the most abusive loans with low initial “teaser” rates and no requirements for down payments or income documentation.

“A significant proportion of the increased demand for subprime-mortgage-backed securities during the years 2003 to 2004 was effectively politically mandated,” he said, adding that the full extent of the mortgage enterprises’ investments in risky loans was not known until September, when a large portion of what had been classified as “prime” mortgages in their portfolios was revealed to be subprime.

While much of the riskiest subprime securities were purchased directly from Wall Street by European investment funds drawn by high yields and low default rates during the housing boom, Fannie and Freddie proved to be the best conduit for rapidly growing demand from more conservative investors in Asia for U.S. mortgage investments.

Fannie and Freddie first issued their own debt, which had an implicit government guarantee that appealed to the Asian investors, and then used the cash to invest in subprime loans, in a process that Mr. Greenspan often criticized at the time as over-acquisitiveness aimed at dominating the mortgage market.

“The subprime market grew rapidly in response,” he said, and “subprime loan standards deteriorated rapidly,” worsening an investment bubble that was already developing in the housing market.

Mr. Greenspan, whose views are still closely followed in financial markets though he left the Fed more than four years ago, spurned repeated assertions by members of the commission that the Fed’s own low interest rate policies in 2003 were what nurtured the housing bubble.

“The house-price bubble, the most prominent global bubble in generations, was engendered by low interest rates,” he said, but “it was long-term rates that galvanized prices, not the overnight rates of central banks.” Long-term rates are largely set in global financial markets and reflect investors’ demand for Treasury bonds and competing instruments, such as Fannie and Freddie mortgage bonds.

As the housing bubble was building in the mid-2000s, Mr. Greenspan frequently noted a “conundrum” that long-term rates were inexplicably low, did not seem to reflect the increasing risks of bond investments and had become divorced from their traditional linkage to short-term rates, which the Fed started to raise in 2004.

Mr. Greenspan theorized that the big drop in long-term rates was the result of enormous cash surpluses being amassed by China and other East Asian countries from their earnings on foreign trade, much of which was invested in U.S. Treasury bonds and mortgage securities, drawing down long-term rates. His analysis is widely viewed as correct today in pinpointing a key cause of the housing bubble.

Mr. Greenspan’s prescience on such matters lends credibility to his testimony. But the former Fed chairman continued to largely reject charges that he personally played a critical role in the run-up to the crisis by not using the Fed’s regulatory authority to set standards for subprime lending while frequently urging Congress not to regulate the complex and fast-growing markets for derivative securities such as credit default swaps in the 1990s.

Mr. Greenspan acknowledged he made “an awful lot of mistakes” in his 21 years in office, though he claimed to be right about 70 percent of the time.

He said that credit default swaps, a kind of insurance on risky mortgages that played a pivotal role in bringing down Lehman Brothers Holdings Inc. and American International Group Inc. in the September 2008 events that triggered the global crisis, were only a tiny share of the derivatives markets when he cautioned against regulation in the late 1990s and were not of much concern to regulators at the time.

“We did not see the risks until after the Lehman bankruptcy,” when the unraveling of derivatives contracts contributed to the collapse in the economy and markets worldwide, he said. After the debacle, he said, it became clear the derivatives markets and the whole financial system were drastically undercapitalized and that the principal response by government should be to substantially increase the capital and liquidity requirements of all globally operating financial firms.

Mr. Greenspan’s successor, Fed Chairman Ben S. Bernanke, remarked separately in a speech to a Dallas business group Wednesday that while the worst of the debacle is over, “We are far from being out of the woods. Many Americans are still grappling with unemployment or foreclosure or both.”