Dear Chairman Greenspan: Remember that cheap money?
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Former Federal Reserve Chairman Alan Greenspan went before a House committee today to provide some insight on the ‘sources’ of the current financial crisis.
One of those sources, you might suspect, would be Greenspan’s decision to keep interest rates at ridiculously cheap levels from 2002 through 2004.
Yet he mentioned nothing about monetary policy in his five-page prepared remarks. Instead, the Maestro focused on the failures of the free-market system.
Here, Greenspan explained how investors fooled themselves:
‘Subprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world. These mortgage backed securities being ‘subprime’ were originally offered at what appeared to be exceptionally high risk-adjusted market interest rates. But with U.S. home prices still rising, delinquency and foreclosure rates were deceptively modest. Losses were minimal. To the most sophisticated investors in the world, they were wrongly viewed as a ‘steal.’ ‘
He also recalled how he mused about investors’ lack of concern about the level of risk they were taking in the boom days:
‘In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences.’
Yet as Rep. Henry A. Waxman (D-Calif.) noted at the hearing, the Greenspan Fed ‘had the authority to stop the irresponsible lending practices that fueled the subprime mortgage market,’ but chose to let them ride.
Greenspan also expressed surprise that the Wall Street rocket scientists who designed derivative securities had failed to account for worst-case scenarios in forecasting how their lab monsters would perform:
‘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. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.’
So why wasn’t he raising those questions about derivatives in 2005, instead of defending them as beneficial for the financial system (and arguing against their regulation)?
More important -- and, again, missing entirely from Greenspan’s explanation of the roots of the crisis -- why did the Fed maintain such a wildly easy-money policy from 2002 to 2004, when the central bank’s benchmark short-term interest rate was no higher than 2.25% the entire period (and was below 1.75% for most of that time)?
Without cheap money, the credit-market bubble could never have reached the epic size that it did.
Greenspan must know this. Admitting it, however, apparently still is a bridge too far for him.