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  • April 25, 2008 03:57 PM EDT by Elizabeth MacDonald

    Greenspan is Right

    Former Federal Reserve chairman Alan Greenspan is now squarely in the bulls-eye, held largely to blame for the housing bubble that has blown up in the country's face, because he and the central bank kept rates down at 1% for too long.

    Greenspan has also been laughed out of the room for saying that the Fed can not prick any incipient asset bubbles whatsoever by raising interest rates.

    Guess what. The economic data show Greenspan is right, that the Fed is not solely responsible for asset bubbles, though it sure can help foster them. Asset bubbles too are devilishly hard to deflate with rate hikes. Moreover, though the Fed was wrong to keep rates down for so long, thus ballooning the bubble and creating inflation, it's wrong to scapegoat Greenspan as the sole creator of the housing bubble when other more appropriate villains are getting off scot-free (and walking away with fatcat pay). It's time to stop scapegoating Greenspan.

    Start at the beginning, when Greenspan first talked about "irrational exuberance," which many took to mean he was referring to the dotcom bubble of 1999 to 2000. Some critics say that, if Greenspan was warning about the bubble back then, why didn't he do more to stop it?

    But Greenspan wasn't referring to the dotcom bubble.

    When Greenspan made that comment in a December 1996 speech before the American Enterprise Institute, he made it not in reference to the Internet bubble, but in reference to the economic downturn in Japan.

    Greenspan asked in the speech: "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

    There is no evidence that the market was in bubble territory in 1996 when Greenspan said this oft-quoted line a dozen years ago.

    The bubble had yet to inflate in the Internet and telecom sectors until three years later, when the Nasdaq really started to take off in 1999 due to the dotcom mania and due to corporate computer spending to avoid the Y2K mess.

    Still, the thinking is, Greenspan should have seen the dotcom bubble and raised rates to stop it.

    But the Fed did in fact raise interest rates six times from June of 1999 through May 2000, until the Fed funds rate topped out at 6.5%, at that time the highest level in nine years.

    However, tech investors scoffed at the Fed's rate hikes when the dotcom mania was in full swing from 1999 to 2000, noting that tech companies wouldn't be hurt by these rate increases because they had microscopic debt on their balance sheets.

    And non-tech stocks were never in a bubble during from 1999 to 2000. Knock out the soaring  tech and telecom stocks from the S&P 500, and the stocks left were actually turning down when the S&P 500 hit its all-time high in March 10, 2000, as Jeremy J. Siegel, a finance professor at Wharton University has pointed out.

    Moreover, from that peak in March 2000 through the end of November 2006, non-tech stocks had an annual return of 8.2%, clearly not a bubble return, Siegel adds.

    And what would have happened to these non-tech stocks if the Fed had raised rates even higher and more rapidly beginning in late 1999 or early 2000?

    Siegel says that these non-tech, ‘brick and mortar' companies "would have borne the brunt of the tightening" and their stock valuations would have been pounded down even lower. He adds that the economy could have tipped into a deeper recession, worse than when the tech bubble finally blew up.  

    Greenspan was wise to cut rates in the early part of this decade, Siegel says. That's because the country was battling both a recession, due to a desolating dotcom implosion,  as well as 9/11, plus Enron and WorldCom was bearing down on the stock market. The bear market didn't let up until March 2003. Remember, Wall Street was screaming for even deeper cuts at the time.  

    Now for the housing bubble. The critics charge that Greenspan tarried too long to hike rates while the housing bubble was ballooning. The Fed first started knocking down rates in January 2001, from 6.5% eventually to a puny 1% in June 2003. The Fed then kept that 1% rate until June 2004, eventually hiking it to 5.25% in June 2006, where it sat until Buzzsaw Bernanke began slashing it last year. Critics say by keeping the rate at 1% for a year, the Fed artificially swamped the system with liquidity and inflated a more lethal echo bubble, the housing bubble.

    But that thinking misses the mark.  

    House prices were rising because mortgages were becoming cheap not just because of the Fed rate cuts.

    Around the world a tsunami of money printed by central banks overseas was pouring into hedge funds, private equity funds, sovereign wealth funds, you name it, money that sought a safe haven after the Internet bubble burst. To be sure, the Fed here is rightfully criticized for printing too much money.

    But central banks overseas are more prone to gunning the printing presses as they tend to be more beholden to politicians desperate to keep a lock on power by appeasing their populations, notably in emerging economies--Russia, India, China, all have seen annual monetary growth of 20% or more.

    That money came flooding to US shores and into long term treasurys, knocking down these yields, which mortgage rates are tied to, and which the Fed doesn't control.  

    Yes, adjustable rate mortgages are tied to short-term rates.

    But the Fed started hiking rates in 2004, well before the subprime mess started to escalate in 2005.

    Look at the government data, and you'll see that subprime mortgages made up less than 10% of mortgage originations in 2003, a number that ran up to 28% in 2006--when the Fed stopped raising rates.   

    And isn't it true that a housing bubble had taken hold in England, Spain, Ireland and Australia, where central bankers have different rate regimes and where central bankers were largely holding the line on lowering rates?

    Yes the Fed cops should have used its regulatory powers to stop miscreant subprime lenders who had gone off the rails. And yes Greenspan should not have told consumers, many of whom were unsophisticated, in 2004 to get ARMs instead of long-term, traditional 30-year loans. Especially when the Fed sheriffs were not on the stick watching shady lenders. Greenspan advocated ARMs in 2004 by citing a Fed study suggesting borrowers could have saved tens of thousands of dollars in the prior ten years if they had these loans.

    Also, it's unfortunate that Greenspan at that time seemed to encourage lenders to cook up more mortgage products. "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," Greenspan had said.

    But it's wrong to solely blame Greenspan for the subprime mess. Blame Wall Street and hotshot, derelict lenders too.

    When Congress opted not to lift the dollar amount of the mortgages that Fannie Mae and Freddie Mac could buy and repackage as securities on the secondary market early in the prior decade, Wall Street gladly dove in.

    Wall Street bought those loans from places like Countrywide (CFC), sliced those loans up into all sorts of exotic securities even the Street could not understand, and then sold them as Frankenstein, mortgage-backed securities to investors. Remember, we are talking about sharks who could sell fertilizer to the guy who cleans up after the elephants in the circus.

    Countrywide then used that money from those securities sales to make even more loans, creating an ever-growing, steroid-boosted hamster wheel of profits, until the wheels came off that company.

    In turn, Wall Streeters willy-nilly assigned values to this $2t of asset-backed debt based on their own internal models, in turn cooking up the earnings it booked off of these securities sales. It then wrote itself big fat bonus checks off these goosed-up earnings and shoved a lot of these junk securities off its balance sheet into structured investment vehicles, or SIVs, to protect its earnings even further (though that move is falling apart).

    Time to rethink the blame game.

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Aez

I disagree with the blame game in its entirety. The mortgage crisis itself was a natural product of the market cycle. With these new forms of mortgages, the markets discovered a new toy. They could now create new forms of house payments that could be tailored to the consumer while benefiting the banks. The banks benefited from the increased payments after the first several years and the consumer benefited from being able to purchase a house while earning his way into a better job. However, the market didn't fully realize the consequences of this new toy. The investment banks assumed that the price of real estate would stay up, so they could make these sub-prime mortgages nearly risk-free from the banks perspective. Since these mortgages became a risk-free way for the banks to gain high profit margins, they then began to abuse this new toy. They offered the sub-prime mortgage loans to people that were clearly unable to pay the later increased interest rates. This plan worked - until real estate prices dropped (Why did they drop? Real estate prices had been rising so fast that supply began to outstrip demand). After the real estate prices dropped, defaulted sub-prime mortgage loans started showing up as more than just a way to make profits. Of course, by then it was too late - the default wave grew and before the investment banks knew it, the housing market crashed and they were being driven to bankruptcy. Other factors (weak dollar, high inflation, high oil prices) made this housing market crash extend to the entire economy. Now, let's cut the rest of the economy out of this incident, because the factors that made the economy turn around can be attributed to the economy as a whole. If you're an investment bank executive, what lesson are you going to get out of this mess? Hopefully, that lesson isn't "Sub-prime mortgages are super-bad!" Hopefully, that lesson is that sub-prime mortgages have their uses, but they should be used carefully and there are consequences when you give these loans to people who can't pay them. This housing market crash will mean that banks will be careful in their use of alternative mortgage tactics. They've learned their lesson, they know how to use their new toy and they know the consequences of abusing it. Alan Greenspan recognizes this. He advocated the sub-prime mortgages because he believed that they were a valuable tool for expanding the housing market to those of lower incomes. His position was that minority groups and the consistently low-income could invest in their first home and therefore, have the opportunity to move to better environments and have a better chance to improve their future. I don't necessarily disagree with this theory and I can certainly see the logic behind it. Unfortunately, this useful financial tool was undermined by the booming/overheating real estate market. An earlier reader, Joe, asserts that Alan Greenspan caused two recessions. This is false. The dotcom bubble and the real estate bubble would have occurred whether Alan Greenspan was involved in the situation or not. The huge growth in these markets provoked Alan Greenspan's famously cited "irrational exuberance" which then led to overspeculation which of course, led to a bubble. Alan Greenspan did not have much to do with the inherent causes of either boom. By working to pop these bubbles earlier, Alan Greenspan helped the markets. The tech bubble was a clean bubble. Silicon Valley startups were smashed left and right and some fortunes were lost, but this was inevitable. There was far too much money chasing far too few good products in this market - investors were dying to get in on the next Google and Yahoo. Alan Greenspan's increasing rates did have some small effect in hastening a crash, this earlier crash made the effects less widespread. The recession suffered from this crash was indisputably mild, which is significant considering the huge period of growth we had recently gone through (normally lots of growth for a long time would herald a massive, long recession...) While Greenspan's effect on bursting this bubble and whether bursting it early really helped to that extent, it certainly can't be said that he hurt the nation with his actions. With the housing market situation, Greenspan bears even less blame. Although he created a favorable climate for the creation of these new mortgage tactics, he also guarded against a recession by increasing rates - once again seeking to pop the housing bubble. The housing bubble did pop and when it did, it had far greater consequences. As I said before, this was not largely because of the severity of the housing market crash, but more because of the high prices of oil, increased inflation, and the weakened dollar. Thus this housing crash brought several huge issues to light. It highlighted the fact that inflation is once again becoming a real factor in policy, which should require some serious rethinking by legislators with regard to their ridiculous spending. It showed the corresponding threat that the weakened dollar posed to Americans, making them acutely aware of the fact that we were making some poor policy decisions. And it demonstrated the effect that high oil prices have on the entire economy, which millions of Americans should take note of when they consider buying that new SUV. The housing crash has shown us that the clouds are NOT rosy on the horizon and we are cognizant of these issues now, rather than later when they could have had a FAR larger impact on our economy.

April 28, 2008 at 11:08 pm

Edward Panetta

Let me get this straight. First a person was required to put down at least 5% to 10%. Then because some politicians claimed that minorities were being left out of the American dream, a person could get a no doc no verification mortgage. Does anyone remember the special loan programs in low income areas to encourage minority ownership? Local leaders in Massachusetts (I use the word leaders loosely) cried racism and discrimination because according to them only whites were able to buy a home. So now the shoe drops and what is the claim by the same "leaders". Yes, discrimination! Those Evil Banks never told these poor folk that they could not afford the payments. In some cases claim, they were never told they had to pay the loan back. Those Evil Banks.

April 28, 2008 at 8:24 pm

Bobby Billings

Anyone who thinks Greenspan was not at fault does not understand the Mortgage Industry. He was on his way out and he knew it. He did a poor job his last few years with monitoring the Mortgage industry, rate adjustments and he is the person we all listened to. The Investors were on a short leash in previous years and were monitored well. He let the leash go and Investor products went out of control and guidelines were poorly written for products that are causing almost all foreclosures at this time. Greenspan is no doubt the reason this Foreclosure crisis has happened. I have been an underwritier for 20 years and I have seen the trends and I'm confident that he let the Banks, Private Investors , Mortgage Lenders, Brokers all have a party with greed. He could have prevented this with past experience and not let the Industry go WILD.

April 28, 2008 at 11:38 am

Zacattac

If you are a Democrate you blame Greenspan, if your a Republican you say it's the Senate, if your a moderate you say it's the House, and if your a DA you say it's the President. Who fault is it really? The borrower or the lender? The answer is simple it is both, and it's is all the above. We are all to blame. So the next time you point finger, make sure you know that as you are pointing that finger, three more are pointed back at you. Stop with the blame hate game. Spend the effort on the solution. We are all to blame! Someone famouse said "you who are with out blame cast the first insult" MLK

April 27, 2008 at 7:43 pm

Bob

Mortgages on steroids - I agree that's what Wall Street created - the whole excercise is a Frankenstein as you aptly call it. Even Paul Volker has thrown up his hands: "the markets are too complicated to be fair or functional" is how I believe he has characterized this mess.

April 27, 2008 at 7:33 pm

Joe

Greenspan and you are Wrong You used a lot of words defending Greenspan. Increasing the number of words you write doesn't change the facts. Greenspan is solely responsible for destroying our economy not once but twice...in the past 9 years. Greenspan hates bubbles. As a boy, he used to chase after them with pins and try to pop them. Some things never change. When the markets skyrocketed in 1999, Greenspan was raising rates through the roof trying to pop the bubble. What he DID do was destroy the economy and cause the Recession of 2001-2003. He tried to FIX the mess he created by lowering interest rates to 1% until 2004. This, of course, led to the housing bubble. Then, in 2004, he pulled out a pin chasing the housing bubble he alone created and started raising rates...17 straight times in fact, and gave Bernanke advice not to let the markets dictate policy. The markets were right and Greenspan was wrong. Again. From 1999-2008, Greenspan caused 2 Recessions within a 9 year period, worldwide famine, stagflation, a commodities bubble and a banking crisis that has caused the Arabs to own a large part of U.S. banks because they had the money to bail them out. Thanks, Mr. Greenspan. Who's side are you on, anyway?

April 27, 2008 at 6:54 am

Walt

Suppose that you are right and that Greenspan and the Federal Reserve cannot affect bubbles? Then why don’t they raise rates to defend the value of the dollar? They can’t possibly hurt the home prices right? If they can’t affect bubbles then they can’t rein in the bubble that is forming in commodities? We are doomed, doooommmmeeeeddd! The problem for the Federal Reserve is that they have established themselves as in charge of the economy. If things go well economically they are heroes if they go poorly they are goats. That is the risk you take being in charge. The bottom line is that Greenspan will just have to deal with it. It is the risk all leaders take and he should have thought about that before taking a position of power. For what it is worth I do agree with you that it is not completely Greenspan’s fault. The Federal Government loosened the lending laws, allowing Wall Street to run wild, forcing them to run wild in order to turn a profit. The housing bubble is in fact old news. The real trouble that the U.S. is facing is a bubble in the U.S. dollar; thanks to the Federal Government allowing our huge deficits. For years the U.S has been exporting inflation by shipping our manufacturing and dollars overseas. Now we are a consumer based society and our dollars are beginning to come home; we are seeing it in the form of inflation. The problem is bigger then it appears because traditionally consumer based societies do very poorly in recessions or depressions compared to manufacturing ones.

April 26, 2008 at 9:13 am

Dale

Your blog defends Mr. Greenspan on the basis of his reacting to the financial bubbles. Shouldn't the horrible facts of outsourcing all of our manufacturing and insourcing milions on millions of cheap labor be something he was looking at? Get real. Mr. Greenspan either knew what was happening or he is the most inept financial wizard in the world.

April 26, 2008 at 8:57 am

joey45

Your comments are right "on the money!" The breath of truth is refreshing in an era where spin-doctors are considered as having the only acceptable market philosophy, concerning both praise and criticisms. Greenspan is hailed as a demigod when he says what people want to hear, and as a demagogue when his view is contrary to conventional wisdom. You correctly point out that the Fed has never had the kind of authority that would have been necessary to deserve the praise or blame that is so often attributed to its ultimate actions. The Fed seems to me to be more like the typical mid-level manager that has to much responsibility, and far too little authority to warrant the criticism--or praise it often gets.

April 26, 2008 at 8:54 am

Dana

The housing bubble could have not occured if the old mortgage monthly payment rule of 25% of before tax income had been used, the home prices would have only risen as fast as wages. BUT, in the the last 4 years that ratio went from 25% to 65%. If your income taxes are 25% and your house payment is 65% that leaves only 10% of your income to live on, that is criminal. the lenders that did that should be held accountable....

April 26, 2008 at 12:54 am

Art Nelson

I never understood the inclination to blame Greenspan. Fear and Greed drive markets and bubbles are self-accelerating phenomena. There will be more to come and the reasons will be debated endlessly by both detractors and supporters of the Fed. Reading your article confirms my gut feeling that there are perhaps more variables at work than one can possibly point to at once. The Fed's actions seems to be more to keep the economy growing than fighting inflation, at least in the years that have mattered in my short life. Perhaps this will reverse after attempts to fight this downturn are blamed for the coming inflation. Surely another 'war' is in the making. The WAR on inflation. Everyone is bemoaning the cheap dollar (often called 'weak' for effect) while not quite getting that if this economy is allowed to tank without intervention, the dollar will sink right with it. With all the bills due in our economy, I prefer growth as a handy solution. I think the Fed is correct in their approach. I think Greenspan was correct in HIS approach. Although I disagree with you somewhat. Just when my e*trade account was climbing nicely, Greenspan's irrational exuberance comments were annoying and it surely seemed as though he was trying to talk down the tech stocks. Or maybe that's my irrational paranoia. In hindsight, it's tempting to 'pinpoint' the blame because the Fed is a huge target. We've forgotten all the other variables that were at work at the time and fall back on a single person. No one has that much power. Time itself seems to rewrite history. I love these blog-style articles. They make me think and I learn a lot. Keep them coming!

April 26, 2008 at 12:29 am

about this blog

  • Elizabeth MacDonald is the stocks editor for Fox Business Network. She is recognized as one of the top prize-winning business journalists in the country, and has received 14 awards, including the top prize in business journalism, the Gerald Loeb Award for Distinguished Business Journalism, and the Newswomen's Club of New York Front Page Award for Excellence in Investigative Journalism.

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