Alan Greenspan on the Cause of the Crash

[_Analytics]

A debate that continues to cycle through here is what caused the economic colapse. Some people blame the government, and others blame the actions of players in the free market.

In his testimony before Congress, Alan Greenspan--former champion of deregulation--blamed the actions of free-market players:

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. But 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.”

The consequent surge in global demand for U.S. subprime securities by banks, hedge, and pension funds supported by unrealistically positive rating designations by credit agencies was, in my judgment, the core of the problem. Demand became so aggressive that too many securitizers and lenders believed they were able to create and sell mortgage backed securities so quickly that they never put their shareholders’ capital at risk and hence did not have the incentive to evaluate the credit quality of what they were selling. Pressures on lenders to supply more “paper” collapsed subprime underwriting standards from 2005 forward. Uncritical acceptance of credit ratings by purchasers of these toxic assets has led to huge losses.

http://clipsandcomment.com/wp-content/u ... 081023.pdf

[_Bob Loblaw]

It's interesting that his only prescriptive regulation would be "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."

That would seem a no-brainer to me.

[_Analytics]

It's interesting that his only prescriptive regulation would be "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."

That would seem a no-brainer to me.

It’s tricky because there are two layers of this. The people who invested in the securities were sophisticated grownups, and they could easily tell the issuers, “look, we’re just not going to invest in your securities unless you retain some of the risk.” That is quite similar to what reinsurance companies do when they help capitalize insurance companies—they’ll take some of the risk, but they insist that the direct writer retains some risk, just so they have some skin in the game. The insurance industry does this without government regulation forcing them to, and investors in securitized mortgage obligations could set the same standards for themselves. So why make a regulation about it? As long as they are reasonably sophisticated players, the government doesn’t need to be there to protect them from themselves.

The bigger issue is what to do about “too big to fail”. If the downside risk to their private business dealings is global economic catastrophe, there is a problem. I like Jon Huntsman’s approach to this: rather than a ton of Dodd-Frank style regulation on banks that are too big to fail, simply declare that banks that are too big to fail are too big to exist and break them up.

[_cinepro]

A debate that continues to cycle through here is what caused the economic colapse. Some people blame the government, and others blame the actions of players in the free market.

In his testimony before Congress, Alan Greenspan--former champion of deregulation--blamed the actions of free-market players:

There is no debate. The economic collapse was caused by both the government and the "free market". It couldn't have happened if both hadn't worked together to create it.

That being said, it wasn't really a "free market". A truly "free market" would have to allow for the losers to take their losses. Once the government steps in and starts writing checks to the losers to make up for their losses, it stops being a "free market" (and to the degree that the players expected the government to do this, such as with Fannie Mae and Freddie Mac, a "free market" never existed in the first place).

The government intervened to help inflate the sub-prime bubble with Fannie Mae, Freddie Mac and the FHA, among other entities and policies, and then intervened to try and stop the bubble from deflating. So it wasn't a "free market" on the way up, or on the way down.

As far as the ratings agencies go, see if you can listen to this podcast without throwing up:

http://www.thisamericanlife.org/radio-a ... e-watchmen

[_Analytics]

There is no debate. The economic collapse was caused by both the government and the "free market". It couldn't have happened if both hadn't worked together to create it.

You said that a week or two ago, which I was I resurrected the topic. Can you explain why the government had to have been a part of it? There was a huge demand for mortgage-backed securities. Sometimes Fannie and Freddie were middle-men in some of the deals. Sometimes they weren’t. As various investment banks proved, the private sector was willing and able to serve as middle-men, and had lower underwriting standards to boot. If you got rid of Fannie and Freddie, then Lehman Bros., Bear Stearns, et. al. would have been that much bigger to fill the void.

That being said, it wasn't really a "free market". A truly "free market" would have to allow for the losers to take their losses….

What is your point here? Are you suggesting that the economy would now be better if the government hadn’t intervened in the crisis? Are you making a bigger point and are philosophically against all government protection, such as the FDIC?

The government intervened to help inflate the sub-prime bubble with Fannie Mae, Freddie Mac and the FHA…

They were a middle-man in a process that had other middle-men that were willing and able to do the job. The bubble would have happened without them.

As far as the ratings agencies go, see if you can listen to this podcast without throwing up: http://www.thisamericanlife.org/radio-a ... e-watchmen

Just so the reader is clear, “ratings agencies” are private companies that simply offer their opinions about the safety of bonds.

[_iamse7en]

The cause of the crash was the cause of the boom: Alan Greenspan.

[_cinepro]

What is your point here? Are you suggesting that the economy would now be better if the government hadn’t intervened in the crisis? Are you making a bigger point and are philosophically against all government protection, such as the FDIC?

I think it's very likely that the economy would be better now if the government hadn't intervened. That being said, I think the bubble would have been much less severe if the government hadn't been involved in creating it (especially Greenspan's and the Fed's encouragement). So I'm against government intervention on both sides of the equation.

The FDIC is interesting, because while I can see its benefits, it does also create a moral hazard on the part of consumers. When people buy a car, "reliability" is usually a very important consideration, because no one wants to be stuck with repair bills if the car breaks down. But what if the government provided "repair insurance" for all new cars? People would stop caring about reliability. Likewise, when was the last time you worried about how "reliable" your bank was? No one cares, because of the FDIC. That has to have an effect on how banks are run.


[quot]They were a middle-man in a process that had other middle-men that were willing and able to do the job. The bubble would have happened without them.[/quote] They were an important "government sponsored" middleman, so while there were certainly other middlemen, I'm not sure the volume of Freddie and Fannie would have been totally replaced by other private firms.

This article has some figures on the subject (although I think they might overstate the degree to which Fannie and Freddie "led" to the collapse):

http://washingtonexaminer.com/conn-carr ... I8yVGeE5U0

Countrywide was a growing force in the mortgage industry when it partnered with Fannie in 1992. But after Mozilo's firm secured a steady government buyer for their loans, business exploded. Revenues went from $92 million in 1992, to $860 million in 1996, to $2 billion in 2000. By 2004, they were the nation's largest mortgage lender.

The secret to Countrywide's success was no mystery: They shredded standard industry lending practices, giving home loans to virtually anybody who asked. Fannie Mae not only knew this, Fannie rewarded it.

In 2000, the Fannie Mae Foundation honored Countrywide for "Outstanding Achievement" in the industry. The foundation's 2000 annual report noted: "When necessary -- in cases where applicants have no established credit history, for example -- Countrywide uses nontraditional credit, a practice now accepted by [Fannie]."

Countrywide continued to be the biggest supplier of loans to Fannie Mae all the way through the height of the housing boom. In 2004, 26 percent of the loans Fannie bought were from Countrywide. In 2007, that number had risen to 28 percent.

This chart shows the breakdown between private suppliers of mortgage backed securities and government backed suppliers:



Obviously the private firms were huge participants, but by 2005, why were Fannie and Freddie needed to sell crap mortgage bonds at all? Fannie Mae has received $170 billion in taxpayer funded bailouts so far, with the total number projected to hit $260 billion by 2016.

Yay for government intervention in the mortgage market!

Just so the reader is clear, “ratings agencies” are private companies that simply offer their opinions about the safety of bonds.

[/quote]

I wouldn't say "simply". Their opinions carried an extreme amount of weight, and investments that were highly rated were assumed to have little (if any) risk. Many investment portfolios such as pension funds had a requirement for a certain rating, so a high rating from the agencies allowed pension funds and other investors to purchase mortgage-backed securities on the assumption that they were safe. At one point, mortgage backed securities were rated as highly as US Treasuries!

[_Gadianton]

What is your point here? Are you suggesting that the economy would now be better if the government hadn’t intervened in the crisis?

I don't think this question is entirely fair. ;)

A disciple of the market must take expectations into account. According to John Cochrane, the market anticipated that the government would not let banks fail. If this is true, then the risk of investment is less than in Cinepro's free market scenario. Will an Indy driver drive the same speed both with and without a seat belt?

According to Cochrane, the problem was that Lehman brothers failed, the government said "uh, sorry..." and the market re-adjusted expectations, resulting in the the collapse. Unanticipated policy does matter, it's akin to an exogenous shock. So in Cochrane's scenario, had there been no precedent, perhaps the risk-taking wouldn't have been so outrageous. But given expectations, the risk taking was rational. When expectations changed, rationality sent the economy into a tail spin.

Given expectations, yes, the government should have stepped in. The worst case scenario is a false sense of security. However, had there been no safety belt in the first place, the driving would have been in better control.

[_MeDotOrg]

A debate that continues to cycle through here is what caused the economic colapse. Some people blame the government, and others blame the actions of players in the free market.

In his testimony before Congress, Alan Greenspan--former champion of deregulation--blamed the actions of free-market players:

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.

Greenspan has described what happened as a 'perfect storm', but it was a perfect storm that was aided and abetted by greed and stupidity. Standard and Poor's. Moody's and other credit agencies were willing accomplices in misrepresenting the risk involved in Collateralized Debt Obligations.

Credit rating agencies routinely gave AA and AAA ratings to CDO's that they knew were dreck. Moody's analytics, an investor tool, routinely gave lower ratings to Credit Default Swaps than the rating side of the Company. In short, in house company investors knew that the ratings they were giving were, ah, less than truthful.

[_cinepro]

Credit rating agencies routinely gave AA and AAA ratings to CDO's that they knew were dreck. Moody's analytics, an investor tool, routinely gave lower ratings to Credit Default Swaps than the rating side of the Company. In short, in house company investors knew that the ratings they were giving were, ah, less than truthful.

I do admit that the fact that the ratings agencies still exist is a spectacular failure of the "free market."

There may not be enough cause (or backbone) to send the players to jail, but the "market" should have summarily executed the companies and replaced them with something better.