Alan Greenspan got taken to the wood shed this week in his testimony before congress regarding the current economic melt down. He called it a "once-in-a century credit tsunami." You can read his entire testimony herehttp://oversight.house.gov/story.asp?ID=2256
The reputation of the once highly regarded financial guru is taking a substantial hit in hind sight as we can examine some of his policies and determine that they had a direct impact on our current situation.
Oversight and Government Reform Committee Chairman Henry Waxman was quick to point the finger at Greenspan in his opening remarks.
"For too long, the prevailing attitude in Washington has been that the market always knows best. The Federal Reserve had the authority to stop the irresponsible lending practices that fueled the subprime mortgage market. But its long-time Chairman, Alan Greenspan, rejected pleas that he intervene."
Some of this is true, but of course Henry is silent on the subject of reining in Fannie Mae and Freddie Mac during the entire period and that failure can be clearly laid at the feet of Barney Frank and others. Democratic affordable housing goals have come back to haunt them in driving prices down dramatically to the point that lots of housing is affordable but there are not enough buyers or lenders with money to enter and stabilize the market up to this point in the crisis.
Had conventional lending practices been allowed to stay in force over the past seven years we might have avoided a good deal of the distress we are now under. By instituting lending practices that encouraged unqualified buyers to over extend themselves, it contributed to an enormous increase in demand and subsequent substantial increase home ownership but like any bubble bursting it is now wreaking vengeance on the down side in a way that has never before been experienced.
This kind of social engineering in the housing markets can also be illustrated in Massachusetts under the Chapter 40B "anti snob" legislation. This legislation allows a developer to get state approval to over ride local zoning ordinances and build very dense projects in markets that would otherwise not allow them.
What this does is to decimate urban housing. The process is simple. In a real estate market that is not artificially manipulated, investment will eventually go to where costs are lower and land is cheaper. Such opportunities have existed all over the Commonwealth. In the North, in cities like Lawrence and Haverhill and in the South in Fall River and New Bedford, land for housing is available but why would housing developers take risks in building or rehabbing in older urban settings when they can use 40B to build very dense and very profitable housing in more desirable suburban communities? Additionally, why would a renter go where market forces would direct them when they could go to a manipulated market that provides roughly the same cost but is in a better location?
Poorly thought out housing legislation in Massachusetts, however, is not what triggered the mess we are in right now across the nation. Some very specific events can be traced to the tumbling financial dominoes that contributed to the problem for the system and then exposed its weakness.
The first was the dramatic decrease in interest rates following the September 11th attacks. In an effort to jump start a paralyzed America, Greenspan and the Fed dropped rates to levels unseen in our life time. After the millenium and internet bubble bursting, the Fed began to reduce the Fed rate from a high point of six percent in May of 2000 down to 3% in August of 2001.http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
Six days after the September 11, 2001 attacks the Fed cut 50 basis points and continued to cut until the rate hit a low of .75% in November of 2002. What followed was a purely natural reaction to such cheap money. The economy flourished in a host of areas particularly in housing and in other large ticket capital consumer goods. The post 9/11 market low on the Dow Industrial averages was 7181.87 on October 10, 2002. Almost five years later to the day, the Dow close on October 9, 2007 was 14,164.53.
Huge amounts of debt were issued through out the entire economy. Home owners accessed money through equity loans, businesses borrowed at cheap rates, big business floated bonds, non profits went on building sprees and municipalities, states and other agencies all did like wise.
The benefits of such a boom were visible through out the United States and other international societies. With money available and cheap sources of labor in such emerging economies as China and India, purchasing power went a long way. The ultimate benefit in the U.S. was that more people entered the housing market than at any time in U.S.history. The benefit globally was that more people left poverty than at any time in history.
The bloom started to come off the rose in 2005. The Fed had begun to raise rates in 2003 in order to bring a more realistic cost of money into the market place. However, by the end of 2005 it became apparent that the inflation fighters at the Fed were going over board. In August of 2005 the Fed had completed ten consecutive increases in the rates and they weren't done. Although stopping increases was apparent even to an amateur, http://philgallagher.blogspot.com/2005/12/stop-raising-interest-rates.html, the Fed went on to raise rates 7 more times, culminating in a Fed Funds rate of 5.25% in June of 2006.
As rates rose it began to affect many of the designer type mortgages that had been created during the housing boom. Adjustable rate mortgages began to reset as well as LIBOR plus mortgages continued to climb and soon a trickle of people in trouble began to become a steady stream. What exacerbated the problem for the home owner was two other assaults on his budget. Heating and utility costs were climbing as well as property taxes. Communities experienced significant increases in residential values while commercial values sank because of increased competition from new construction. This resulted in property taxes rising on the residential sector significantly.
Where the crack in the credit markets came was in a rather odd place . Earlier this year it was reported that an obscure debt market called the auction rate market ceased to operate.
The auction rate market was a place where a variety of issuers of debt could get short term rates on long term paper by simply having an auction every 7 or 28 days. The buyers were companies, government entities and investors with lots of cash who wanted higher than money market rates of return, yet could have liquidity if they needed the money. The market was made by Wall Street firms who would buy up paper for their own books to smooth out any liquidity differences between buyers as sellers.
This system enabled the Wall Street firms to essentially sell this market on the basis of it being as good as cash. Having participated in this market myself for many years and having purchased hundreds of millions of dollars for clients, I had no doubt as to the veracity of that statement. Working a different book of business these days in the banking industry I was not close to events as they unfolded, yet when the auction rate market failed earlier this year I was stunned that such a thing could happen so quickly.
Here is where rates and foreclosures in the housing market began to take a huge toll and up to this point what has decimated and perhaps killed the investment banking business. Sub prime is now a term that entered the American lexicon.
During the housing boom, Wall Street saw an opportunity to sell securities made up of tranches of mortgages that were sub prime, meaning made up of home owners who would not qualify for a conventional mortgage you might find in the regular banking community. Because they were made up of something as stable as the American home and they offered a good rate of return, many institutional buyers purchased them and added them to their portfolios. Of course, many of the investment banks who wrote these SIVS (structured investment vehicle) and (RMO's (residential mortgage obligations) had them on their own books.
Now comes the bursting of the bubble and the term liquidity crisis becomes a common term in America and around the world. Mark to market accounting, although less well known also plays a key role.
As home owners began to fail and as the housing market began to cool, suddenly mortgages contained in the investments on the books of these companies began to drop in value. As companies who needed cash began to liquidate these securities at discounted prices it spread through the markets like a fast moving virus. If you have a similar security to mine in your book and I sell it at a 20% discount the rules now said you had to adjust your balance sheet to show that loss of value.
As the values plummeted and subsequently became unable to even be priced, the damage began to unfold in the form of a complete lack of buyers. The story continues to unfold and although we may be at or near a bottom we are still in uncharted waters.
I can leave you with one very dramatic example of the damage done to a companies balance sheet. On July 28, a famous Wall Street firm sold a total of 30.6 billion dollars worth of CDO's (Collateralized debt obligations, CDOs are an unregulated type of asset-backed security and structured credit product) for a total of 6.7 billion dollars. They sold at this level because the firm could not find anyone else willing to buy the portfolio for more.
Was it a fair price? Fair of course is in the eyes of the beholder. The buyer got a basket of securities back by mortgage collateral. If we say that everyone of those mortgages default and go to auction, in order for the buyer to lose money every single one of those mortgages would have to auction at 22 cents on the dollar. The world famous firm that was the seller of those securities was bought in a fire sale two months later.
It is difficult to guess the bottom of the market and when the credit conditions will stabilize. One thing that is not hard to predict is that going forward it will not be business as usual in the credit markets. Fundamental rules must be put in place and maintained so that the leveraging of the economy does not precipitate a near destruction of the country again.
