Dissecting Alan Greenspan's Testimony, Finds Flaw in His Ideology

I hate to keep writing about C-Span hearings, but Former Federal Reserve Chairman, Alan Greenspan, admitted there was a flaw in his ideology that markets could regulate themselves without a problem. Greenspan didn't price in "failed banking model" risk into his ideology. This kind of reminds me of Long Term Capital Management's collapse in 1998, when unpredictable outside forces caused the genius treasury arbitrage model to fail, and these models were Pulitzer Prize certified.

Greenspan basically said he thought he could trust the banking system, credit rating agencies and loan officers to price risk appropriately when playing with shareholders equity. But with extremely low interest rates, home buyers salivating, and shareholders, CEOs and loan officers getting rich, why would they think about sacrificing their stock price, profit or commission? Debt securitization was also a big money maker and it turned out quantity not quality ruled the game. Greenspan blamed the heated securitization market from 2005-2007, and felt everything before that time period was working out just fine. Originators of debt securities decided not to waste time underwriting because the debt was quickly securitized and shoved off to somebody else's balance sheet, all for a nice fee. So should Greenspan have used his powers to clamp down on the market??? Would he have done something if he was still Chairman in 2006/07, after the fact? Did he lower rates too much to cause the overheated credit market to collapse? What if Greenspan started raising rates in 2003 and not 2004, would that have caused just a minor credit correction? That I wish I knew.

Fed Funds Rate


Below are quotes by Alan Greenspan and Henry Waxman during the hearing, taken from the C-Span script which is attached to the video. The video is queued up to start right when Greenspan speaks. In the beginning of the hearing Alan Greenspan gave his reasons why the financial crisis occurred, and then came Q&A.


Alan Greenspan Testimony “As I wrote last march those of us who have looked to the self-interest of lending institutions to protect shareholders equity, myself especially, are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial market’s state of balance. If it fails as occurred this year, market stability is undermined. 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 the 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 the 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. It was the failure to properly price such risky assets that precipitated the crisis.

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 historical periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today in my judgment.

Oversight Committee Chairman Henry Waxman: I will start the questioning. Dr. Greenspan, I want to start with you. You were the longest serving chairman of the Federal Reserve in history and during this period of time were perhaps the leading proponent of deregulation of our financial markets. Certainly you were the most influential voice for deregulation. You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements. In 1994 you testified at a congressional hearing on regulation of financial derivatives. You said there’s nothing involved in federal regulation which makes it superior to market regulation. In 1997, you said there appears to be no need for Government regulation of off exchanged derivative transactions. In 2002 when the collapse of Enron led to renewed congressional efforts to regulate derivatives, you wrote to the Senate, we do not believe a public policy case exists to justify this Government intervention and earlier this year you wrote in the Financial Times, bank loan officers in my experience know far more about the risks and workings of their counterparties than do Bank regulators. My question for you is simple, were you wrong?

Alan Greenspan: I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was capable of protecting their own shareholders and the equity in the firms, and it has been my experience, having worked both as a regulator for 18 years and similar quantities in the private sector, especially 10 years at a major international bank, that the loan officers of those institutions knew far more about the risks involved and the people to whom they lent money than I saw even our best regulators at the fed capable of doing. So the problem here is something which looked to be a very solid edifice and indeed a critical pillar to market competition and free markets did break down and I think that shocked me. I still do not fully understand why it happened and obviously to the extent that I figure out where it happened and why, I will change my views. As the facts change, I will change.

Oversight Committee Chairman Henry Waxman: I’m going to interrupt you. The question I have for you is, you had an ideology. This is your statement. “I do have an ideology. My judgment is that free competitive markets are by far the unrivaled way to organize economies. We have tried regulation, none meaningfully worked.” That was your quote. You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. And now our whole economy is paying its price. Do you feel that your ideology pushed you to make decisions that you wish you had not made?

Alan Greenspan: I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works"

Source: C-Span Video Library (Video/Script)

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