Greenspan Testimony on Source of Financial Crisis

Former Federal Reserve Chairman Alan Greenspan is set to testify today before the House Committee of Government Oversight and Reform. These are his prepared remarks:

Mr. Chairman, Ranking Member Davis, and Members of the Committee:

Thank you for this opportunity to testify before you this morning.

We are in the midst of a once-in-a century credit tsunami. Central banks and governments are being required to take unprecedented measures. You, importantly, represent those on whose behalf economic policy is made, those who are feeling the brunt of the crisis in their workplaces and homes. I hope to address their concerns today.

This morning, I would like to provide my views on the sources of the crisis, what policies can best address the financial crisis going forward, and how I expect the economy to perform in the near and longer term. I also want discuss how my thinking has evolved and what I have learned in this past year.

In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences. This crisis, however, has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment. Fearful American households are attempting to adjust, as best they can, to a rapid contraction in credit availability, threats to retirement funds, and increased job insecurity. All of this implies a marked retrenchment of consumer spending as households try to divert an increasing part of their incomes to replenish depleted assets, not only in 401Ks, but in the value of their homes as well. Indeed, a necessary condition for this crisis to end is a stabilization of home prices in the U.S. They will stabilize and clarify the level of equity in U.S. homes, the ultimate collateral support for the value of much of the world’s mortgage-backed securities. At a minimum, stabilization of home prices is still many months in the future. But when it arrives, the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards reengagement with risk. Broken market ties among banks, pension, and hedge funds and all types of nonfinancial businesses will become reestablished and our complex global economy will move forward. Between then and now, however, to avoid severe retrenchment, banks and other financial intermediaries will need the support that only the substitution of sovereign credit for private credit can bestow. The $700 billion Troubled Assets Relief Program is adequate to serve that need. Indeed the impact is already being felt. Yield spreads are narrowing.

As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ 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 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.

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 derivates 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.

When in August 2007 markets eventually trashed the credit agencies’ rosy ratings, a blanket of uncertainty descended on the investment community. Doubt was indiscriminately cast on the pricing of securities that had any taint of subprime backing. As much as I would prefer it otherwise, in this financial environment I see no choice but 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.

There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitization. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.

The financial landscape that will greet the end of the crisis will be far different from the one that entered it little more than a year ago. Investors, chastened, will be exceptionally cautious. Structured investment vehicles, Alt-A mortgages, and a myriad of other exotic financial instruments are not now, and are unlikely to ever find willing investors. Regrettably, also on that list are subprime mortgages, the market for which has virtually disappeared. Home and small business ownership are vital commitments to a community. We should seek ways to reestablish a more sustainable subprime mortgage market.

This crisis will pass, and America will reemerge with a far sounder financial system.

Editor’s Note: What did you think about this testimony? Do you think Big Al is full of you-know-what? Please feel free to send any comments to Short Fuse at

The mood was bleak on Wall Street at the closing bell yesterday, with stocks looking at the seventh-biggest drop in history, falling 514 points. A litany of data showed that neither Wall Street, nor the global economy, was anywhere in the vicinity of the road to recovery.

In addition to extremely poor 3rd quarter earning results, Realty Trac reported that over 81,000 home were foreclosed upon in September. This is a 71% increases from the same time period just a year ago.

"I wouldn’t be surprised to see foreclosures increase as the economy slows down," said Rick Sharga, Realty Trac’s VP of marketing. "The people living paycheck to paycheck are at risk if they lose their jobs. It will cause more people to lose their homes."

It could be argued that perhaps these homeowners should have thought about that minor detail before they took on mortgages they couldn’t truly afford, but we digress…

Shelia Blair, chairwoman of the FDIC is working on a plan to help the struggling homeowners.

"Loan guarantees could be used as an incentive for services to modify loans," Blair said, "Specifically the government could establish standards for loan modifications and provide guarantees for loans meeting those standards."

The outcome of which being, Blair continued, "unaffordable loans could be converted into loans that are sustainable over the long term."

This news should make the protesters that we at the Mortgage Bankers Association annual convention this week happy. MarketWatch reports that several members of the political protest group Code Pink showed up at the convention and the groups co-found Medea Benjamin "walked on stage during a panel discussion on Fannie Mae and Freddie Mac and demanded a moratorium on foreclosures. Meanwhile, outside the Moscone West Convention Center in San Francisco, another group of people picketed as convention attendees entered on Monday morning."

Code Pink and the Party for Socialism and Liberation were in full effect at the convention, with their main issue being the over $700 billion bailout. The battle cry was "Jail them, don’t bail them." Catchy.

"The main point, and the main issue for everyone, is there should be a stop to foreclosures and evictions and the government should be assisting the victims of the crisis and not the people who created it," said Richard Becker, spokesman for the Party for Socialism and Liberation.

But why are they protesting at the MBA conference? "The relationship between the mortgage bankers and Wall Street is just connecting a couple of dots," Benjamin said. "When the housing bubble became a more general economic crisis, the ways to deal with it were coming from Wall Street and the bankers, and not coming from the point of view of who were the victims of this, people who had been pushed into loans they should never have gotten," Benjamin said.

Now, we agree that $700 billion is a steep price tag to help out Wall Streets ‘masters of the universe’ – but there is something to be said about accountability at all levels of this crisis. We can’t help but wonder how these homeowners did not see this coming. If you live paycheck to paycheck, how did you think you could afford a mortgage payment?

We are astounded by the overwhelming naiveté of the American people, who believed that interest rates would always stay low and that they could used their home as an ATM indefinitely.

But, as our fearless leader often points out, "People believe what they need to believe when they need to believe it."

*** The Labor Department reported yesterday that there were more "mass layoffs" (where 50 or more employees are let go at one time) than in any month since September 2001.

From The Washington Post:

"Companies that announced plans this week to cut jobs include Internet company Yahoo (1,500 positions), pharmaceutical company Merck (7,200), National City bank (4,000) and Comcast, the cable company (300)."

Looks like we can forgo the retail boost we usually see in the next couple of months because of holiday spending. Santa’s bag is sure to be a little lighter than usual this year…

*** Our friend Chuck Butler highlighted an interesting quote from Founding Father Thomas Jefferson in today’s issue of The Daily Pfennig :

"The central bank is an institution of the most deadly hostility existing against the Principles and form of our Constitution…Bankers are more dangerous than standing armies…(and) if the American people allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the People of all their property until their children will wake up homeless on the continent their Fathers conquered."

We thought this quote was quite apropos, especially considering that one of the ‘Founding Fathers of the credit crisis’ testified today in Washington. That’s right, Big Al was on the Hill today, and said that we in the midst of a ‘credit tsunami’. What he said, in full, below…

*** And we’ll wrap up this section of The Daily Reckoning today with a few words on the gold price from Bryon King:

"The price has bounced all over the charts lately, from the mid-$800s per ounce down to $750 and below. The thing is, the ‘paper’ price from gold has just plain disconnected from the price – and the availability – for the real stuff.

"Have you tried to buy real gold lately? Many dealers are just out of bullion and coins like the U.S. Gold Eagle and Krugerrand. The U.S. Mint has customers on allocation. The only way to get real gold is to pay a premium over the ‘paper’ price, and I don’t mean the former $20 markup per ounce.

"As far as I can find out from a spokesperson, the SPDR Gold Shares does have physical gold to back up every ounce on the books. The only other way to find out is to go tour the vault and count each gold bar.

"The other gold and precious metals miners in the Outstanding Investments portfolio are all way down. It’s a combination of low metal prices and the market meltdown. I know that it’s frustrating to watch these gold miners decline. It’s painful. What ever happened to the ‘dollar down, gold up’ thesis? I’m just going to wait it out. Unless I absolutely needed the money right now – and if I did not come up with the money, there would be a severed horse head in my bed – I would not sell the gold shares.

"I’d like to think that the current share prices are absolute bargains. I’d like to think that we would all kick ourselves in five years for not buying up all the shares we can get hold of right now. But then again, this market is confounding. There always seems to be another down day. So my advice is to hang in with what you’ve got. And buy shares only with your speculation money, not any funds that you cannot afford to tie up for a long time.

"And speaking of long times, I believe that the current banking ‘bailouts’ (pardon me, ‘rescues’) are going to be inflationary. The general macroeconomic trend right now is deflation. And the U.S. and most other central banks of the world are fighting that with inflation of the money supplies. This can only be bad news for the dollar. And it should be good for gold."

So, you could wait it out empty-handed…or you could take advantage of gold’s uncharacteristically low price and stock up. And at just a penny per ounce, this will hardly make a dent in your bank account.

Well, that’ll do it for us today. Until tomorrow,

Short Fuse
The Daily Reckoning
October 23, 2008

The Daily Reckoning