Greenspan's Housing Bubble
THE CONFIRMATION HEARING OF ALAN GREENSPAN has been the focus of some of my past pieces. With that hearing still in sight, this time, the prophetic warnings of Sen. William Proxmire receive attention. The then-chairman of the Committee on Banking, Housing and Urban Affairs expressed several concerns, the greatest of which was the trend toward the concentration in banking.
Proxmire made it plain he expected Greenspan would encourage these tendencies. And while the chairman’s statements and questions were directed to Greenspan, he spoke with the frustration of a man who sees danger ahead, but finds little acknowledgment among his fellow legislators.
Greenspan’s confirmation hearing was in July 1987. This was during the great deregulation of banking. Initiatives included the emancipation of the savings and loan industry and the authorization for commercial banks to cross state lines, offer home mortgages, enter the brokerage business, underwrite securities and change themselves into conglomerates offering all of the above services and more.
Toward the end of the hearing, Proxmire declaimed the trend: “It seems to me that banking in this country, and finance in this country, is likely to move very sharply…in the direction of concentration…I think most senators, if they thought very long about it, might be very concerned too. And I think the American people would be concerned too.”
A coincidental development was the socialization of risk, unwritten (at least in legislation), but gradually understood by all: the “too big to fail” doctrine. The government bailout of Continental Illinois in 1984 made it plain that the federal government would not allow one of the largest banks in the country to suffer insolvency.
In the same year that Continental Illinois was born again, 1986, Henry Kaufman, then the managing director and chief economist at Salomon Brothers, wrote an important book, Interest Rates, the Markets, & the New Financial World. As is often the case with books published well ahead of their time, nobody read it. Kaufman saw that banks would augment their balance sheets and profits by securitizing mortgages, consumer credit and commercial property. Financial derivatives were young. He expected these markets to explode.
Proxmire tutored Greenspan on the beauty of markets. He explained that the chairman of the Federal Reserve is the county’s leading bank regulator. Proxmire was concerned that Greenspan was taking this job at a time when bank concentration was looming. Just weeks before, the second and third largest banks in Wisconsin announced their intention to merge and form a bank that would be much larger than its nearest competition throughout the state.
Greenspan’s term was marked by government distortion of asset markets and the economy by consistently setting the short-term interest rate at a level that encouraged speculation, borrowing and bubbles, at the expense of long-term capital investment. It requires courage for a Fed chairman to resist the temptation of low interest rates.
Proxmire questioned the candidate’s resolve. Could Greenspan be able to say no to a Congress and president that would certainly love to claim credit for an expansive low-interest rate policy?
Proxmire continued to address financial concentration. Worried by Greenspan’s record, the senator questioned whether Greenspan would be able to disapprove of massive bank mergers that promote financial concentration. Proxmire believed that no regulator could do the job that competition can when it comes to the stability of the banking system.
Proxmire was looking in the wrong place for conviction. He probably knew this, since he described Greenspan elsewhere as a “get along, go along” guy. Over the course of Greenspan’s term at the Fed, banks merged and expanded until they were no longer banks. Now they take deposits, make loans, trade for their own accounts, manage hedge funds, serve as brokers for competing hedge funds, offer mortgages, securitize mortgages, sell securitized mortgages, (e.g., CDOs, CBOs, CMBS) and then sell credit derivatives to protect the buyer against bankruptcy of the securitized mortgage.
Kaufman foresaw the abstraction of matter. Derivatives grew fancier and more profitable and detached themselves from economic purpose: In a world that produces a $50 trillion gross domestic product, derivatives, mostly created from within the banking system, now top $500 trillion. Financing exceeds economic output by at least a factor of 10 — for what purpose?
The financial system serves an economic function of its own: Additional finance is needed to grow the real economy (e.g., that of manufacturing automobiles and selling flowers). Credit expanded faster than production. This impaired the ability of those living in the real economy to service debt (most obvious now in California, where, at the peak, the median house price exceeded $500,000, with a median income of $60,000).
Overindulgence is an age-old problem that rehabilitates itself in a recession, but the expedient route of faster financing beckoned. Too-low interest rates fueled the factories of finance with more energy than at Ford’s River Rouge, Mich. plant. The banks produced billion-dollar derivative instruments and sold them to hedge funds. Hedge funds produced more and sold them to banks. Generally, no capital was required to back these promises.
No money existed the moment before the transaction, yet the security was immediately integrated into the bouillabaisse of stocks, bonds and cash savings. Physical objects were turned into tradable currency — houses, powerboats, face-lifts, coffins and David Bowie. Finance was mimicking installation art; Alan Greenspan admitted to Congress he no longer knew what money was; money had grown more abstract than Greenspan’s syntax; if exhibited at the Whitney Museum Biennial, the chairman, stuffed and seated at the FOMC conference table, would win the blue ribbon for coherent symbolism.
The imprimatur of the Fed chairman went a long way to relieving concerns of derivative activity. Congress held hearings during the 1994 derivatives maelstrom. George Soros appeared before the House Banking Committee and stated: “There are so many [derivatives], and some of them are so esoteric that the risks involved may not be properly understood even by the most sophisticated of investors, and I’m supposed to be one of them.” After Congress completed its study, Alan Greenspan dismissed it as unnecessary. He described the risk of derivatives as “negligible.” Congress chose to believe the testimony of Greenspan and ignore Soros.
Whatever ran through Greenspan’s mind (it is not clear if Greenspan understood the consequences of his actions), the Federal Reserve, as the leading bank regulator, held an institutional bias toward expanding the derivatives markets: Commoditized and securitized loans relieved banks of default risk on their balance sheets.
The Fed chairman was ever vigilant in assuring all that derivatives reduced risk.
In May 2003: “Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management… As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”
In April 2005: “Lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers… These improvements have led to rapid growth in subprime mortgage lending.”
In May 2005: “The use of a growing array of derivatives and the related application of more sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions.”
Henry Kaufman viewed the development differently: “Institutions with aggressive [derivative] models will get the business and garner the profits. Senior managers will find it more difficult to resist increasing pressures to compete using riskier models, especially if doing so would cause the earnings and stock process to lag behind those of institutions deploying riskier models. Ongoing financial intermediation and balance sheet leveraging also will continue to support riskier modeling on the near horizon.”
In March 2007, before all hell broke loose, Kaufman viewed the preferable solution as impractical.
“One [solution] is to let competitive forces discipline market participants,” Kaufman said. “In this scenario, the managers who perform well will prosper, while those who do not will fail. [But] the failure of behemoth financial conglomerates not only exacts enormous social costs, but also poses systemic risks for markets around the world.”
During Greenspan’s recent book tour promotion, the most enterprising interviewer was Jon Stewart on Comedy Central. Stewart, unencumbered with presumptions of how he should think and what he should not say, spoke much as the boy who asked why the emperor wore no clothes:
STEWART: “Many people are free market capitalists, and they always ask about free market capitalism, and that is our economic theory. So why do we have a Fed?… Wouldn’t the market take care of interest rates and all that? Why do we have someone adjusting rates if we are in a free market society?”
GREENSPAN: “You’re asking a very fundamental question.”
STEWART: “I am? Should I leave?”
Greenspan convinced his host to both stay and listen to an inaccurate Federal Reserve pep talk. (The former chairman seemed to think the Fed was founded in the 1930s.) Stewart was not satisfied with the mumbo jumbo
STEWART: “So we’re not in a free market, then.”
GREENSPAN: “No. No.”
STEWART: “There’s a…benevolent hand that touches us.”
GREENSPAN: “Absolutely. You’re quite correct.”
Proxmire, Kaufman and Stewart alerted their audiences to government interference in the market. (The Greenspan myth includes a commitment to laissez-faire economics, which is a wholly inaccurate characterization.) In the end, both Proxmire and Kaufman tacitly conceded defeat to the monster they saw so clearly and that may devour us all. Proxmire concluded: “This nomination should result in a slam-bang debate in committee and the floor. It won’t, and it is startling, given what you have told us.”
At the end of his 2007 speech, Kaufman noted that decisive changes in economic thought occur only after collapse: “In light of this pattern, it seems unlikely that a new economic philosopher will come forth with an integrated economic and financial approach anytime soon. Today’s most influential economists have strong vested interests in preserving the integrity and reputation of their views…especially for those who have reached a leadership role. A lifetime of research and writing is at stake.”
In other words, the former chairman of the Princeton economics department, Ben Bernanke, is unlikely to question the viability of his own institution. The comedian from Comedy Central at least planted the seeds for a new economic philosopher.
January 21, 2008