Bank Crisis Aftermath: Greenspan Speaks

For those of us who have nothing better to do than get immersed in the banking crisis and its aftermath, this week has presented some riveting television. The Financial Crisis Inquiry Commission has been grilling some of the key players – dare I say villains? – of the implosion that led us into recession. Some of the conversation and questioning is revealing. Quite what this will all lead to is anybody’s guess, but in the meantime we are being treated to a typically American gala of recrimination, self-congratulation, and, in some cases, of reputation defending.

Yesterday’s star was Alan Grenspan, who amongst all the key players is probably most culpable, both for the actions he took and for the many that he refused to take. His testimony provides us with an acid test for the problems we face as we reconstruct banking to make it less damaging to our economic health.

With that in mind let’s pick apart some of his key points.

First off he reminds us that sub-prime lending has been around a lot longer than simply the past few years. It was a small, and well functioning segment of the mortgage market for the previous decade as well. Sub-prime loans were a way of extending home ownership to people who would never have been qualified for a regular loan. It was always higher risk business than regular mortgage lending, but because it was so small a piece of the whole market that risk was eminently manageable.

Where the wheels fell of was when home prices began their bubble driven rise.

Once home prices began that rise, many people who would have qualified for a normal mortgage found themselves being squeezed out of home ownership opportunities. In a nation obsessed with home ownership, and with a conservative political regime dedicated to private property as part of its ideological platform, lenders who began to deploy sub-prime techniques more broadly were encouraged rather than discouraged. Add in the inherent profit advantage sub-prime loans present the lender – which is only reasonable given their higher risk – and a we lay the groundwork for the disaster of 2006/2007.

At least this is Greenspan’s view.

He may be stretching things a little, but by and large this much is correct.

In and of itself however this would not have caused the crisis, we needed more ingredients.

The next that Greenspan identifies is the role played by the quasi-government agencies – the GSEs – Freddie Mac and Fannie Mae. These two bodies fell under intense political pressure to accommodate and encourage the boom in mortgage lending during the 2000’s. This pressure was a manifestation of the ideological approach of the Bush administartion, which is why it odd to see so many Republicans listing the GSEs as prime villains rather than supporting cast players. Greenspan himself falls into this same trap. Yes, the GSEs we part of the problem, but they were not responsible alone for the crisis, and they were coerced at first to jump into the quagmire that they then enjoyed so much later on.

Crucially, Greenspan cuts his data short when he throws blame the GSE’s way. He leaves off the two years immediately prior to the collapse. These were two years when the GSE’s role was much diminished compared with the extraordinary excesses of the private sector.

The next villain Greenspan list is the boom in securitization, and the foolery – my words not his – of the rating agencies.

It was securitization that opened the door for the final orgy of self-destruction the industry indulged in.

By dint of incompetent math, incredulous management, and outright greed on the front lines, banks willingly destroyed their balance sheets in a two or three year epic of stupidity.

The trick was that they rushed to lend ever larger amounts of sub-prime loans, making what had been a small segment of the business into the largest segment in no time at all. They then off loaded the loans by packaging and selling them to investors the world over. These investors thought they were buying safe assets – after all the rating agencies had confirmed that by giving the packages the highest possible rating. We all now know, of course, that the magic trick that converted the market’s riskiest loans into its safest was just that – a trick. The math wizards who invented the trick still haunt Wall Street, but their incompetence and venality was exposed on the grandest of scales.

What they believd was that by bundling together enough bad loans the package as a whole becomes less risky. The idea was that not all bad loans will go bad all at once. So if there are enough of them the cash flow from those that turn out to be OK will be more than sufficient to offset the losses on the inevitable, few, duffers. Whoops. The idea that the entire national housing market could implode at once never entered the febrile brains of these dolts. To be fair the data they used to convince themselves supported their case. Post war America had never experienced a national housing debacle. All the post war problems in housing had been local. So bundling a bunch of loans from all over the country looked like the safest of safe bets.

But American economic history doesn’t begin in 1945. Prior experience completely contradicts the evidence used by the bankers. But I imagine few of them wasted their time in history classes.

So Grenspan has laid the table for the crisis. The major ingredients are all there. His testimony is excellent, if sometimes self-selecting in its memory.

The final and crucial piece of the puzzle, and one few people mention, was the international economic conditions. Greenspan nails this well.

The story is a bit complicated as these things always are.

The point is that during the decade running up to the crisis the international economy was buffeted by a string of imbalances. The most important of these was the inability, or unwillingness, of some countries to expand their domestic consumption fast enough. That sounds arcane, but please focus on it. The upshot of this under-consumption was that the world economy was flooded with savings. Cash was everywhere. And it all needed a home. Investors were hungry for places to park their money and make good returns.

Let’s repaet that.

Some countries grew so fast that their domestic ability to consume was outstripped by their population’s new found wealth: China and India are classic examples. Both generated cash for investment, but their was simply not enough opportunity at home either to spend or to invest. So the money went into the global economy. Other countries, Germany and Japan, deliberately kept a lid on domestic consumption, which had the same effect: their populations ended up with extra savings that needed to be invested somewhere.

Either way, during the mid-2000’s the global economy was awash with cash and had too few investment opportunities.

Into which breach stepped the American banks and all those securitized loans. Those loans were the biggest single asset class available for investors around the world to buy. Since the loans were rated so highly, investors, mainly foreign banks and insurance companies, stepped up and bought billions upon billions of them.

This cash abundance was the vector through which what was a peculiarly American disease infected the entire world.

So when the American bubble burst it took the world with it.

That in a nutshell is what happened. As told by Alan Greenspan.

His examination of the regulatory response and the improvements we can make is also revealing.

In many ways he becomes old fashioned really quickly.

He advocates much higher capital levels for the banks. His argument being that had Lehman been better capitalized it would have weathered the storm. I doubt this. Lehman’s problems were more than this. It was running a shoddy book of assets, that turned out to be worth far less than its balance sheet suggested. Indeed at the loss rates it suffered even Greenspan’s suggested capital level of 15% would have been swamped.

Plus Lehman, like most of its kind, had developed an unhealthy reliance on short term funding. Greenspan recognizes this as well and advocates a much more stringent oversight of liquidity requirements.

My issue with this is that liquidity is a property of the system not an individual company. By this I mean that markets are liquid and that companies access liquidity only so far as the market remains liquid. Were such a market to freeze up and lose it liquid properties, then all the participants in that market suffer together. No one company loses its liquidity, they all do.

Where liquidity becomes an individual company issue is when it overlaps with solvency: do the other players in the market believe the valuation of the company’s assets it uses for collateral? If not it suffers more than the others. Which is what happened to both Bear Stearns and Lehman. No one believed their balance sheets.

So building a regulatory regime for the future needs to recognize that defending liquidity is the central banks role. Defending solvency is the individual company’s responsibility.

So while Greenspan is probably correct in arguing for much higher levels of capital and renewed emphasis on protecting liquidity, I am not convinced that we can arrive at easily constructed answers as to what those levels should be. There will always be an odd circumstance when even the highest level fails to save the bank.

Which brings me to a final comment on Greenspan’s testimony.

He litters his comments and his answers to questions with statements about the instability of banking and the waves of euphoria that sweep through it periodically. His analysis is oddly similar to that of Hyman Minsky, whose name I have mentioned here often. Minsky, you will recall, was the inventor of the Financial Instability Hypothesis, which is a theory about banking and its role in the economy based upon Keynesian economics, and in particular upon Keyne’s insight that the economy is inherently unstable due to the existence of uncertainty.

Throughout Greenspan’s testimony I get the feeling of someone grappling with the failure of long held ideas, theories, or beliefs. Sometimes he sounds almost naive in his statements, as if no one had ever though about things like this before. Or that no one could possibly have predicted the outcome the string of events he so capably summarized.

That’s my problem.

Plenty of people could. Anyone familiar with Keynes or Minsky for instance. Anyone who was not beholden to the market magic thinking that dominated Greenspan’s actions for is entire tenure at the Fed.

In other words: while Greenspan is to be congratulated for his revelations and his concise and accurate rendering of events, and, perhaps, for his latter day conversion away from market magic, he still bears responsibility. He could have listened. Instead he continud to drink from the same poisoned well as the bankers.

Instead of acting as a bulwark, he became a facilitator of their folly. He became a channel through which they spread the disease.

Unfortunately for him, that’s the way history will most likely remember him.