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Greenspan also highlights the risks of securitization

In a statement to the Congressional Hearing, Alan Greenspan, the former chairman of the Federal Reserve, defended his policy on interest rates and placed the blame for the recent crash on the fact that most new mortgages in the final years of the property boom were securitized. According to Mr. Greenspan: “By the first quarter of 2007, virtually all sub-prime originations were being securitized, and sub-prime mortgage securities outstanding totalled more than $900bn.”

An economist of equal weighting and stature, Mark Zandi, chief economist of Moody's Analytics, countered Mr. Greenspan’s comments by suggesting to the hearing that “aggressive monetary policy in the wake of the technology bubble contributed to the inflating of the housing bubble.” He went on to say that “There's strong evidence that the Federal Reserve kept interest rates too low for too long.”

It is interesting to know just how one goes about determining the impact of low interest rates on the creation of bubbles, since Mr. Zandi made that statement with the same degree of certitude that a physicist uses to explain the speed of a car. How can we say that a housing bubble might have been averted had interest rates been 1 or 2 percentage points higher? Many of us can remember the housing bubble in the U.K. in the 1980s, and where the interest rates were at that point, ranging between 9% and 12%. It took an increase to around 15% to bring the house of cards down. Can we also suggest that it was the access to cheap money that caused the property bubble during this period? Is 9% a low interest rate? Of course, we are told that it is the real interest rates that determine bubbles even though borrowers have no idea of what the real rate really is? But, even if we were to look at real rates, they were in excess of 5% in the U.K. in the late 1980s.

The fact is that there is never any logic to bubbles and no one can really explain why people fall prey to them. Were interest rates to blame for the Internet bubble? When the bubble was at its full strength no one was willing to accept that the way some of these companies were priced had no bearing on reality. Most investors simply refused to accept that this was all a fantasy and that it made no sense for a company with no profits and $14 million in revenues to have a market capitalization of in excess of $3 billion. Yet, when the crash happened everyone asked why did so many people mortgage their homes to buy more shares in businesses. It made sense at the time to those who had invested and they refused to believe anyone who stated the obvious. In fact, it took more than three years from when the same Mr. Greenspan made his famous Irrational Exuberance speech in 1986 for the markets to correct themselves. They even refused to listen to Mr. Greenspan at a time when people thought he was the god of finance since what he was saying went against what they wanted to hear.

What Mr. Zandi and the people sitting on that committee fail to realize is that the way Mr. Greenspan managed the U.S. economy in response to the bursting of the Internet bubble was absolutely remarkable. The U.S. stock market lost more than 60% of its capitalization, significantly more than the amount lost in the crash that preceded the Great Depression. Many of us did think that the danger might be that the crash is simply delayed and not completely averted, but no one can deny that what he did was beyond remarkable. That was the first successful response to a major stock market crash since the Great Depression.

More importantly, if low interest rates are responsible for the recent crash, then why are we not witnessing another bubble today? Interest rates have been kept very low for more than a year now and an unprecedented amount of liquidity has been pumped into the economy and yet if anything house prices are still feeling downward pressure. Japan is an even better example of the lack of relationship between housing bubbles and interest rates.

The problem with economics is that no one really knows if the bubble might have been averted had interest rates been higher. However, one thing we can be certain about, and I am very glad that Mr. Greenspan also agrees with us, is that securitization allowed banks to pass on the risks of their mortgages onto unsuspecting investors and forgo due diligence. Once the banks’ main source of income became arrangement fees from mortgages, rather the spread between borrowing and lending, they were incented to lend as much as they could to as many people as they could. If there was to be any default, the loan was not sitting on the banks’ books and it was not their problem. Now, the fact that some banks bought these highly questionable assets and used them as collateral with the Fed illustrates just what happens when the left hand does not talk to the right hand. If those who were investing in these securitized assets had taken two minutes to talk to their mortgage banking departments to see just how much due diligence goes into each new issue they would not have touched them.

If those on the Committee wish to prevent similar crises in the future they need to sort out the securitization mess that still exists. Banks cannot be allowed to divert the entire risk of a mortgage to investors who have no access to the underlying pool of mortgages. Banks must be forced to keep a minimum percentage of the loan on their books so that they are forced to undertake some due diligence for the loan and that they also share in the pain when there is default. Trying to determine whether better monetary policy will be able to prevent future speculative bubbles will not achieve anything. We should try and sort out the mechanical inefficiencies within the system first and then hope that if future bubbles appear we have the wherewithal to use monetary policy effectively. The problem, of course, is that we would not know if it was managed effectively until a few years after it was implemented. So, if I was Mr. Bernanke I would not feel too confident just yet that he has effectively managed the current crisis, as his many supporters have led him to believe. He could just as easily find himself in front of another Committee to explain why he felt it was necessary to pump so much liquidity into the market and cause a gold bubble, or something like it, and having another world renowned economist, such as Mr. Zandi, handing out first class economic advice about how he got it completely wrong.

We highlighted the risks of securitization and the limitations of risk management within banks in a recent paper entitled: Economists’ hubris – The case of risk management. You can read the article at


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