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I RECENTLY WATCHED Frost/Nixon on HBO and came away with increased admiration for the disgraced former president and rather less for the Brit television presenter.
This came to mind after reading a new paper by former Federal Reserve Chairman Alan Greenspan, who presents a defense against allegations that his policies caused the biggest credit bubble, and accordingly, the biggest financial bust in history. Greenspan might come off better in a movie version of events.
In a new Brookings Institution paper, called simply The Crisis (available at http://www.brookings.edu/economics/bpea.aspx), Greenspan argues that the Fed's policy of pushing the federal-funds rate target down to 1% and then lifting it only at glacial speed did not cause the housing bubble. Therefore, the central bank should be held blameless for the inevitable ensuing bust.
Greenspan's paper cites history from the Civil War to the fall of the Berlin Wall in defense of the central bank's policies while he was at its helm. But most of his arguments center on modern financial theory -- which he defends -- but has broken down to a significant extent.
According to his narrative, the fall of the Berlin Wall and the entrance of formerly controlled economies into market-oriented ones unleashed a torrent of savings. Securization of mortgages satisfied the resulting demand for investable assets.
Moreover, ratings agencies gave top triple-A ratings to most mortgage-backed securities, so most institutions could load up on them without regard to risk. Risk-based bank regulations required more capital to be held against riskier assets, a most reasonable principle. So, triple-A securities required minimal, if any, capital to be held against those assets.
Greenspan remarks that even the ratings agencies, with decades of experience in assessing risk, missed the impact of the housing collapse. Yet that same lack of prescience resulted in their rating many mortgage-backed securities -- even though they were backed by subprime mortgages.
Part of the blame lies in having only two-to-three decades of loan-loss experience on which to rate those MBS, Greenspan argues. But less emphasis is given to the now-widely recognized conflict of interest in ratings agencies being paid by issuers. Moreover, MBS issuers were given guidance by raters about how to structure the securities in order to win the highest ratings.
And structure was the key in turning the dross of subprime mortgages into the gold of triple-A MBS. By arraying a series of tranches, -- in which the most junior absorbed the losses from defaults and left the senior ones unscathed -- the top tier could get gilt-edged ratings. It's analogous to having pawns to protect the king and queen on the chessboard. But if all the pawns fall, unexpectedly, the king and queen are left vulnerable.
Greenspan credits modern finance theory and the theorists behind it for much of our knowledge for controlling risk and even for the prosperity of the non-financial sector, which he asserts was dependent on finance. But they data on which these theorists' models depended went back only a few decades, and therefore found that residential real-estate prices only went up.
And in the crucial aspect of the paper, Greenspan asserts Fed policy could not be responsible for the housing bubble because, in effect, nobody finances a home based on the overnight federal-funds rate. Residential real-estate values are more attuned to long-term mortgage rates than the short-term rates under the Fed's control. Thus, he concludes, the Fed's decisions regarding the fed-funds rate had little if any effect on housing.
Yet, the world isn't as simplistic as the former Fed chairman contends. The Fed aided and abetted financial conditions that permitted unscrupulous borrowers to hook up with feckless borrowers to buy houses that they could never could have afforded. Investors desperate for high-quality investments offering good yields were readily accommodated by mortgage-backed securities with an undeserved triple-A rating.
What evolved was an investment environment in which the presumption was, quite simply, nothing bad could happen. That was reflected in the steady decline in risk perceptions, evident in the fall in options prices, an indicator implicitly endorsed by Greenspan in his praise for the Black-Scholes model in his paper.
But what isn't explained is how falling volatility crucially encouraged financial markets participants, from Wall Street dealers to hedge funds and everyone in between, to take on more risk. An outgrowth of modern financial theory is a concept of value at risk or VAR.
As volatility falls, expected risk declines implicitly, and a portfolio can take on more risk, and vice versa. The inverse turned out to be vicious when volatility spiked as the crisis exploded in 2008. That meant portfolios had to reduce risk, which meant selling positions and cutting leverage. Yet these prudent actions by individual firms increased the risk faced by the entire system. It was the classic case of everybody trying to get out the door first in a fire.
VAR boosts risk when markets are rising and volatility is falling and works viciously in reverse. Greenspan asserts no systemic problem can arise if there is adequate capital and liquidity. VAR sought to address systematically the adequacy of capital.
One reason volatility fell was that the fed-funds rate was raised at a "measured pace" of a quarter-percentage point per Fed meeting, Starting in 2004, the Federal Open Market Committee raised its funds-rate target by just 25 basis points per meeting. That arguably lulled the markets into a false sense of security for market participants, and volatility steadily fell thereafter.
As for liquidity, it was always available, and usually for a cheap price. The ability for portfolios to be funded through repurchase agreements seemingly assured traders a nearly unlimited source of cash. But at the first sign of trouble, the repo market would all but disappear.
Thus, in this period of low perceived volatilities and ample liquidity, lenders could package ever-more complicated mortgage securities and other instruments, which were snapped up by eager global buyers with dollars they were looking to put to work.
While Greenspan didn't exactly hand out blank checks for prospective homebuyers, the Fed undoubtedly aid and abetted the mortgage bubble. Nothing can be done to change that history, but the damage would be multiplied if the current Fed sought to offset previous errors by being overly aggressive in raising rates.
Comments: randall.forsyth@barrons.com
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