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"Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief." — Alan Greenspan, testimony before the House Committee on Oversight & Government Reform, Oct. 23, 2008
The crash of 2008 put to rest the intellectual model that inspired, and to a large degree facilitated, the bubble. It spelled the end of the immodest faith in Wall Street's ability to forecast. No better testimony exists than the extraordinary recanting of former Federal Reserve Board Chairman Alan Greenspan, the public official most associated with the thesis that markets are ever to be trusted.
In October 2008, 10 days after the first round of Troubled Asset Relief Program (TARP) investments, Greenspan appeared in the House of Representatives in effect to repeal the credo by which he had managed the nation's economy for 17 years: "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 derivative markets....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."
This remarkable proclamation, close to a confession, was the intellectual counterpart to the red ink flowing on Wall Street. Just as Fannie Mae (FNM), Freddie Mac (FRE), and Merrill Lynch (BAC) had undone the labors of a generation—had lost, that is, all the profits and more that they had earned during the previous decade—Greenspan undermined its ideological footing. And even if he later partly retracted his apologia (in the palliative that it wasn't the models per se that failed but the humans who applied them), he was understood to say that the new finance had failed. The boom had not just ended; it had been unmasked.
Why did it end so badly? Greenspan's faith in the new finance was itself a culprit. The late economist Hyman P. Minsky observed that "success breeds a disregard of the possibility of failure." Greenspan's persistent efforts to rescue the system lulled the country into believing that serious failure was behind it. His successor, Ben Bernanke, was too quick to believe that Greenspan had succeeded—that central bankers had truly muted the economic cycle. Each put inordinate faith in the market and disregarded its oft-shown potential for speculative excess. Excessive optimism naturally led to excessive risk.
The Fed greatly abetted speculation in mortgages by keeping interest rates too low. Meanwhile, the willingness of government to abide teaser mortgages, "liar loans," and home mortgages with zero down payments, amounted to a staggering case of regulatory neglect.
The government's backstopping of Fannie and Freddie, along with the federal agenda of promoting homeownership, was yet another cause of the bust. Yet for all of Washington's miscues, the direct agents of the bubble were private ones. It was the market that financed unsound mortgages and collateralized debt obligations (CDOs) that spread their contagion globally; the Fed permitted, but the market acted. The banks that failed were private; the investors who financed them were doing the glorious work of Adam Smith.
Rampant speculation in mortgages was surely the primary cause of the bubble, which was greatly inflated by leverage in the banking system, in particular on Wall Street. High leverage and risk taking in general was fueled by the Street's indulgent compensation practices.
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