Greenspan -- Flawed Ideology, Deregulation Cause of Collapse, Fannie Mae and Freddie Mac Only a Factor

Former Federal Reserve Chairman Alan Greenspan, long considered the icon of Free Market capitalism, testified yesterday before the House Oversight Committee on the causes of the worst financial crisis since the Great Depression. Committee members, led by chairman Henry Waxman asked the 82 year old Greenspan a series of tough questions in an attempt to isolate "regulatory mistakes and misjudgments" leading up to the collapse. The result was a number of era-defining statements by Greenspan revealing the flaws of absolutist Free-Market capitalism and irresponsible deregulation of the financial system.

Flawed Ideology Enables Systemic Failure

Greenspan noted that he had made a mistake in believing that banks would be rationally compelled, through self-interest, to protect their institutions and shareholders. This belief is a key foundation of free-market capitalist ideology -- that individuals will act rationally to pursue their own self interest and that financial institutions would magnify this rational thought to result in long-term economic growth and increasing general prosperity. What ended up happening, instead, is that both individuals and institutions ignored severe risk in order to pursue massive short-term gains. In this sense, rational self interest rapidly turned into irrational greed. While a few individuals who had gained access and control of key institutions were enriching themselves, the rest of the economic system was isolated, neglected, and suffered increasingly severe strains and failures. Furthermore, private-backed predatory lending exploited the vehicle of sub-prime mortgages and rapidly toxified a massive segment of the international financial system. Greenspan described these failures as resulting from "a flaw in the model... that defines how the world works."

That flaw, in particular terms, is an attempt to rationalize an irrational impulse. Greenspan would be better off turning to that ancient lesson of human history -- power corrupts, absolute power corrupts absolutely. Instead he relied on an ephemeral Free Market ideal -- blind faith in rational self interest -- as a foundation for our economy. What he didn't realize was that by removing the regulations that compelled institutions and individuals to act responsibly, he was leaving our financial system vulnerable to a terrible force -- unfettered greed.

When deregulation fails

In particular, Greenspan noted that the loophole permitting credit default swaps when combined with the internationalization of the mortgage market set the stage for a world-wide disaster. In short, this allowed banks to bundle questionable assets and then shift their liabilities to almost any entity, even investors overseas. Greenspan noted that the boom in sub-prime lending occurred, primarily, due to a massive demand for investment opportunities within the global economy. This demand created an opportunity for lenders to provide mortages, even to borrowers with very weak credit. It also provided impetus for often misleading adjustable rate mortgages, which Greenspan himself advocated, and which resulted in a majority of the initial housing foreclosures.

All of these practices were enabled by the removal of key regulations that left both banks and consumers vulnerable. Greenspan noted that "As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue." In short, this means that banks must hold more assets in order to hedge against lending risks. Where as before banks could leverage twenty, thirty, or even fifty to one (loaning out up to fifty times the assets they hold in accounts), now they would be required to substantially 'deleverage' only loaning out what banks could reasonably cover at a loss.

What is, however, most tragic, is that Greenspan appears to be honestly shaken by the failure of markets to behave as he believed they would. Greenspan noted he was shocked by the widespread failure of banking officials to protect shareholders from bad loan decisions. "A critical pillar to market competition and free markets did break down," Greenspan stated, "I still do not fully understand why it happened."

Fannie and Freddie Only Cited as a Factor

Perhaps the most critical finding of the House commission, however, was that Greenspan and his fellow panelists Chris Cox (SEC Chairman), and former Treasury Secretary Jonathan Snow all agreed that Fannie Mae and Freddie Mac were not the root cause of the financial crisis, but only a factor in how events played out. Furthermore, facts weighed heavily against republican-spread misinformation claiming Fannie and Freddie caused the meltdown. Included among these facts are that the majority of sub-prime loans were originated by institutions other than Fannie Mae and Freddie Mac and that by the time the crisis was realized only 13 percent of all sub-prime loans were owned by Fannie and Freddie.

According to Center for American Progress Senior Fellows Michael S. Barr and Gene Sperling, Freddie and Fannie didn't become involved in securitizing subprime mortgages in substantial numbers until 2005 --"The sub-prime boom was led by investment banks and mortgage brokers, not by government-sponsored enterprises. Fannie and Freddie became unhinged in the middle of this decade when they tried to play catch-up." In addition, Fannie Mae and Freddie Mac remained compelled by law not to participate in the kind of predatory lending that severely impacted the housing market. This kind of lending occurred through private firms that, essentially, took advantage of lower income borrowers.

The deregulation allowing sub-prime loans to exist resulted in one of the largest predatory lending sprees in the history of this country. According to findings of the Federal Reserve Board the "turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for U.S. sub-prime mortgages, beginning in late 2004 and extending into 2007." The result was that more than 80 percent of sub-prime mortgages and all predatory mortgages were issued by private lending institutions and these loans were at the very epicenter of the housing collapse.

Once unfair loans began to go south, predatory lenders did their best to shift liabilities into the hands of investors. To do this, they exploited an erosion in Depression era regulations enabled by John McCain's chief economic advisor Phil Gramm. The legislation Gramm authored -- The Commodity Futures Modernization Act -- allowed for the unregulated swapping of debts from one lender to another. So almost as rapidly as the bad debt was produced it was pushed on to other holders, quickly infecting the entire financial system. According to Michael Greenberger, former director of the CFTC's division of trading and markets, unregulated swaps were at "the heart of the sub-prime meltdown. I happen to think Gramm did not know what he was doing. I don't think a member in Congress had read the 262-page bill or had thought of the cataclysm it would cause."

One Hundred Year Tsunami or Unleashing the Monster?

This irresponsible deregulation and an almost blind faith in free markets, therefore, enabled the worst financial disaster in more than seventy years. Greenspan himself referred to the disaster as an economic 'tsunami' of the kind that only occur once every hundred years. But to label the disaster a tsunami is to dehumanize its causes which are both very real and very quantifiable. Greenspan's attempt to shift the disaster into the realm of a force of nature is either naive or misleading. For the root causes of the disaster was, essentially, an economic system designed out of a blind faith in the ability of financial markets to responsibly self-regulate. An apt metaphor, therefore, is that we have once again let the monster of human greed run rampant through the world's financial systems. The result is a godzilla-like swath of devastation. And the disaster won't stop until we once again contain and chain the monster.

In short, we can't use more of the failed economic policies that caused the disaster in the first place to get us out of it and we must, if we are to have any hope of re-establishing integrity, curtail the ability of individuals and institutions to create environments that foster economic weakness and then prey upon it.

Sources:

http://www.nytimes.com/2008/10/18/opinion/18barr.html

http://ap.google.com/article/ALeqM5ioHc80xKMiATnqCpK0cDKJzk_nPQD940KCO01

http://www.guardian.co.uk/business/2008/oct/24/economics-creditcrunch-federal-reserve-greenspan