Don't get me wrong: Alan Greenspan isn't at fault for all of today's woes. Maybe some, maybe a lot, but not all. He's only one man.
One man, but one very powerful man. As the then-chairman of the organization responsible for the nation's monetary policy and Washington's go-to guy on economic issues, Greenspan's more than deserving of a little criticism for his oversight during the greatest financial run-up the nation has ever seen.
Here are five Greenspan quotes uttered during the bubble that we can only imagine he wished he'd never said.
"I believe that the general growth in large [financial] institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically -- I should say, fully -- hedged." -- 2000
D'oh! Hedging -- meaning losses in one investment get offset by gains in another -- works wonders when markets remain rational, and it allowed investment banks like Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM) to leverage up to their gills without much worry. Problem is, once markets turn from rational machines to emotion-driven lunatics (as they have been lately), securities that should zig when something else zags don't always follow their intended path.
Here's an example of rational markets going haywire: On Sept. 19 -- the first day the ban on short-selling certain financial companies was enacted -- Berkshire Hathaway (NYSE:BRK-B) class B shares closed at $4,595, while class A shares closed at $147,000. The A shares are transferable into 30 B shares, so one B share should always be worth roughly 1/30th of one A share. On Sept. 19, that natural link vanished (with each B share worth about 1/32 of an A share) because investors couldn't short the A shares and close the gap. Situations like that are when the "fully hedged" argument Greenspan preached falls to pieces.
"Even though some down payments are borrowed, it would take a large, and historically most unusual, fall in home prices to wipe out a significant part of home equity. Many of those who purchased their residence more than a year ago have equity buffers in their homes adequate to withstand any price decline other than a very deep one." -- October 2004
Think about Russian roulette: If there's a 25% chance you'll end up dead, would you play? Most people say no, because even though the odds are in their favor, the outcome of landing on a bullet isn't worth the risk. Now use that same logic for owning a home: If there's a 25% chance of a "very deep decline" that would mean losing your home and sending the economy into oblivion, would you buy? Remarkably, most homeowners, and even Greenspan, thought the answer should be "yes," and used it as an excuse to buy homes with little or no money down.
"The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions .... Derivatives have permitted the unbundling of financial risks." -- May 2005
In hindsight, we all know that the "growing array of derivatives" didn't unbundle financial risk, they complicated things to such an extent that even the people who created them can't figure them out.
Earlier this year, George Soros claimed that the complexity of derivatives and the near-impossible task of unbundling the products themselves "must have played a role in the Fed's decision not to allow Bear Stearns to fail." Meanwhile, AIG (NYSE:AIG) had to pay the head of its unit responsible for derivatives $1 million per month for consulting services after he was fired, perhaps because he was one of the few who knew how insanely complex these products really were.
"Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities." -- October 2004
Ah, yes: Many American's had "previously unrecognized borrowing capacitates." What they didn't have was previously unrecognized capacity to pay off those borrowings. By December 2007, the default rate on securitized subprime loans stood at more than 25%. It should come as little surprise that the banks that chose to tap the "unrecognized borrowing capacitates," such as WaMu and Wachovia (NYSE:WB), crashed and burned, while banks that stuck to good-ol' "loan-money-to-people-who-can-pay-it-back" practices like Wells Fargo (NYSE:WFC) and BB&T (NYSE:BBT) are doing just fine.
"Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward." -- February 2004
What seems a little sketchy is that Greenspan made the comment about "interest rates trending sharply upward" in February 2004, when the Fed funds rate stood at a historically low 1%. With rates that low, it was preposterous to think rates would do anything but trend sharply higher ... which, of course, they did, and many of those holding adjustable-rate mortgages found themselves saddled with mortgages they couldn't afford after Greenspan nearly quintupled the fed funds rate.
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