Alan Greenspan responses to critics - We will never have a perfect model of risk

On March 17, Alan Greenspan wrote an article for the FT entitled “We will never have a perfect model of risk“, in which he argued: “We will never be able to anticipate all discontinuities in financial markets.” He concluded: “It is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation [do] not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.”

The article attracted a number of critical responses in this forum. For example, Paul de Grauwe wrote: “Greenspan’s article is a smokescreen to hide his own responsibility in making the financial crisis possible.” (Read all the responses.)

The article below is Mr Greenspan’s reply to those criticisms, written exclusively for the Economists’ Forum:

I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long term interest rates statistically explains, and is the most likely major cause of, real estate capitalization rates that declined and converged across the globe. By 2006, long term interest rates for all developed and major developing economies declined to single digits, I believe for the first time ever.

Doubtless each individual housing bubble has its own idiosyncratic characteristics and some point to Fed monetary policy complicity in the US bubble. But the US bubble was close to median world experience and the evidence of monetary policy adding to the bubble is statistically very fragile. Paul De Grauwe depends on John Taylor’s counterfactual model simulations to conclude that the low funds rate was the source of the US housing bubble. Taylor (with whom I rarely disagree) and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. This suggests important missing variables. Counterfactuals from such flawed structures cannot form the basis for policy.

De Grauwe asserts that “signs of recovery” (I assume he means sustainable recovery) were evident before 2004 and hence the Federal Reserve should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported “conditions remained sluggish in most districts.” Moreover, low rates did not trigger “a massive credit . . . expansion.” Both the monetary base and M2 rose less than 5% in the subsequent year, scarcely tinder for a massive credit expansion. In fact, growth in total credit market debt owed by the U.S. financial sector declined from a 13% gain during 2001 to an 8% gain during 2004. Nonfinancial sector growth was less.

Some argue that adjustable rate mortgage (ARM) originations fueled the bubble. Yet the ARM’s share of total originations is a very weak forecaster of home prices, implying ARMs, although a source of cheap financing, are not a determinant of home prices. If ARMs were not available from 2001 to 2004, home purchases presumably would have been financed with long term debt, which was also very affordable.

De Grauwe is correct; I do believe bank risk managers and loan officers are more knowledgeable than government bank regulators. Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do the bank regulators that examine those counterparties.

Regulators, to be effective, have to be forward looking to anticipate the next financial malfunction. This has not proved to be feasible. Regulators confronting real time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act preemptively. Most regulatory activity focuses on activities that precipitated previous crises and that investors have long since largely abandoned, although new laws may prevent recurrences. New problems, to repeat, are by their nature incapable of being anticipated with any degree of confidence.

Aside from far greater efforts to ferret out fraud (a long time concern of mine), would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation, but unrealistic expectations about what regulators are able to anticipate and prevent. How we otherwise explain how the FSA, whose effectiveness is held in such high regard, fumbled Northern Rock? Or in the US, our best examiners have repeatedly failed over the years. These are not aberrations.

Could tightened regulation of subprimes have contained some of the reprehensible, and presumably criminal, acts of lenders? Probably. But the broader crisis would likely have arisen even with increased micro-surveillance.

The core of the subprime problem lies with the misjudgments of the investment community. Subprime did not break from its localized niche status until 2005. As Ben Bernanke recently put it: “The deterioration in underwriting standards …appears to have begun in late 2005.” I assume that judgment reflected the increased delinquency behavior that is now evident for loans initiated in late 2005 and subsequently.

Subprime securitization exploded because subprime mortgage-backed securities (MBS) were seemingly under-priced (high-yielding) at original issuance. Subprime delinquencies and foreclosures (in a rising home price market) were modest at the time, creating the illusion of great profit opportunities. Investors of all stripes pressed securitizers for more MBS. Securitizers, in turn, pressed lenders for mortgage paper with little concern about its quality. As a consequence underwriting standards collapsed, and mortgage originations and securitizations rose to far greater heights than would have occurred without securitization. Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle. It would have required insights that would enable regulators to override the investment judgments of the most experienced analysts of the private sector, the very people on whom regulators rely for their market insights. When investment judgments are distorted by euphoria, even so valuable a financial innovation as securitization will perform poorly.

Counterparties, of course, also confront uncertainty but they appear invariably to know more about their customers than do regulators. They have a much better, but clearly not a flawless record, as the subprime breakdown exposed.

If counterparty surveillance is abandoned or significantly weakened, we are left with regulation by the less informed. Counterparty surveillance needs to be repaired, not abandoned. In the meantime markets are readjusting risk spreads, as a precursor to the new structure that will evolve with time.

I admit to being surprised and appalled at the recent collapse in bank underwriting standards. In response, since last summer, market forces have driven leverage down materially and leverage will doubtless fall further before it stabilizes. Basel II eventually will be altered accordingly.

Investors henceforth will balk at the fees that most hedge funds and private equity funds have been able to obtain during the past surge of euphoria. Future stand-alone SIVs will find financing costs prohibitive. The CDO market will revive, but in a more viable form, perhaps with the relevant counterparties determining the credit ratings of individual tranches through issuance of CDS rather than through credit rating agency evaluation. Securitization, though abused in its subprime applications, is a valued transferor of risk from highly leveraged institutions. It will revive largely in its current form. CDS back office operational risks will not be tolerated.

Indeed, the current low volume of issuance of all such securities suggests much of the fall away of bids has already happened. The restoration of bids and issuance when it occurs will be in a fundamentally changed pricing environment from that which existed prior to last August 9.

I agree with Wolf that social insurance has its price and with his concern of privatizing profits and socializing losses. If we are to have a system in which some financial firms are designated officially as being “too large to liquidate quickly,” we need to recognize that such institutions will gain the advantage of a competitively lower cost of capital. The implicit subsidy of those firms who choose to be “too large” will have to be addressed.

I disagree with Wolf that I have ignored “evidence of malfeasance and gross incompetence.” I have consistently bemoaned criminal fraud and the “excessively lax terms to encourage (subprime) mortgage applications,” for example, last fall in London (HM Treasury Financial Stability Forum).

Wolf argues that central banks “can surely lean against the wind” even if they cannot eliminate bubbles. I know of no instance in which such a policy has been successful. For reasons I have outlined elsewhere, (American Economic Association presentation, January 2004) I doubt that it is possible. If it turns out it is feasible, I would become a strong supporter of “leaning against the wind.”

As far as US monetary policy being (in Wolf’s words) “dangerously asymmetrical,” I point out that over the past half century the US economy has been in recession only one-seventh of the time. Yet the unemployment rate exhibits no trend. Hence the average rate of rise of the unemployment rate has been far greater than its average pace of decline. Monetary policy in response has been more active during recessions than during periods of expansion, but scarcely “dangerous.”

Much of the commentary critical of my FT article is directed less at its substance and more, as Wolf describes it, to “the ideology I display.” Ideology, which regrettably has become a pejorative term, defines that set of ideas that we each believe explains how the world works and therefore how we need to act to achieve our goals. Some of our views of causative forces are rational, some are otherwise. Much of what we confront in reality is uncertain, some of it frighteningly so. Yet people have no choice but to make judgments on the nature of the tenuous ties of causation or they are immobilized.

I do have an ideology. So does each of the members of the Forum. I trust our views are subject to the same standards of evidence that apply to all rational discourse. My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicting some earlier judgments and confirming others. I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken, but not my judgment that free competitive markets are by far the unrivaled way to organize economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?

Central banks, US economy, US policy

In my view, the mortal sin of chairman Greenspan was not irresponsible monetary policy, but rather dropping the ball on bank supervision and market structure. I described the ill effects of allowing the liberal academic economists at the Fed’s Board of Governors in Washington to set bank supervision policy in a comment in Friday’s American Banker.

In particular, in the two decades of Greenspan’s tenure, the Fed’s Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter instruments. This change is described by people like Treasury Secretary Hank Paulson as “innovation,” but my old friend Martin Mayer rightly calls it “retrograde.”

In a market comprised primarily of exchange-traded instruments, there is little or no counterparty risk. OTC trades that reference exchange-traded benchmarks are likewise far more stable. By replacing exchange-traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed’s Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.

BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm’s books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the “financial innovation” of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.

Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America’s financial markets into an increasingly unstable, derivative house of cards. If all federally commercial banks and funds subject to ERISA were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee.

Mr Whalen is a co-founder of Institutional Risk Analytics, a Los Angeles unit of Lord, Whalen LLC that provides customized financial analysis and valuation tools.
There is an argument that Mr Greenspan bears responsibility for the US housing bubble and collapse due to his policy of “gradualism” in the increase of the FFR by 1/4 point increments begining in 2004. This argument was not posited by Mr De Grauve and it was not defended by Mr Greenspan. The rational basis of the argument is that the broadcast of the Fed’s intention to increase rates in monthly increments until some unstated and unknown condition of interest rate neutrality was eventually reached, encouraged leveraged economic decisons to move forward in order to avoid higher interest rates that were promised to follow. This effect was particularly pronounced in residential housing decsions where borrowers were encouraged to act sooner to buy or refinance, rather then wait until rates certainly would go up. This brought demand for real estate forward and sent false signals to the housing and mortage industries with regard to demand for housing and the value of housing asset collateral. As a consequence the builder community overbuilt and the lending community over leveraged, becoming vulnerable to the inevitable trough in demand that occured as rates continued to rise.

An additional criticism of this “gradualism” policy is that it was begun at an time when there was very low inflation according to the index measures. Mr. Greenspan admits as much in his defense above that he did not leave rates low for too long. He notes that in addtion to low index measures of inflation there was very little growth in the M2. One can fairly ask, whether it was wise to begin raising interest rates gradually at that time, and what was the policy imperative that drove the decision if there was no indication of emerging inflation. Many economists at the time did criticise the decsion as contributing to a “treadmill” effect, where rather than reducing inflation, the gradualism actually created the inflation that is was ostensibly designed to avoid.

In the context of defending policy decisions in the face of uncertainty, Mr. Greenspan should defend his policy of gradualism in FFR increase at a time of no inflation that resulted in a housing bubble and increased inflation before it was ended.

Edward Breen is an attorney and a director of a manufacturing company. He was the president of a real estate development company, Axial Investors Group, during the S&L and real estate collapse of the early 1990s.

Financial markets and institutions serve a useful purpose to channel funds from savers to borrowers. Spending by borrowers increases the current level of economic activity. To the extent that funds are used to increase the public and private capital stock, channeling funds from savers to borrowers increases an economy’s productive capacity in the future as well.

Financial markets and institutions also have the potential to destabilize an economy if poor decisions are made when funds are lent or when excessive speculation occurs. Poor decision-making could be the result of poor management or the result of societal incentives that allow financial institutions to take risks with managers and employees bearing little if any of the costs associated with those risks. Because financial institutions use other people’s money, there is an inherent potential conflict of interest between the institution’s managers and employees and its shareholders, depositors, and others who provide funds to these institutions.

Speculation occurs when monetary policy is too lax. Those with money can either spend it, putting upward pressure on consumer prices, or invest it, be it in stocks, bonds, commodities, derivatives, or real estate. Bubbles can occur in any of these markets when too much money in circulation and interest rates are set too low.

The current crisis in the credit markets is a direct result of misaligned incentives in the financial services industry, government policies that create moral hazard, and loose monetary policy. Addressing each of these issues is necessary to reduce the probability of a similar crisis in the future. To the extent that this requires regulatory reform, the following issues should be considered.

First, long-run economic growth depends on a society’s legal, political, and cultural institutions. Faith in the underlying stability of the financial system promotes economic growth. Hence, regulatory reform should be directed toward promoting stability of the financial system without unnecessarily inhibiting the useful function of channeling funds from savers to borrowers. Included in this reform should be the establishment of an institutional framework to manage future financial crises as another crisis will undoubtedly occur at some point.

Second, all financial products of a similar type should be regulated by the same authority. This will create a level playing field and prevent circumvention of regulations within a country. Different products or different lines of business could be regulated by different agencies if a mechanism for interagency cooperation and coordination is also created.

Third, a global financial crisis requires a global regulatory response. The current crisis spread from its source in the US mortgage market to financial institutions throughout the world due to securitization of mortgages and globalized investing. If a country is unwilling to cede direct regulatory oversight to a global regulator, some type of international body to resolve financial crises and disputes should be established to create as level of a global playing field as possible and to prevent circumvention of regulations by crossing country boundaries.

Fourth, internal firm compensation policies and governmental policies that create moral hazard need to be corrected. Minimum capital requirements are a necessary but not a sufficient condition to promote stability in the financial services sector. A minimum level of capital is needed to provide for unanticipated withdrawals from a financial institution. However, if internal company compensation policies and regulatory bailouts reward excessive risk-taking, excessive risk-taking will occur regardless of the capital requirements.

Direct government regulation of compensation within a firm is unwieldy, politically infeasible, and would likely involve greater social losses than those generated by an unregulated system. But moral hazard must be mitigated. A tax on financial institutions that is tied to the riskiness of the institution’s investments would reduce the incentive to take excessive risk without destroying the incentive to generate productive innovation in the financial services industry.

Fifth, any institution that expects assistance from the government, either via direct taxpayer dollars or via access to central bank funds, must agree to regulatory supervision. This condition also requires that supervisory authorities supervise. Regulators must be aware of the incentives of financial market participants to take advantage of whatever system is in place and to generate noise that obscures their actions. The tax discussed above would provide the funds necessary for supervision and also provide funds that could be used to address the next crisis.

Sixth, use of off-balance sheet accounting techniques to hide risky investments must be curtailed. Potential liabilities must be clearly disclosed or turned into direct liabilities and moved onto the balance sheet. The accounting regulatory bodies bear some of the responsibility for the current crisis by allowing firms to hide liabilities off the balance sheet. The initial tightening in the credit markets was due to direct losses on mortgage-backed securities. The continuation of the crisis long after the initial losses were reported is due to lack of trust between institutions. Proper accountancy that informs rather than obfuscates will restore trust and prevent a temporary crisis from turning into a long-term loss of faith.

Seventh, central bankers must be vigilant in monitoring asset markets as well as consumer and producer prices when setting monetary policy. A low real interest rate environment creates the incentive for speculation. Excessive leverage in the financial system, enabled by margin requirements on short sales and security purchases that are set too low or by other forms of borrowing by financial market participants, also encourages speculation. As Keynes noted many years ago, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.” It is the responsibility of regulatory authorities to prevent the speculation that threatens the steady stream of enterprise.
Institutions matter. Investors, regulators, and financial institutions should use the current crisis as an opportunity to create an institutional framework that will serve the global economy well in the future, long after the current generation of managers and regulators are gone.

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