Who's to Blame? The Fed


Each day for five days, a different writer from TheStreet.com will make the case for why one of five prime culprits—the banks, Congress, irresponsible home buyers, the Federal Reserve or the rating agencies—is most to blame for the credit crisis and ensuing economic meltdown.

Alan Greenspan was lauded by Wall Street as the maestro for his role in presiding over a 9,000-point rally on the Dow Jones Industrial Average over his 18 years as chairman of the Federal Reserve.

But on the way to becoming "the greatest central banker who ever lived," a funny thing happened: The maestro played a key role in inflating a credit bubble that has put the global economy in its most dire straits since the Great Depression.

Clearly, there is plenty of blame to share among many parties for our current predicament. Homeowners bit off mortgages larger than they could chew, aided and abetted by an overzealous Congress bent on making homeownership dreams come true for record numbers of Americans.

Banks, emboldened by an era of deregulation that minimized risk (for them, unfortunately, not for the global financial system), were only too eager to make home loans to consumers who couldn't afford them, then profit off securitizing and trading them.

But Greenspan's stewardship of the Fed was the most significant constant in the nearly 20 years preceding housing prices hitting their apex in 2006. Appointed by Republican President Ronald Reagan in 1987 and reappointed four times by Republicans George H.W. Bush and George W. Bush and Democrat Bill Clinton, Greenspan occupied the economic bully pulpit at a time the seeds of excess were sown.

The main criticism of Greenspan has centered on his decision to aggressively lower interest rates in the wake of the dot-com bubble's bursting in 2000, and keep them low too long. As the country battled recession, the Fed cut rates to 1% in June 2003, and did not begin to raise them again until a year later.

The federal funds rate was at 6.50% in January 2001, when Greenspan began cutting. The average rate for a 30-year fixed mortgage, according to Freddie Mac, was 7% at that time. By the time Greenspan's Fed had cut the fed funds rate to 1% in June 2003, the average 30-year mortgage dipped to 5.23%, the lowest level it had reached since at least 1971, according to the Freddie Mac data.

The result of this cheap availability of credit was money pouring into the housing market, which Wall Street was only too happy to securitize -- allowing banks to spread out the risk of making the new loans and free up capital to make even more. In 2001, when Greenspan's Fed began cutting, $1.35 trillion in new mortgage-backed securities flooded the market, more than twice the amount the year earlier, according to data from Inside MBS and ABS, a trade magazine.

In each of the next six years, financial institutions exceeded $1.86 trillion in new mortgage-backed securities. By the end of 2006, there was $6.79 trillion in mortgage-backed securities in existence, a 140% increase from the end of 2000.

It's these securities that form a large part of what are often referred to as the "toxic" assets today plaguing banks like Citigroup (Stock Quote: C) and Bank of America (Stock Quote: BAC)which digested the country's largest lender, Countrywide Financial, and Merrill Lynch, a big player in the securitized debt market.

Giant mortgage lenders Fannie Mae (Stock Quote: FNM) and Freddie Mac (Stock Quote: FRE) also had to be placed in conservatorship by the federal government after buckling under their weight. And while the securitized loan market's growth certainly required willing borrowers and lenders, it was the Fed's cheap credit that provided the gasoline for the fire.

But low interest rates were not the Greenspan Fed's only contribution to the crisis.

As the maestro—an economic guru who won the bipartisan trust of four separate presidents—Greenspan held enormous sway over Wall Street, policymakers and the public at large. Evidence of his popularity can be found by typing "Alan Greenspan" into the search queue of the satirical Web site The Onion, which frequently lampooned the central banker's rock star-like status in the late 1990s and early 2000s. In one 1999 entry, a diva Greenspan trashes a Los Angeles hotel room after a request to remove green M&Ms from bowls in his room, while proclaiming, "I'm Alan blanking Greenspan."

Thus, his opinion on all things financial carried tremendous weight. Greenspan's libertarian leanings -- he is an admirer of Ayn Rand and a devoted free market advocate -- greatly influenced the deregulatory landscape that eventually led to the banks having virtual free rein to do what they pleased. Consider Greenspan's testimony to the Senate Banking Committee in 2003, on the subject of derivatives like credit default swaps, unregulated contracts designed to insure against risk of default on debt:

"What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so," Greenspan said, adding "it would be a mistake" to burden the marketplace with deeper regulation of the contracts.

The lack of regulation of credit default swaps allowed companies like American International Group (Stock Quote: AIG) to write obscene amounts of contracts, with virtually no regard for holding capital in reserve to pay them off if worst came to worst and companies began defaulting on their debt. That is, of course, what happened last year, forcing the federal government to step in and bail out AIG to the tune of $170 billion and counting, to prevent a potentially cataclysmic unwinding of the maze of trades it entered.

Greenspan has fiercely defended his legacy since it first began to come under attack last year, most recently in The Wall Street Journal on Wednesday. In an op-ed titled, "The Fed Didn't Cause the Housing Bubble", Greenspan argued that short-term federal funds rates ceased to have any significant correlation to mortgage rates, after decades of moving "in lockstep." He attributed the change to global market forces trumping local central planning.

The piece is largely a rebuttal to a long-running debate with former colleague and Stanford University Professor John Taylor, who last month wrote in a Journal op-ed that "government actions and interventions ... caused, prolonged and dramatically worsened the crisis." Taylor pinned the origin of a series of policy missteps to "monetary excesses" at the Fed between 2003 and 2005.

Tomasz Piskorski, a professor of economics at Columbia University, who is performing a study to determine what factor contributed the most to the global economic crisis, notes that the U.S. has historically high debt levels, a situation he blames on the Fed keeping interest rates low to maintain a good relationship with China, and to avoid a recession in the early 2000s.

"For political reasons we were providing cheap credit for the rest of the world," says Piskorski. "There should have been a recession in the United States in 2001, but there wasn't, and instead a worse one is happening now."

Perhaps it is unfair to ascribe Greenspan's motives for low interest rates to politics. But the idea that his policies—so popular on Wall Street—helped skirt a recession that should have been worse more than seven years ago raises a thought: Maybe the economy doesn't need a Fed chairman Wall Street loves.

Maybe the economy needs someone willing to let Wall Street take its lumps every once in awhile.

Staff Reporter Lauren Tara LaCapra contributed to this report.

Dan Freed blames the rating agencies tomorrow.

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