Why are armchair generals blaming Greenspan?

Former Federal Reserve chairman Alan Greenspan told the Financial Times that he and the Federal Reserve could not be held responsible for the residential mortgage meltdown and the subsequent credit crunch merely because they lowered Federal Funds rate to 1 percent. The truth is Greenspan is right in general. In 2002 and 2003, the US economy faced a recession and serious deflationary pressures as a result of the tech bust and the telecom meltdown. After 2000, there was three major stock bubbles burst in quick succession, namely the dot-com, the IT and telecom. The terrorist attack on 11 Sept. 2001 only exacerbated the recessional pressure. As a result, Greenspan lowered rates at times at 50 basis points increments.

The bust of the housing bubble is largely the result of creative financing to put people who were priced out by the rate hikes in 2004. In other words, if the interest rates were what it was six months before the perspective homeowner purchased the house, the homeowner could have afforded the mortgage in question. Unfortunately, they missed the opportunity to buy a house at the lower rate. Naturally, banks were only to happy to accommodate the prospective homeowners by introducing teaser rates and the options adjustable rate mortgage (or ARM). The idea of ARM was to give those homeowners the faint hope against hope that Greenspan might lower rates to something more favourable. Unfortunately, the Federal Reserve hiked rates for 17 straight meetings at a quarter point increments. New homeowners soon found themselves unable to keep up with the adjusted monthly payments. Worse, any attempt to refinance the home loan meant refinancing at a higher interest rate.

To compound the current mortgage crisis, banks decided to effectively price in more homebuyers by lowering the minimum down payment requirement from 20% to 0%. Twenty years ago, banks would simply not loan homebuyers more than 80% of the home value. This meant homebuyers had to put down 20% or have a FHA or veteran loan before asking the bank for money. A sole purpose of a FHA or veteran loan was a guarantee by the Federal government that the homebuyer in question could meet the 20% down payment requirement before going to the bank. Hence the Federal government was liable for whatever portion of that 20% down payment the homeowner did not make. This was the underlying reason why the American economy was much more resilient when the savings and loan blew up during the administration of the elder George Bush. In an attempt to take over the FHA home loan business without the FHA restrictions or requirements, banks created mortgage products that allowed them a slice of that pie. Over the past fifteen years, the FHA has becoming increasingly redundant with banks doing their business and in the process lowered the minimum down payment to 0%.

As everyone knows, the Federal Reserve has two mandates, namely to grow the economy and fight inflation. It is a contradictory responsibility when one thinks about it. In order to grow the economy, the central banks need to keep interest rates low. In order to ensure stable prices or fight inflation, the central banks need to raise interest rates to tighten the amount of money in the economy. Throughout the 70s, 80s and most of the 90s, when unemployment rate fell to 6%, consumer prices in general goes up because it becomes more expense to hire people because wages went up. This was one of the principal reasons why 6% unemployment rate was considered full employment in those decades.

Was the mortgage crisis preventable? The answer is to a limited degree, but it is totally unrelated to the interest rate. Remember the problem was not how long did Greenspan leave the Federal Funds rate at 1 percent, but what financial institutions choose to do to make a buck after Greenspan raised rates. If Greenspan choose to raise rates earlier say by four to six months, this crisis would still have happened, but only earlier by that amount of time. It is preventable if banks or financial institutions like GMAC or Countrywide actually did their homework like assessing the perspective homebuyer's cash flow and his or her liabilities before lending the money. More importantly, if banks and financial institutions stayed discipline by offering conventional mortgage products and insisting on a maximum leverage of 80% of the value of the collateral, this crisis would not be as severe as what it is now. At the end of the day, the financial sector probably had no choice, given that Wall Street and the investor community had priced so much to perfection and the power of major shareholders to dictate the CEO's job security or, as it might be, insecurity. As for the sub-prime mortgage mess, it was unavoidable if banks or financial institutions choose to lend money to people they know will have trouble in re-paying the loan.

Although Greenspan ran the Federal Reserve, the Federal Reserve was not the regulatory body overseeing bank lending policy or their risk comfort level. Greenspan's role in the creation of this mess is at worst minimal and at best probably non-existent. Remember, this is defense is purely premised on the inevitability of the raising of interest rates and the financial institutions would have still opted to pursue the course of the action they chose to pursue. However, Greenspan's decision to actively defend his record at the helm of the Federal Reserve is questionable. He should allow other economists to respond to the proverbial Monday morning quarterbacking that is now taking place.