The Face on the Ace of Spades

When during the invasion of Iraq the United States government issued its famous deck of playing cards with the 52 arch villains of the Iraqi police state, Saddam Hussein's face adorned the Ace of Spades. If the Barak Obama administration in the United States wanted to engage in a similar public relations campaign for the real estate crisis, the top card should be reserved for Alan Greenspan who, like the Ancient Mariner, continues to traipse the earth, buttonholing wedding guests and saying he had no idea where the dead albatross had come from.

In a speech last week before the National Association of Realtors, Sir Alan “the-bubble-blower” claimed that his low interest rate policies in the early and middle years of this decade had no effect on mortgage rates or real estate prices. As a result, he claims no responsibility for the subprime mortgage crisis. But despite his protestations, he was the architect of not just that single crisis but a series of them that started with the US housing market and metastasized across a growing number of asset classes and countries and, according to the International Monetary Fund, will ultimately cost financial institutions alone US$4.1 trillion.

Although Asia has been relatively less damaged to the global financial fiasco, with its better-capitalized banks and its relatively small exposure to subprime loans, the spreading crisis has reversed economic growth across much of the region, with Singapore, Malaysia, Thailand and other countries reporting negative growth for the first time in decades and thrown tens of millions of people deeper into poverty. China, with its massive foreign currency reserves, has had to devote a stunning US$586 billion to a two-year fiscal stimulus program to keep its economy going. And while it is primarily the United States where attention is being focused, it is important for Asians to know the source of a major part of their troubles.

Not all of this can be blamed on Greenspan, of course. The west had been living beyond its means for decades. But even the current US Treasury Secretary Timothy Geithner, who shared interest rate policy responsibility as governor of the New York Fed during the Greenspan regime, recently acknowledged that overly accommodative policy helped inflate the bubble. So what does Greenspan know that everyone else doesn't?

His primary defense is that US mortgage rates were a function of long-term interest rates which were simply not responding to the movement in short term rates, which he did control. While it is true that the flow of capital from foreign creditors with excess dollars did keep long rates low despite rising short rates, this “conundrum” was not the leading factor in the housing bubble. Although rates on 30-year fixed rate mortgages are based on long-term bonds, by 2005 such loans had become an endangered species. The US housing bubble was all about adjustable-rate mortgages with 1-7 year teaser rates primarily based on the Fed funds rate.

The rock bottom teaser rates, permitted by the 1 percent Fed funds rate, were the primary reason that many home buyers were able to qualify for mortgages they couldn't otherwise afford, and in turn, to bid up home prices to bubble levels. By pushing down the cost of short-term money, the Fed enabled US homebuyers to make big bets on rising real estate prices. Without the Fed's help, few borrowers would have qualified for these risky mortgages and real estate prices never would have been bid up so high.

Greenspan expresses exasperation now, as he did then, that his careful nudging of interest rates higher by quarter point increments did not translate into corresponding increases in long-term rates. Unfortunately, according to Greenspan, the markets would not cooperate with his wise guidance, and to his dismay, mortgage rates fell despite his best efforts. As they say in Texas, this dog will just not hunt. If the “measured pace” of his quarter point hikes were too slow to produce the desired effect, why didn't Greenspan jack up the pressure? With interest rates far below the official inflation rate for many years during the bubble, he certainly had plenty of room to maneuver. The claim that he was unhappy results of his rate hikes, despite his having done nothing to adjust that policy, is ridiculous.

In addition to his colossal errors on interest rate policy there were many other ways Greenspan blew air into the real estate bubble. One example was what the market called the “Greenspan put.” By creating the perception in word and deed (since proven accurate) that the Fed would backstop any major market or economic declines, lenders became more comfortable making risky loans. In an often quoted 2004 speech, Greenspan went so far as to actively encourage the use of adjustable-rate mortgages and praised home equity extractions for their role in contributing to economic growth.

In fact, rather than criticizing homeowners for treating their houses like ATM machines, he often praised the innovative ways in which such homeowners were “managing” their personal balance sheets. Greenspan was as much a proponent of leverage for homeowners on Main Street as he was for bankers on Wall Street.

The bottom line is that Greenspan fathered the housing bubble and now he refuses to acknowledge kinship of his wayward child. His denial of responsibility is an act of stunning bravado, and is a testament to his ability to turn even the simplest of situations into an impenetrable tangle of theories and statistics. The private sector jokers who now hold top dishonor in our pack of economic villains are easily trumped by the Maestro. The fact that Greenspan still has any credibility shows just how little understanding the American general public, including Wall Street and the media, actually have about this crisis.

Peter D. Schiff (schiff@europac.net is president of Euro Pacific Capital, Inc of Darien, Connecticut, USA. He publishes the free, on-line investment newsletter http://www.europac.net/newsletter/newsletter.asp)