Alan Greenspan (DOC)

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Martin Hadjisky
Senior Seminar

                                        Alan Greenspan

                                     An “ARM” and a Leg

       It’s 2010 and we are out of the financial crisis….right? The Federal Government of the

Unites States of America reports that the financial crisis is over; however unemployment rates

and foreclosure rates are at all time highs. In today’s world nobody wants to take

responsibility and everyone is willing to point the finger at one another. Time Magazine in list

of people to blame for the financial crisis pointed the finger at Alan Greenspan as number

three on the list of twenty-five. The former Federal Reserve chairman, the economist and the

disciple of libertarian icon Ayn Rand. Rand is known as the creator of the philosophy of

objectivism, which according to Rand it holds that the only social system which fully

recognizes individual rights is capitalism, specifically what Rand described as "full, pure,

uncontrolled, unregulated laissez-faire capitalism."1 Greenspan met his first major challenge

of his career, while serving in office as Chairman of the Federal Reserve by preventing the

1987 stock-market crash from spiraling into something much worse. Then, in the 1990s, he

presided over a long economic and financial-market boom and attained the status of

Washington's resident wizard. But the super-low interest rates Greenspan brought in the early

2000s and his long standing disdain for regulation are now held up as leading causes of the

mortgage crisis. The maestro admitted in an October 2009 congressional hearing that he had

"made a mistake in presuming"2 that financial firms could regulate themselves. Throughout

 Rand, Ayn (1967) [1966]. Capitalism: The Unknown Ideal (paperback 2nd ed.). New York: Signet.
 Andrews, Edmund L. "The New York Times Log In." The New York Times - Breaking News, World News &
Multimedia. 23 Oct. 2008. Web. 28 Feb. 2010.

my paper I will give a brief over view of the Greenspan’s background and focus primarily on

his role of aiding the crisis to be as we all currently know it.

          Alan Greenspan was born on March 6, 1926 to Herbert Greenspan of German descent,

and Rose Goldsmith of Polish descent in Washington Heights, three years prior to the come of

the Great Depression. 3 Greenspan in 1943 was accepted into Julliard Art Academy to study

on the basis as a clarinet major, in 1944 Greenspan drops out of Julliard to join a jazz band,

until 1945 when he returns to college and attends New York University until 1948 when he

graduates with a Bachelors of Science degree from New York University, Greenspan

continues his education at Columbia University where he receives his masters degree in

economics in 1959.

          He worked briefly as an economist with the National Industrial Conference Board,

then opened an economic consulting firm with bond trader William Townsend, called

Townsend, Greenspan, & Company. With prestigious clients such as US Steel and J.P.

Morgan, the firm had some successful years, but some accounts suggest that T G & Co was

wobbling when Greenspan took a job as director of policy research for Richard M. Nixon's

presidential campaign in 1968. He later popped up as chairman of President Gerald Ford's

Council of Economic Advisers, before returning to T G & Co. In 1977, New York University

gave Greenspan his PhD, without requiring a dissertation.

          In 1987, President Ronald Reagan nominated Greenspan as Fed chairman, a post he's

held ever since, through the administrations of George W. Bush, Bill Clinton, and George W.

Bush. Six months after taking the job, Greenspan presided over the biggest stock market crash

in Wall Street's history.

    Martin, Justin (2000). Greenspan: The Man behind Money. Cambridge, Massachusetts: Perseus. 2

          As Fed chairman, he set interest rates, and as such was largely responsible for

directing U.S. national monetary policy. In essence, Greenspan was the human face of

American capitalism. Twice a year, he gave Congress his assessment of America's economic

status, and millions of investors paid close attention to what he said. Greenspan is not,

however, universally respected. Bill Gross, the founder of Pacific Investment Management

Company (PIMCO) who oversees some $350 billion in fixed income securities, has compared

Greenspan to Barney Fife, the bumbling deputy from the Andy Griffith Show.

          Greenspan's first wife, Joan Mitchell, introduced Greenspan to Objectivist author Ayn

Rand, who became his friend and mentor. Greenspan wrote for Rand's The Objectivist

newsletter, and in 1957, he wrote an angry letter to The New York Times complaining about

the paper's review of Atlas Shrugged. Admirers of Rand, however, generally see Greenspan as

a traitor, since he never advocated anything that approaches Rand's absolute laissez-faire

capitalism. In House hearings during the second month of the market meltdown of 2008,

Greenspan testified that he had "found a flaw" in his market ideology, and conceded that he

had been "partially" wrong in opposing regulation of derivatives. 4

          Greenspan may have admitted to be partially at fault for the housing bubble exploding

and the current state of the economy being as is due to the decision to keep interest rates to

low for too long from 2001-2003. Paul Krugman from the New York Times commented on

Greenspan’s decisions and indecisions as following: “Greenspan’s rate cuts helped make the

bubble possible, but I’m not sure there was an alternative… what Greenspan did not do was

listen to the warnings about subprime. The Fed had substantial regulatory and moral suasion

    Andrews, Edmund L. "The New York Times Log In." The New York Times - Breaking News, World News &
          Multimedia. 23 Oct. 2008. Web. 28 Feb. 2010.

power. They could have done a lot to limit the excesses.” 5 Paul Krugman is an American

economist, columnist and author. He is Professor of Economics and International Affairs at

the Woodrow Wilson School of Public and International Affairs at Princeton University. In

2008, Krugman won the Nobel Memorial Prize in Economics for his contributions to New

Trade Theory and New Economic Geography. He was voted sixth in Prospect's 2005 global

poll of the world's top 100 intellectuals.

        Nearly 2.2 million people will lost their homes to foreclosure due to loose lending by

banks who were allowed to as there was no regulation in place over the past years under the

Bush administration from 2001-2009. The average median income of a family has 50% of it

going directly to mortgage payment including insurance, when the standard historically

ranges from 30 percent to 35 percent. The mortgage crisis does not appear to have an end in

sight, Alan Greenspan when asked to comment on the recession and possible end to it he

stated as follows: “The current credit crisis will come to an end when the overhang of

inventories of newly built homes is largely liquidated, and home price deflation comes to an

end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all

home mortgages, but most importantly for those held as collateral for residential mortgage-

backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis.

But after a period of protracted adjustment, the U.S. economy, and the world economy more

generally, will be able to get back to business.”6

        In the 1930’s the United States experienced a mortgage crisis worse then the one at

hand, in the 1930’s the crisis was worse because it led to the shut down of the housing market.

President Barack Obama has urged and tried to emphasize the critical stage of the country,

particularly that of the status of the housing market and how it is a major priority of his
  Overtveldt, Johan Van. Bernanke's Test: Ben Bernanke, Alan Greenspan, and the Drama of the Central Banker.
Chicago: Agate, 2009. Print. Pg. 91
  Greenspan, Allan, Wall Street Journal Online-The roots of the mortgage crisis. Dec.12 th, 2007

administration. At the time, President-elect Obama talked of spending the remaining $350

billion of the bailout money that was approved during the Bush administration on the housing

crisis, as of today there is $175 billion remaining. However, Republicans were especially

opposed on using the bailout funds to help out nonfinancial sector industries; instead money

from the fund has gone to assist or bailout as this term has become more and more popular,

insurance giant American International and motor vehicle manufacturers such as General

Motors Corp and Chrysler LLC. At the time former Secretary of the Treasury Henry Paulson

told legislators that “money will be used to buy toxic assets held by banks…”7 in hopes that

would help them make more loans, but the Treasury soon changed its course and used the

money to make direct infusions into financial institutions.

        Beyond significantly increased capital requirements is the necessity of addressing the

problems of some financial firms being “too big to fail” or more appropriately in some

peoples opinion, too interconnected to be liquidated quickly. The productive employment of

the nation’s scarce saving is being threatened by financial firms at the edge of failure,

supported with taxpayer funds, designated as systemically important institutions.Alan

Greenspan agreed with Gary Stern, the former President of the Federal Reserve Bank of

Minneapolis, who has long held the position that “. . . creditors will continue to underprice the

risk-taking of these financial institutions, overfund them, and fail to provide effective market

discipline. Facing prices that are too low, systemically important firms will take on too much

risk.”8 These firms absorb scarce savings that needs to be invested in cutting edge

technologies, if output per hour and standards of living are to continue to rise.

        After wallowing in the backwaters of economics for years, “too big to fail” has

arisen as a major visible threat to economic growth. It finally became an urgent problem

 Jim Juhnehenn, Huffington Post, January 14, 2009- Obama would spend bailout funds on Housing Crisis
 Statement before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, DC,
May 6, 2009

when Fannie Mae and Freddie Mac were placed into conservatorship on September 7,

2008. Prior to that date, U.S. policymakers could point to the fact that Fannie and Freddie, by

statute, were not backed by the full faith and credit of the U.S. government. Market

participants however, did not believe the denial, and consistently afforded Fannie and Freddie

a special credit subsidy. On September 7, 2008, market participants were finally vindicated.53

One highly disturbing consequence of the “too big to fail”-bailout problem that has emerged

since the September 2008 federal takeover of Fannie Mae and Freddie Mac is that market

players are going to believe that every significant financial institution, should the occasion

arise, would be subject to being bailed out with taxpayer funds. Businesses that are bailed out

have competitive market and cost-of-capital advantages, but not efficiency advantages, over

firms not thought to be systemically important. For years the Federal Reserve had been

concerned about the ever larger size of our financial institutions. Federal Reserve research had

been unable to find economies of scale in banking beyond a modest-sized institution. A

decade ago, Alan Greenspan noted “megabanks being formed by growth and consolidation

are increasingly complex entities that create the potential for unusually large systemic risks in

the national and international economy should they fail.”9 Regrettably even though Mr.

Greenspan thought of this, he did not implement it into his tactics during his reign as

Chairman of the Federal Reserve.

        In the wake of the subprime mortgage and credit crisis in 2007, Greenspan admitted

that there was a bubble in the US housing market, warning in 2007 of "large double digit

declines" in home values "larger than most people expect".10 However, Greenspan also noted,

  Greenspan, Alan. The Evolution of Bank Supervision. Before the American Bankers Association,
Phoenix, AZ. October 11, 1999.
   Guha, Krishna, Financial Times. September 17, 2007- Greenspan on the US housing prices.

"I really didn't get it until very late in 2005 and 2006."11 On a list of 25 people to blame for

the financial crisis, Time Magazine placed him at # 3.

        Greenspan admitted that the housing bubble was “fundamentally engendered by the

decline in real long-term interest rates”,12 though he also claims that long-term interest rates

are beyond the control of central banks because "the market value of global long-term

securities is approaching $100 trillion" and thus these and other asset markets are large

enough that they "now swamp the resources of central banks".13

        Following the September 11, 2001 attacks, the Federal Open Market Committee voted

to reduce the federal funds rate from 3.5% to 3.0%. Then, after the accounting scandals of

2002, the Fed dropped the federal funds rate from then current 1.25% to 1.00%. Greenspan

acknowledged that this drop in rates would have the effect of leading to a surge in home sales

and refinancing.

        Besides sustaining the demand for new construction, mortgage markets have also been

        a powerful stabilizing force over the past two years of economic distress by facilitating

        the extraction of some of the equity that homeowners have built up over the years.14

However, Greenspan's policies of adjusting interest rates to historic lows contributed to a

housing bubble in the US. The Federal Reserve acknowledges the connection between lower

interest rates, higher home values, and the increased liquidity the higher home values bring to

the overall economy.

   Felsenthal, Mark. Greenspan didn’t see the subprime storm brewing.
   Guha, Krishna, Financial Times. September 16,2007- A global Outlook
   Greenspan, Alan. Wall Street Journal- The Roots of the Mortgage Crisis
   Greenspan, Alan. November 12, 2002-Statement from Economic Outlook Hearing before the Joint Economic
Committee, Congress of the United States

        In a speech in February 2004, Greenspan suggested that more homeowners should

consider taking out Adjustable Rate Mortgages (ARMs) where the interest rate adjusts itself

to the current interest in the market. The fed own funds rate was at an all-time-low of 1%. A

few months after his recommendation, Greenspan began raising interest rates, in a series of

rate hikes that would bring the funds rate to 5.25% about two years later. A triggering factor

in the 2007 subprime mortgage financial crisis is believed to be the many subprime ARMs

that reset at much higher interest rates than what the borrower paid during the first few years

of the mortgage.

        In 2008, Greenspan expressed great frustration that the speech he made on February

23, 2004 was used to criticize him on ARMs and the subprime mortgage crisis, and stated that

he had made countervailing comments eight days after it that praised traditional fixed-rate

mortgages. An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on

the note is periodically adjusted based on a variety of indices. Among the most common

indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds

Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own

cost of funds as an index, rather than using other indices. This is done to ensure a steady

margin for the lender, whose own cost of funding will usually be related to the index.

Consequently, payments made by the borrower may change over time with the changing

interest rate alternatively, the term of the loan may change. This is not to be confused with the

graduated payment mortgage, which offers changing payment amounts but a fixed interest

rate. Other forms of mortgage loan include the interest only mortgage, the fixed rate

mortgage, the negative amortization mortgage, and the balloon payment mortgage. Adjustable

rates transfer part of the interest rate risk from the lender to the borrower. They can be used

where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower

benefits if the interest rate falls and loses out if interest rates rise.

       One of the major developments leading to the large increase in subprime lending over

the last few years was the adoption of new credit scoring techniques. This allowed lenders to

sort applicants by creditworthiness and set risk-based loan interest rates. A large percentage of

these loans were originated by mortgage brokers who then sold the loans to Wall Street

investment banks. The investment banks, in turn, packaged the loans into collateralized debt

obligations and sold these to investors around the world. As with any new credit product,

investors had difficulty evaluating the subprime debt default risk. Historical data suggested

that if the unemployment rate remained low, so too would default risk. But the quantitative

models ignored two factors keeping defaults low over the 2002-2005 periods. Rising home

prices allowed subprime borrowers the opportunity to refinance the loan or sell the property

whenever they where unable to make their monthly payments. Second, falling interest rates

from 2001 to 2004 reduced ARM indexes which limited the teaser interest rate increases.

The large number of nontraditional mortgages has intensified the current housing market

slowdown. A record number of ARMs, option ARMS, and interest-only loans are expected to

reset in 2008. Many of these loans, particularly those with teased initial rates and inadequate

caps, will default as borrowers find they can’t afford the higher payments and are unable to

refinance because house prices are falling and they now owe more than their homes are worth.

Until recently, subprime borrowers were able to refinance into another subprime loan and

avoid the payment reset. Most subprime loans over the last few years were of the 2/28 variety,

fixed for 2 years and then adjust every six months thereafter. But the 2005-2006 subprime

borrowers who are now facing payment resets and are having difficulty refinancing due to

tighter underwriting standards and lower home prices. For many small down payment

borrowers, the recent decline in home prices has more than eliminated their home equity and

put their loans underwater—with home values less than the loan amount. There are two

channels though which deteriorating subprime mortgage credit quality will affect the

housing market and home prices over the next couple of years. First, foreclosed property

could increase the supply of housing by 500,000 units each year. In a market already

experiencing excess inventory, this will put additional downward pressure on home prices.

Moreover, foreclosed homes typically sell at a discount relative to existing market prices. This

will further reduce home prices and exacerbate the credit problems of other borrowers

wishing to refinance their resetting mortgage. These borrowers moving into foreclosure will

set in motion a self-reinforcing cycle which could spiral downward the housing market.

       One may look at Greenspan responsible for the housing market crash and wonder how

it completely affected the entire economy and lead to the crisis as we know it today. The

housing market slowdown has already affected the overall economy. The drop in housing

demand and the corresponding rise in home inventories have put the residential construction

industry into a recession. This decline in new home residential construction shaved 1.2% off

GDP growth in the fourth quarter of 2007, and is expected to due the same for the first half of

2008. But the housing market affects more than just the residential construction sector of the

economy. Surging home prices over the last four years produced large capital gains for

households which created a strong wealth effect for consumer spending and helped reduce the

national savings rate. Since 2003, the average annual growth rate of real consumer spending

was a strong 3.2%, with consumer durable spending (furniture, appliances, autos) increasing

5.7% annually. Since personal consumption expenditures makes up more than 71% of the

total economy, rising home prices were a major catalyst for overall economic growth. Rising

home prices were also a contributing factor to the nearly negative U.S. household savings rate

over the last two years. If nationwide home prices fall by 5 percent in 2008, a negative wealth

effect will decrease consumption spending, increase the national savings rate and reduce

economic activity.Over the last few years, many households treated their home as an ATM

and withdrew equity every time a new car, a home remodeling project or college tuition

needed financing. But falling home prices will reduce mortgage equity withdrawals in 2008,

putting additional brakes on consumer spending and the economy. Economic growth could

thus slow to a 1% annual rate in 2008, down from 2.5% in 2007. In the first half of the year,

the economy may well dip into a recession.

        In his speech, Greenspan had suggested that lenders should offer to home purchasers a

greater variety of mortgage product alternatives other than traditional fixed-rate mortgages.15

Greenspan also praised the rise of the subprime mortgage industry and the tools which it uses

to assess credit-worthiness in an April 2005 speech:

        Innovation has brought about a multitude of new products, such as subprime loans and

niche credit programs for immigrants. Such developments are representative of the market

responses that have driven the financial services industry throughout the history of our

country … With these advances in technology, lenders have taken advantage of credit-scoring

models and other techniques for efficiently extending credit to a broader spectrum of

consumers. … Where once more-marginal applicants would simply have been denied credit,

lenders are now able to quite efficiently judge the risk posed by individual applicants and to

price that risk appropriately. These improvements have led to rapid growth in subprime

mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the

number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.16

        The subprime mortgage industry collapsed in March 2007, with many of the largest

lenders filing for bankruptcy protection in the face of spiraling foreclosure rates. For these

reasons, Greenspan has been criticized for his role in the rise of the housing bubble and the

   Greenspan, Alan. February 23, 2004. - "Understanding household debt obligations". Credit Union National
Association 2004 Governmental Affairs Conference
   Greenspan, Alan April 8, 2005. "Consumer Finance". Federal Reserve System’s Fourth Annual Community
Affairs Research Conference

subsequent problems in the mortgage industry, as well as engineering the housing bubble


          It was the Federal Reserve-engineered decline in rates that inflated the housing bubble

... the most troublesome aspect of the price runup is that many recent buyers are squeezing

into houses that they can barely afford by taking advantage of the lower rates available from

adjustable-rate mortgages. That leaves them fully exposed to rising rates.17

          Stiglitz an American economist and a professor at Columbia University stated that

Greenspan “didn't really believe in regulation; when the excesses of the financial system were

noted, (he and others) called for self-regulation — an oxymoron.”18 Greenspan, according to

The New York Times, says he himself is blameless. On April 6, 2005 Greenspan called for a

substantial increase in the regulation of Fannie Mae and Freddie Mac. Appearing before the

Senate Banking Committee, the Fed chairman, Alan Greenspan, said “…the enormous

portfolios of the companies — nearly a quarter of the home-mortgage market — posed

significant risks to the nation's financial system should either company face significant

problems.”19 Despite this, Greenspan still claims to be a firm believer in free markets,

although in the 2007 publication of his biography, he writes, "History has not dealt kindly

with the aftermath of protracted periods of low risk premiums" as seen before the credit crisis

of 2008.

          In Congressional testimony on October 23, 2008, Greenspan admitted to being at fault

on regulation. The New York Times wrote, "a humbled Mr. Greenspan admitted that he had

put too much faith in the self-correcting power of free markets and had failed to anticipate the

self-destructive power of wanton mortgage lending. ... Mr. Greenspan refused to accept blame

   Coy, Pete. July 19, 2004. "Is A Housing Bubble About To Burst?"
   Stiglitz, Joseph (September 17, 2008). "How to prevent the next Wall Street crisis”
   Labaton, Stephen (April 7, 2005). "Limits Urged in Mortgage Portfolios". New York Times

for the crisis but acknowledged that his belief in deregulation had been shaken."20 Although

many Republican lawmakers tried to blame the housing bubble on Fannie Mae and Freddie

Mac, Greenspan placed far more blame on Wall Street for bundling subprime mortgages into


           In 2007 Greenspan refused to accept any liability in regards to the housing crisis. He

blamed everybody and anybody but himself. In fact Greenspan calls the root of the crisis

dating back to 1989 and the fall of the Berlin Wall. “The fall of the Berlin Wall exposed the

economic ruin produced by the Soviet bloc’s economic system”21. In response, competitive

markets quietly, but rapidly, displaced much of the discredited central planning that was so

prevalent in the Soviet bloc and the then Third World.

           Through all the decisions made by Greenspan he has had his fair share of bad and

good, great and horrible decisions. What about his legacy? Well from savior to one to blame

for our crisis at hand? If Mr. Greenspan had acted differently during his tenure as Federal

Reserve chairman from 1987 to 2006, many economists say, the current crisis might have

been averted or muted.Over the years, Mr. Greenspan helped enable an ambitious American

experiment in letting market forces run free. Now, the nation is confronting the consequences.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and

inscrutable that they required federal oversight to protect the financial system. In meetings

with federal officials, celebrated appearances on Capitol Hill and heavily attended speeches,

Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off


           Ever since housing began to collapse, Mr. Greenspan’s record has been up for

revision. Economists from across the ideological spectrum have criticized his decision to let
     Associated Press. October 23, 2008.
     Greenspan, Alan April 7,2007 Statement from Financial Crisis Inquiry Commission

the nation’s real estate market continue to boom with cheap credit, courtesy of low interest

rates, rather than snuffing out price increases with higher rates. Others have criticized Mr.

Greenspan for not disciplining institutions that lent indiscriminately.

           But whatever history ends up saying about those decisions, Mr. Greenspan’s legacy

may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the

spectacular boom and calamitous bust in derivatives trading. “It seems superfluous to

constrain trading in some of the newer derivatives and other innovative financial contracts of

the past decade,” Mr. Greenspan writes. “The worst have failed; investors no longer fund

them and are not likely to in the future.”22

           The question of how adjustable rate mortgages came about is one that most can not

disagree too much with Mr. Greenspan. Your average American family in order to flourish

and live the American Dream had to put a down payment of 20% in order to qualify for a

mortgage and the opportunity to own a home. As ARMs became more and more profitable

and popular it became a matter of time and money for the situation to eventually get to this

point. Greenspan believes that the mortgage firms that are “too big to fail” were aware of the

situation; however they believed that they would have time to react to the crisis on the rise.

Obviously things did not turn out that way.

           As the crisis is supposedly on the way to recovery in the United States, one can choose

to blame many for it. The best way to leave my evaluation of the role that Mr. Greenspan took

on in the development of the crisis is, “I guess I should warn you, if I turn out to be

particularly clear, you've probably misunderstood what I've said”. Is the crisis over or still

developing? Nothing is clear; however the role of the adjustable rate mortgage has had in the

development of the crisis is without a question in the top 3 reasons why the situation spiraled

     Greenspan, Alan. The Age of Turbulence: Adventures in a New World. New York: Penguin, 2007.

out of control to the point where it not only affected the housing market, but the construction

industry, the consumerism of the nation, and the employment of the nation obviously as the

unemployment rate has significantly risen. Foreclosures have risen, and the number of

applicants for home loan modifications during 2008-2010 was quite significant to the

economy getting a grip and beginning to “recover”.

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