Alan Greenspan, the formerchairman of the US Federal Reserve, has dramatically repudiated large parts of his laissez-faire ideology and joined the chorus of voices saying that the credit crisis reveals a need for more regulation of the finance industry.
Returning to Capitol Hill to testify before Congress, where lawmakers were once in awe of his intellect and his reputation as a steward of theeconomy, a bewildered-sounding Mr Greenspan admitted that his view of the world had been flawed.
Self-regulation by Wall Street had failed, he said. "Those of us who have looked to the self-interest of lendinginstitutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."
And he went on: "I found a flaw in the model that I perceived is thecritical functioning structure thatdefines how the world works. That's precisely the reason I was shocked... I still do not fully understand why it happened and obviously to the extent that I figure where it happened and why, I will change my views. If the facts change, I will change."
The 82-year-old former chairman, who ran the Fed for 18 years under four presidents before retiring in 2006, has seen his reputation torn to shreds by those who accuse him of havingcontributed to a credit bubble which, on bursting, has brought the world to the brink of economic calamity.
The housing market was inflated tounsustainable levels, in part by Mr Greenspan's keeping interest rates too low for too long, his critics argue. And he rejected calls as far back as 2000 to beef up the Fed's regulation of themortgage lending business in the US, where so-called "sub-prime" borrowers were handed home loans theycouldn't afford by predatory lenders who operated without strong oversight.
Those sub-prime loans wereparceled up into mortgage-backedsecurities and other derivatives, which were sold throughout the world – and which have subsequently collapsed in value as US borrowers defaulted on mortgage payments in record numbers and as house prices slumped.
The explosion of these derivatives markets was based on flawed assumptions, by traders and their counterparties, about the levels of risk that they were taking, Mr Greenspan said. "The whole intellectual edifice collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria."
Although the former Fed chairman said he had warned as far back as 2005 that markets might be underpricing risk, his testimony yesterday was a major departure – following many months in which Mr Greenspan has declined to identify mistakes he made during his tenure and has insisted that he could have done little to prick a bubble in the credit markets in any case.
Yesterday he called for better oversight of the financial markets, and in particular those issuing mortgage-backed securities and other derivatives. "As much as I would prefer itotherwise, in this financial environment I see no choice but to require that all securitisers retain a meaningful part of the securities they issue," he said.
"This will offset in part market deficiencies stemming from the failures of counterparty surveillance. There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitisation." And it was not just Mr Greenspan who was taking a different tone at yesterday's House of Representatives oversight committee meeting. Committee members showed substantially less reverence for the former Fed chief and his views than members of Congress did in the days when he ruled the Fed and was near-deified for his apparent ability to keep the US economy on an even keel despite shocks such as the stock market crash of 1987 or the terror attacks of 2001.
Henry Waxman, the oversight committee chairman, demanded that Mr Greenspan take his share of the blame for the current crisis.
"For too long, the prevailing attitude in Washington has been that themarket always knows best," he said. "The Federal Reserve had the authority to stop the irresponsible lending practices that fuelled the sub-prime mortgage market, but its long-time chairman rejected pleas that he intervene. The Securities and Exchange Commission had the authority toinsist on tighter standards for credit rating agencies, but it did nothing. The Treasury department could have led the charge for responsible oversight of financial derivatives, but instead, it joined the opposition. The list of regulatory mistakes and misjudgements is long, and the cost to taxpayers and our economy is staggering."
Christopher Cox, chairman of the SEC, was also on the panel testifying yesterday, as was John Snow, who was Treasury secretary until 2006.
Mr Cox said that the SEC had been hampered in its oversight of Wall Street firms by the lack of adequate legislation defining its role, and Mr Snow blamed Congress for ignoring the Bush administration's warnings about the systemic risk posed by mortgagesecuritisation giants Fannie Mae and Freddie Mac.
Fannie and Freddie had a government mandate to promote home ownership, and drove down mortgage rates by guaranteeing or buying half of all US mortgages – but spiralling losses forced the federal government tonationalise them earlier this year.
Mr Greenspan addressed the root cause of the housing bubble and theexplosion of risky sub-prime mortgages. "We didn't know that a deterioration in standards was occurring until 2005. The real toxic mortgages occurred with the increase in securitisation and the huge demand from abroad, and to the extent that Fannie and Freddie were involved, from them as well."
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