Is America’s subprime mortgage crash the second blot on the reputation of former Fed chairman, Al Greenspan?

The first was his failure to act to rein in the “irrational exuberance” (his words 11 years ago) of the tech and net booms. They culminated in the crash of 2000 and the three year bear market and economic slowdown which saw him cut interest rates to just 1% by 2003 to keep the US out of a nasty recession.

Looking back, that cheap money policy contributed heavily to the US housing boom, and our present mad worldwide liquidity bubble, aided by the cheap money policies of deflationary Japan.

Figures show the extent of the bubble in subprime mortgages: with Wall Street’s appetite for high-yielding mortgage bonds driving demand for high-return, high-risk loans, financial companies dropped their lending standards.

Regular mortgages were so common and rates so low that there was no real gains to be had in buying them, except to underpin a bond portfolio, not supercharge the performance.

So more and more subprime loans were made to people of declining credit worthiness, and more and more investors looking for outperformance bought repackaged and sliced and diced residential mortgage bonds backed by these less than prime loans.

As a result subprime mortgages almost doubled to $US640 billion last year 2006 from $US332 billion in 2003.

The Fed and other regulators did little to control or control this rapid growth.

Greenspan was always opposed to heavy-handed intervention or rule-writing, and favored self-regulation and the primacy of markets.

US media are now reporting that the Fed and other federal regulators issued non-enforceable warnings, advising bankers and federal examiners about best practices in mortgage lending.

Agencies issued guidelines defining unfair and deceptive practices in 2004, on home-equity lending in 2005, and on non-traditional mortgages in 2006. But there was no crack down.

The media reports are saying that because the Fed has expansive authority it was better placed to have stopped abuses. Other federal regulators oversaw chunks of banking and the markets but none had the wide view or the credibility that Greenspan and the Fed possessed.

The US has a Federal law called The Truth in Lending Act. It gives the Fed rule-writing authority over disclosures for consumer credit among all financial institutions. The Home Ownership and Equity Protection Act of 1994 also gave the Fed a role in preventing predatory lending, according to consumer advocates.

Analysts point out that federally regulated banks and Wall Street firms were often the financiers standing behind state-regulated mortgage lenders.

Struggling New Century Financial, the almost bankrupt number two operator in subprime mortgages, had Morgan Stanley, Citigroup, and Goldman Sachs Group among its creditors. All these banks or investment banks are controlled federally.

It’s odd to some in the US markets that the Fed and other banking regulators only told lenders and others in the subprime area a fortnight ago to tighten their procedures, documentation and lending practices.

You can argue that Greenspan’s inaction from 1996 through to around 2005 effectively allowed the financial markets to produce bubbles, twice, in a regulatory vacuum.

Some achievement for all the halo’s still clinging to the man.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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