"A Period of Protracted Adjustment" Ahead

by: Greg Newton

The Wall Street Journal Tuesday turns over way too many of its ink-and-pixels to former Federal Reserve Board chairman Alan Greenspan for a less than edifying few hundred smug and self-exculpatory words along the general lines of “Sorry officer, I was in the bath at the time and anyway it was the East Germans.” Or something like that:

...Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction. The crisis was thus an accident waiting to happen.

If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums...

I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.

Demand in those days was driven by the expectation of rising prices—the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. In fact, home prices continued to rise for two years subsequent to the peak of ARM originations (seasonally adjusted).

...More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies...

...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.

So that’s all right then.

The Roots of the Mortgage Crisis
by Alan Greenspan
The Wall Street Journal Dec. 12 2007