Greenspan: Still Almost Childlike in His Idealism

by: Tim Iacono

Former Fed Chairman Alan Greenspan wrote in yesterday's Financial Times of more bank failures to come and warned on the need to resist heavy-handed regulation in an effort to prevent the re-occurrence of what happened on his watch.

Falling home prices are the critical factor in the current crisis. That is, the reversion to the mean for property values that rose at annual rates of between 10 and 20 percent during the first half of the decade when everyone was dismissing the low savings rate and marveling at how wealthy we had all become.

The insolvency crisis will come to an end only as home prices in the US begin to stabilise and clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities. However, US home prices will stabilise only when the absorption of the huge excess of single-family vacant homes that emerged as the US housing boom peaked in 2006 is much further advanced than it is now. New single-family home completions are currently barely under the rate of home demand generated by household formation and replacement needs. Only later this year will the current suppressed level of housing starts be reflected in completion levels consistent with a rapid rate of liquidation of the inventory glut, and this, of course, assumes that current levels of demand for housing hold up.

Look for the inventory glut to be "rapidly liquidated" later this year. This year? Really?

And why is it that no one talks about rapidly de-flating "equity cushions" like they talked about them when they were in-flating a few years back.

It sounds as though the current crisis just snuck up on everybody. Though surely there were steps that could have been taken to prevent the occurrence of this particular epidemic (e.g., tighter lending standards that successor Ben Bernanke eventually provided), the failure to recognize impending problems (e.g., thinking that home prices only go in one direction) makes these events, by definition, unanticipated.

A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was nonetheless a surprise.

Recent history is replete with such underpricing persisting for years. Those market players who withdraw from “long” commitments at the first sign of an excess of exuberance, risk losing market share. They thus continue “to dance” as Chuck Prince, the former Citigroup chairman put it, but always assume they will have time to exit the markets. The vast majority invariably fail. When the current crisis emerged, it was assumed that the weak links would be unregulated hedge and private funds. The losses, however, have been predominately in the most heavily regulated institutions – banks.

It seems the underpricing of risk would be a bit more difficult if money wasn't so cheap and regulation so light, both of which are the purview of the central bank.

And those "heavily regulated banks" somehow managed to accumulate all kinds of toxic waste that were somehow kept off of their balance sheets until such time that people started to question exactly what was in them and then all hell broke loose.

Finally, the warning that government meddling will only make things worse.

We may not easily confront or accept the price dynamics of home and equity prices, but we can fend off cries of political despair which counsel the containment of competitive markets. It is essential that we do so.

Look where "competitive markets" have gotten us.

He still seems to be almost childlike in his idealism and similarly challenged to understand just what it was that happened when he sat in the big chair in the big white building on Constitution Avenue.