Greenspan Put, aka “Be Nice to Banks”, Trumped Recognition of Housing Bubble in 2005

In an interesting bit of synchronicity, we’re getting other “how did we get there” snippets from the global financial crisis today. Bloomberg reports that the Federal Reserve actually did see that a housing bubble was underway, but stuck to its guns of measured interest rate increases. The problem is that its account is far too kind to the Fed and comes awfully close to being revisionist history:

Federal Reserve staff and policy makers identified a housing bubble in 2005, and failed to alter a predictable path of interest-rate increases to slow down the expansion of mortgage credit, transcripts from Open Market Committee meetings that year show….

The FOMC in June heard presentations from staff economists, with some raising alarms about housing markets, the transcript shows. Those warnings didn’t translate into a more aggressive policy. The committee raised the benchmark lending rate a quarter-point at that meeting and said “policy accommodation can be removed at a pace that is likely to be measured.”..

“There was a fundamental failure of economic analysis to understand what was going on in the potential for house prices to stop rising,” said William Poole, the former St. Louis Fed president who attended the meetings in 2005. “The high degree of assurance that we all felt that house prices could not decline on a national average basis in a fundamental way — that was a significant mistake.”

You need to take this report with a fistful of salt:

1. William White of the Bank of International Settlements had been warning central bankers, including Greenspan, of a housing bubble in multiple markets since 2003

2. In June 2005 the Economist had a cover story, with a very detailed analysis, of the rise in housing prices. In other words, the idea that housing prices were frothy was clearly visible to mere readers of the financial press

3. Poole does accurately say that all the Fed did was consider that housing prices would stop rising, not that they might fall. This is another symptom of bubble denial and a major failure of imagination

4. It is not just that the staff warnings were largely ignored in terms of Fed policy, but it did not decide to engage in closer monitoring or do additional forensics. This again reflects the Greenspan “let the markets alone” anti regulatory bias. The Fed had other tools at its disposal besides interest rates. Jawboning or more intrusive inspections of bank would also have sent a message (yes, we know now that CDOs were the big driver of the toxic phase of the market, but a dim Fed view would have also influenced investors and would have led to a concern that the riskier tranches of RMBS were soon to be repriced, since risky debt usually takes it on the chin first when markets turn down. That could have led investment banks to be reluctant to gin up CDOs on a large scale, since they provided warehouse lines to CDO managers as well had exposure to unsold deals)

5. The Fed continued to defend the housing market in public statements. That’s the wrong thing to do; it tells investors and financial firms that the officialdom is on the case and thinks there is nothing to be worried about. For instance, ECONNED took note of this statement in a May 2005 speech, which is after the FOMC discussions in question:

Some observers have expressed concern about rising levels of household debt. . . . However, concerns about debt growth should be allayed by the fact that household assets (particularly housing wealth) have risen even more quickly than household liabilities. Indeed, the ratio of household net worth to household income has been rising smartly and currently stands at 5.4, well above its long-run average of about 4.8. . . . One caveat for the future is that the recent rapid escalation in house prices . . . is unlikely to continue. . . . If the increases in house prices begin to moderate as expected, the resulting slowdown in household wealth accumulation should lead ultimately to somewhat slower growth in consumer spending

The flaw in the logic is in plain sight. Consumer debts levels had continued to rise since the 1980s and the household savings rate had been hovering around zero. Debt has to be serviced out of income, liquidating savings, borrowing against other assets (a self-limiting process) or from the proceeds of asset sales. With real incomes of average consumers stagnant, a large number of consumers were in the position that everything had to work out right for them to be money good on their debt. We now know how this movie ended.

5. In the wake of the crisis, the Fed has continued to try to shirk blame for the crisis. The argument made all too often by the Fed and economists is that it’s impossible to see a bubble in progress and the officialdom can’t be expected to pop it. It was only when it became clear that policy thinking was moving in favor of macroprudential regulation that the Fed moved to protect its turf and started to act as if it was on board with taking on this role. I’m not entirely convinced of its enthusiasm for this job.

So now that the dirt is coming out, that the Fed did see the evidence of the housing bubble and continued to steer the Titanic at the same speed towards the iceberg, the nature and magnitude of its error is still being underplayed. But that should be no surprise. The fact that Bernanke remains at the helm of the Fed demonstrates that no one in any important pre-crisis role has been or will be held to account.

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30 comments

  1. Conscience of a conservative

    What can’t you understand the Fed does not target asset prices…….

    No wait that’s wrong.
    They repeatedly took actions that had a “wealth effect” from increased stock and real estate prices.

    I guess they only take responsibility for increasing asset prices, but not failing to prevent the decline.

    1. spectator

      The cost of artificially increasing asset prices, and Greenspan’s put in support of the financial industry, is seriously underestimated. The financial crisis and it’s aftermath don’t look so bad if you ignore the underlying corruption of society.

      For a capitalist society based on the almighty dollar, it’s hard to overestimate the corrosion caused by corruption of the currency. The most damage is caused by subtly shifting power to bad actors that waste society’s valuable resources, e.g. the corrupt Wall Street firms that waste so many of the country’s brightest minds, say MIT PhDs. It appears to have demotivated many of these bright kids even when they don’t go into finance.

      And so we can expect more of the same, as we continue to underestimate the damage caused by the Fed monkeying with the almighty dollar.

  2. shayre

    Does this sound too much like a conspiracy theory?

    I think it comes down to the fact that homes were built that needed 30 years of work to be paid off, and they were being bought by people who, at tops, had jobs that were only going to last 8 years. Once the housing bubble popped, those that found good-paying jobs in construction would soon be part of the structurally unemployed, and their homes would be lost.

    The good news is that the house got built. That means, there are houses for all Americans. That is a huge plus going forward. Without the bubble, these homes would never have been built and we would have been in the mess we are in today, but only 8 years earlier.

    And then, the 9/11 terrorists could take credit for having brought down the US.

    1. Detroit Vacancies

      what? .. Many borrowers were purchasing existing housing stock that was shooting to the moon price wise. Houses built in the 50s, 60s and 70s. The worst looting occured in older smaller working class ‘hoods filled with post war capes. These areas were decimated, as is always the case. The lower income hoods where the housing stock is less desirable is usually where the financial criminals clean up, blighting entire streets into abandoned decay. They had already done this before in some places as early as a decade before the “actual” housing bubble.

      1. Lyle

        Note that a lot of the activity was re-fis many cash out numbers suggest that 75% of subprime was re-fis not purchase money mortgages.

    2. armchair

      I have speculated for years that the bubble and the put were a result of Bush hitting the trifecta. It was a patriotic bubble.

    3. gepay

      The facts are that some people in the FED knew there was a problem: “… “Edward Gramlich, who was Fed governor from 1997 to 2005, said he proposed to Mr. Greenspan in or around 2000, when predatory lending was a growing concern, that the Fed use its discretionary authority to send examiners into the offices of consumer-finance lenders that were units of Fed-regulated bank holding companies.
      “I would have liked the Fed to be a leader” in cracking down on predatory lending, Mr. Gramlich, now a scholar at the Urban Institute, said in an interview this past week. Knowing it would be controversial with
      Mr. Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich broached it to him personally rather than take it to the full board. “He was opposed to it, so I didn’t really pursue it,” Wall Street Journal

      …When Bill Moyers queried Mr. Greider about whether Wall St., The Fed, the Banks and/or Congress had “put the watchdogs to sleep?” He answered: “A better metaphor, instead of putting them to sleep would be—‘castration!” – Moyer’s interview on PBS 07/18/2008

      Eliot Spitzer had this to say:
      “…Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye…
      In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government’s actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.

      So the Bush administration actively kept the state regulators from looking out for Main Street. Greenspan actively dissuaded anybody at the FED from looking into it.
      Mark Twain phrased it best,
      “Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it.”
      My thoughts run to a combination of greed, conspiracy, and idiocy.

    1. shayre

      I think this is true.

      Look at what the dotcom bubble and the housing bubble have left behind in the way of legacy assets.

      Without the bubbles, we would not have had the advances in technology (and the related infrastructure), and we would not have had enough houses built to eventually house all Americans. That is progress.

      People will feel pain in losing their homes and their jobs. But, for many, without the housing bubble, they would not have had a home or a job in the first place.

      At least now, there will be plenty of rental homes for them to choose from, and the amount they pay for rent will be based on the limited amount of income they earn, or receive in welfare.

      This is what the rental pool is going to be made up of, and anybody buying “investment” property will have the choice of either renting it out at these much lower rents, or leaving the home vacant. How many investors can afford to leave rental properties vacant? Therefore, rental properties are going to be a money-loser because people are assuming that they will be able to continue to collect the same amount of rent that current rental properties are generating.

      1. F. Beard

        There is a better way to do money. The boom-bust cycle is obsolete as well as being crooked and dangerous.

        Plus the excessive wealth disparity is another bad effect of the debt-money system.

      2. paper mac

        ‘Look at what the dotcom bubble and the housing bubble have left behind in the way of legacy assets.’

        Ah yes, all those McMansions built in the Mojave desert with toxic Chinese drywall- truly a monumental “legacy asset” to be proud of. Opportunity cost? Malinvestment? What are those?

      3. Lyle

        Becoming historical we had 2 railroad bubbles in the 19th century 1873 and 1893. Both were the result of rampant overbuilding at the time, and the finance industry running amok, (1873 Jay Cooke and the Northern Pacific) (1893 most of the railroad industry). If you look at the rate of building of rails it increased rapidly before the crashes. One can also look at Holland and Tulips, England and the South Sea, France and the Mississippi company, and the like and find that bubbles are part of a capitalist economy. People get caught up in a herd, this time is different, everyone is doing it mode and all go lemming like over a cliff. Recall as noted in the minutes that Flip this House and other shows were common at the time, and the way to get rich quick (which is as american as apple pie) was to flip homes.

    2. jake chase

      Bubbles are an inevitable result of limitless electronic money shoveled into a banking cartel. Veblen explained how asset inflation is necessary to validate the business process, which involves repeated recapitalization of companies, shares, commodities. The Fed is the engine of this process, which has become totally unglued by its willingness to accept anything held by the banks as collateral, and to lend at a rate approaching zero.

      The only question is whether the necessary commodity price inflation will take place soon enough to validate the speculation. Shrinking wages, growing although unmeasured unemployment and continuing excess capacity suggest that it will not. The day the bulls run for cover the game may be over.

  3. steelhead23

    “The high degree of assurance that we all felt that house prices could not decline on a national average basis in a fundamental way — that was a significant mistake.”

    Dear Mr. Poole, No sir, the view you elaborate was not “a significant mistake.” Managing the credit/money supply in a manner that ignores the simple fact that bull markets can become bear markets and asset values can decline – precipitously, is a clear indication of incompetence. Yes, incompetence. This sophomoric belief facilitated both the bubble and the euphoria-driven excesses in the derivatives markets and the spectacular growth in VaR that fueled the collapse. Allow me to spell it out – either you, and the rest of the Fed governors are woefully inept, or, you knowingly adopted a “maximize bank profit” objective within your rather limited Fed charter. As such charter expansion is at least extralegal if not illegal, your admission suggests that you are either dumb as a stump, or a criminal. Allow me to take another step down this road. The Fed should follow a policy of managing the money supply in a manner commiserate with economic growth. Also, credit growth should not greatly exceed wage growth because it is wages, not corporate revenues, that pays most debts. During the first decade of this century, aggregate debt grew much faster than wages. Here are two simple tautologies you should commit to memory: That which cannot be sustained, won’t be – and Debts that cannot be repaid, won’t be. Never forget that most debts are paid by wages and while credit went to heaven in the past decade, wages were flat. You, and all your friends on the Board of Governors, should resign, NOW.

    1. shayre

      They could now resign content with the fact that their mission has been accomplished. They did good.

      The paper wealth being wiped out today would never have existed in the first place had we not had a credit bubble. But houses that otherwise would not have been built, still remain. That has to be a plus for society.

      They have maximized the benefit of America’s good credit on behalf of the American people, and they can be proud of that.

      American’s have gotten countries to ship them their depleting oil reserves and the Chinese have sent over manufactured goods, all for what? IOU’s that have virtually no value? Those IOU’s must eventually be cashed in by buying something from the US? Pray tell, what does the US produce that cannot be bought from elsewhere at a lower price or of a better quality?

      The US produces IOU’s and food. Therefore, the only ones that will suffer from higher food prices would be those that currently get it for free in the way of aid as less will be provided for free.

      1. F. Beard

        The paper wealth being wiped out today would never have existed in the first place had we not had a credit bubble. But houses that otherwise would not have been built, still remain. That has to be a plus for society.

        Many of those homes will likely rot. Many are over-sized and wasteful.

        They have maximized the benefit of America’s good credit on behalf of the American people, and they can be proud of that.

        They should be ashamed of being part of the government backed counterfeiting cartel that killed 50-86 million from the last Great Depression alone (WWII).

        Fractional reserves, usury and PMs are all obsolete. The only thing holding them up is government privilege and inertia.

      2. attempter

        Leaving aside the fact that most of these houses are cheap fabrications which will rot and collapse within a generation, let’s say you’re right.

        OK, we have the legacy housing stock – so let’s reclaim it. We can start by strategically defaulting but staying in place wherever we are, and by redeeming all REO from below. That’s the only way the bubble can be turned to any good account.

        As for this:

        The US produces IOU’s and food. Therefore, the only ones that will suffer from higher food prices would be those that currently get it for free in the way of aid as less will be provided for free.

        No, once we restore the land to its proper owners, we’ll be growing our own food on a self-managed, self-owned basis. Food will no longer have any price beyond our own labor. So that problem will be solved as well.

        As with everything else, the solution is simple: Take back from the robbers all they stole; restitute all to the proper owners, the productive people; justice for all.

  4. emca

    The number of times during the bubble build-up I heard from financial commentators and nabobs, “the FED says its ok.”

    Either the FED lied or were ignorant, I hardly see the better.

  5. Jim Haygood

    In Feb. 2004, with the Fed Funds rate still at 1.0%, Greenspan touted adjustable-rate mortgages at one of the most inopportune moments in history:

    While borrowers can refinance fixed-rate mortgages, Greenspan said homeowners were paying as much as 0.5 to 1.2 percentage points for that right and the protection against a potential rate rise, which could increase annual after-tax payments by several thousand dollars.

    He said a Fed study suggested many homeowners could have saved tens of thousands of dollars in the last decade if they had ARMs. Those savings would not have been realized, however, had interest rates shot up.

    “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan said.

    http://www.usatoday.com/money/economy/fed/2004-02-23-greenspan-debt_x.htm

    Some might allege malevolence on Greenspan’s part, suckering the rubes into floating-rate product just before he and his henchmen cranked short rates by 425 basis points over the next two years. But I’d attribute his remarkably inept timing to Greenspan’s being a second-rate intellect — an incompetent hack who never had a clue.

    Greenspan introduced the ‘quarter-point tiptoeing’ procedure, negating the Fed’s former modus operandi of employing half-point and even whole-point policy rate changes.

    Centrally-planned interest rates are wrong to start with. But adding more constraints, such as the unwritten ‘Greenspan rule’ that ‘we can only tighten by a quarter point every six weeks,’ only further degrades the performance of this value-subtracting cartel.

    1. Leviathan

      It’s funny, I distinctly remember Greenspan saying that because my better half waved it under my nose a few weeks later when we were looking for a house in the new city we were moving to.

      The chairman of the fed says it’s ok. That’s like the Surgeon General saying “try heroin, it can’t hurt you.”

      Can I sue? I really think there is a fraud case to be made against the Fed. I hear they’ve got deep pockets too.

      1. Procopius

        Hey, sure you can sue — if you’ve got the money to pay a lawyer. Why do you think most homeowners being foreclosed on don’t get a lawyer to fight it? Because lawyers have to be paid. If you have enough money you can always find a lawyer who will do what you ask, although you might find many others as well who tell you not to bother because you haven’t got a snowball’s chance in downtown Bangkok’s chance of prevailing.

  6. Ep3

    Yves, I just want to relay some general stories of people I knew who used their homes as ATMs here in Michigan. Actually if you didnt do that, you were considered foolish. Many had nothing and didn’t expect any inheritance. Most were high school grads, some not. Many were two income families. When interest rates began to drop at the end of the 80s, money was freed up from 3 things: lower house payments, debts were rolled over into the mortgage loan, and equity accumulated faster from lower interest rates. As long as they could refinance, they could keep spending.
    But I also think the older generations are at fault. They have raised us all into thinking that trips to Europe, cruises, big SUVs, expensive whatever, is our right and this has engrained in peoples minds that things will only get better when they will not. Yes the grandparents can spend the winter in Florida because they lived the first 50 years of their lives in near poverty conditions. That skill to live frugally has never been passed on. Reagan promoted American exceptionalism while he was dismantling our middle class, which is what made us great.

  7. rd

    I read your article and immediately thought of the similarities with the Challenger space shuttle disaster findings of how the NASA and subcontractor management systems and cultures allowed the failure to happen. As far as I can see, the primary difference between major engineering failures and financial crises is that engineering failures have investigations with real fixes while financial crises don’t (Pecora Commission and Glass-Steagal Act appear to be a major exception).

    Some excerpts from the Wikipedia article:

    “More broadly, the report also considered the contributing causes of the accident. Most salient was the failure of both NASA and Morton Thiokol to respond adequately to the danger posed by the deficient joint design. However, rather than redesigning the joint, they came to define the problem as an acceptable flight risk. The report found that managers at Marshall had known about the flawed design since 1977, but never discussed the problem outside their reporting channels with Thiokol—a flagrant violation of NASA regulations. Even when it became more apparent how serious the flaw was, no one at Marshall considered grounding the shuttles until a fix could be implemented. On the contrary, Marshall managers went as far as to issue and waive six launch constraints related to the O-rings. The report also strongly criticized the decision making process that led to the launch of Challenger, saying that it was seriously flawed.

    “ …failures in communication… resulted in a decision to launch 51-L based on incomplete and sometimes misleading information, a conflict between engineering data and management judgments, and a NASA management structure that permitted internal flight safety problems to bypass key Shuttle managers.[37] ”

    One of the commission’s most well-known members was theoretical physicist Richard Feynman. During a televised hearing, he famously demonstrated how the O-rings became less resilient and subject to seal failures at ice-cold temperatures by immersing a sample of the material in a glass of ice water. He was so critical of flaws in NASA’s “safety culture” that he threatened to remove his name from the report unless it included his personal observations on the reliability of the shuttle, which appeared as Appendix F. In the appendix, he argued that the estimates of reliability offered by NASA management were wildly unrealistic, differing as much as a thousandfold from the estimates of working engineers. “For a successful technology,” he concluded, “reality must take precedence over public relations, for nature cannot be fooled.”

    The U.S. House Committee on Science and Technology also conducted hearings, and on October 29, 1986 released its own report on the Challenger accident.[40] The committee reviewed the findings of the Rogers Commission as part of its investigation, and agreed with the Rogers Commission as to the technical causes of the accident. However, it differed from the committee in its assessment of the accident’s contributing causes.

    “ …the Committee feels that the underlying problem which led to the Challenger accident was not poor communication or underlying procedures as implied by the Rogers Commission conclusion. Rather, the fundamental problem was poor technical decision-making over a period of several years by top NASA and contractor personnel, who failed to act decisively to solve the increasingly serious anomalies in the Solid Rocket Booster joints.”

  8. readerOfTeaLeaves

    2. In June 2005 the Economist had a cover story, with a very detailed analysis, of the rise in housing prices. In other words, the idea that housing prices were frothy was clearly visible to mere readers of the financial press.

    Yup. I filed my copy away, assuming this would blow up. Although I had no grasp of **how much** it would blow up. But I guess us ‘mere readers’ lack omniscience ;-)

  9. Procopius

    I was struck by this assertion:

    Debt has to be serviced out of income, liquidating savings, borrowing against other assets (a self-limiting process) or from the proceeds of asset sales. With real incomes of average consumers stagnant, a large number of consumers were in the position that everything had to work out right for them to be money good on their debt. We now know how this movie ended.

    You know, I don’t think any of those people at the FOMC had any idea that wages were stagnant. Wages weren’t stagnant for them, or the people they knew, how could they be expected to realize that wages were stagnant for the lowest 90% of the population? And given that they don’t know what’s going on in the lives of most people, how can they be expected to make good economic decisions?

    1. psychohistorian

      You just need to understand that the banks are PRIVATE organizations and they are owned by a small percentage of the 10%. Those people put Greenspan at the helm and set the policy he puppeted to. They were being paid well to execute the policy of the bank owners and develop institutional blinders to the economic status of the lower 90%.

    2. Elli Davis

      I agree, but to the degree that the FED officials didn’t want to know that the wages were mostly stagnant. But they had to have the most up to date statistics on the median of the wages. They knew this was coming up, but the people in charge of the banks who assigned them didn’t want to hear anything about it. They just counted the dollars coming out of the mortgage backed securities.

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