Tuesday, April 27, 2010

Possible Misunderstandings about Municipalities and their Bonds

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

Problems of state and municipal finance worsen. Governors announce new spending cuts at press conferences but inspire little confidence. The fury of emergency announcements leaves the listener (as well as the governors) in a daze. Research reports offer broad explanations but have left bondholders, as well as employees and local residents, unprepared for discontinuities. In other words, there will be instances when these constituencies will find themselves marched to the slaughterhouse without warning.

Following are corrections to the more common misunderstandings.

Claim #1: "General Obligation bonds do not default." Financial planners sometimes reassure retail clients with this claim. Following is a case study that shows how a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.

From a credit agency report: "Even in the event of default on [General Obligation] bonds, investors are likely to enjoy a full recovery of principal and interest because municipalities are required to levy additional taxes to repay debt backed by the general obligation pledge." The most significant word in that sentence is "likely." [Note: General obligation (GO) bonds are debt instruments issued by states and local governments to raise funds for public works. In contrast, revenue bonds are repaid from the revenue generated by the specific project that the bonds are issued to fund. Only GO bonds are addressed here.]

From a brokerage firm report: "General obligation debt is backed by a state municipal pledge to raise taxes to service debt if necessary." This is also true, but not the whole truth.

Courts have rebutted this pledge. A 1990 Missouri court ruled that "tax caps in effect when municipal debt was incurred cannot be overridden even if necessary to pay off the debt." (Kevin A. Kordana, "Tax Increases in Municipal Bankruptcy," Virginia Law Review) The court admonished the litigating bondholders: "[E]very purchaser of a municipal bond is chargeable with notice of the statute under which the bond is issued." (Missouri had a statutory tax rate cap.) In words the judge might have used: "Stop whining and wasting my time. Next time, read the bond offering."

Aside from a legal interpretation, raising taxes is often impractical. "At a certain point, raising taxes ceases to raise tax revenues." (McConnell and Picker, "When Cities Go Broke," University of Chicago Law Review).

The City of Vallejo, California may be an important precedent. It filed for bankruptcy in 2008. Both bondholders and city employees agreed to receive less money. The decision is before an appeals court.

Claim #2: "General Obligation default rate is 0.01%." This calculation is used to prove Claim #1. From a brokerage firm report: "The default rate on general obligation municipal bonds since 1970 is 0.01%." The calculation is correct. The brokerage firm used the default rate of Moodys-rated GO bonds since 1970.

Although true, this is misleading. It seems like yesterday when all - and it was all - the certified experts bellowed: "House prices never go down nationally." Just as mortgage payments had risen to uncollectible heights, municipal costs have risen to unsustainable levels. This is a different world than the period addressed by the Moodys study.

Even though money rained on municipalities during the salad days (sales tax revenue increased 46% between 2003 and 2007), it was only by playing games with the books and issuing a record amount of bonds that municipal spending grew so extravagantly over the past decade. States and municipalities issued $442 billion of bonds over the five years from 1998-2002. They issued $804 billion over the next five years, 2003-2007. The growth rate was not quite as steep, but, not dissimilar to mortgage securitizations and private-equity LBOs. The downward slope may not look that different, either.

Claim #3: "Most states are required by law to balance their budgets." This implies the restriction on revenues diverging from spending reduces the possibility of default. Municipal finance is often a shell game, shifting capital-project funds to meet today's burgeoning payrolls and benefits. [See Miami's Municipal Woes (Again): Exiting Before the Tide Goes Out].

Claim #4: "States cannot declare bankruptcy." This is a conclusion drawn by statements such as the following from a brokerage firm report: "The state is not permitted to file for Chapter 9 bankruptcy. Such filings are permitted only for 'municipalities' (e.g., levels of government below the state) under certain conditions." This is true. Bankruptcy law in the United States does not address the states. This does not mean states will not default. They might be in limbo according to the bankruptcy code, but still bankrupt according to the dictionary: "Any person unable to pay his creditors in full." Bondholders should take heed of the dictionary instead of waiting for the law to codify state bankruptcy.

Claim #5: "There has never been greater demand for municipal bonds." This is a sales pitch that implies "buy now, or you'll regret it later." Evidence for this claim is the willingness of retail investors to buy California municipal debt that yields 2% (for debt maturing in 2012; 5.8% for debt maturing in 2030). Another "get 'em while they're hot" argument is an initiative in Congress that would end the tax deductibility on interest from municipal bonds issued in 2011 and after.

First, the possibility of Congress passing such legislation is remote. Second, the "safe" asset classification by financial advisers is the real energy propelling retail investors into municipal issues. It was only two years ago when money market funds were thought of as "safe." They were often classified as "risk-free." (Beware of investment categories and classifications. Labels are often applied after their characteristics have been deemed predictable. By the time the predictable has been awarded a classification, the category has probably attracted too much attention and mindless buying.) After panic selling in September 2008, the federal government guaranteed the net asset value of money market funds.

Municipal appetite is also strong because Federal Reserve Chairman Ben Bernanke has chased savers out of short-term investments. His monetary policy (zero percent fed funds rate) is designed to refloat too-big-to-fail banks (that invest at zero percent and buy 3% Treasury notes) while leaving savers in the poor house. Municipal bonds produce some income, so are the new "cash" option.

Individuals are the only remaining net buyers. In 1975, commercial banks, savings banks, life insurers, and casualty insurers were municipal bond buyers. Only the individual is left today. This is a lonely outpost.

Monday, April 12, 2010

The Best and Brightest Protect Greenspan and Betray the American People

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

Alan Greenspan's reputation has a whiff of terminal decline after his appearance on April 7, 2010, before the Financial Crisis Inquiry Commission (FCIC). Prudence is warranted though, before taking a short position on the former Federal Reserve chairman. The celebrated central banker has spent a lifetime pouring his deep reservoirs of energy and ambition into his own advancement, and now, his legacy.

The pillars of respectability find common ground with Greenspan. Not having foreseen the meltdown of the western world, of what use are they? So, the universities and think tanks offer Greenspan a podium to play the part of scholar even though he makes less sense than Crazy Guggenheim.

Three weeks before his FCIC appearance, Alan Greenspan addressed the Brookings Institute (on March 19, 2010). He presented a 48-page paper, "The Crisis." The title was one of the few honest statements of the day. Greenspan exonerated himself from any blame for The Crisis. It would serve little purpose to address his misstatements, most of which are either absurd or had already been shown to be self-serving fabrications. [See Panderer to Power]

It is worth reviewing the process by which preposterous ideas drain through the establishment sieve and calcify. Greenspan's most glorious success in this respect was on June 17, 1999, when he told Congress: "[B]ubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." For that hallucination, the economics profession (such as it is) awarded him the Greenspan Doctrine. [For a review of this episode, See February 11, 2010, blog Alan Greenspan: Party Boy

Times have changed. His audience's net worth is no longer tethered to Greenspan's serial bubbles. He could be dismissed, as should be the case, as an unctuous failure. He should be denied a distinguished podium that confers respectability. The Brookings Institute, a prestigious think tank, lent its valuable brand name to the man most responsible for the housing wreckage and who has demonstrated his incapacity to tell the truth since the denouement. The authority of established institutions is in steep decline and stronger moral fiber is required for those that survive.

Greenspan told Brookings' invited guests, who should chide themselves for contributing to the speaker's credibility, that short-term interest rates did not contribute to the housing bubble. The man-who-should-be-too-ashamed-to-appear-in-public stated the absurd: "To my knowledge, the lowering of the federal funds rate nearly a decade ago was not considered a key factor in the housing bubble." (The federal funds rate was cut from 6.5% in 2001 to 1.0% in 2003.)

What was not absurd was deceitful: "[I]t appears the decision to buy homes preceded the decision of how to finance the purchase. I suspect (but cannot definitively prove) that a large majority of home buyers financing with ARMs [adjustable-rate mortgages] were ARMs not being offered (during that period of euphoria), would have instead funded their purchases with 30-year fixed rate mortgages. How else can one explain the peaking of originations of ARMs two years prior to the peak in house prices (exhibit 18). Market demand obviously did not need ARM financing to elevate home prices during the last two years of the expanding bubble."

If the Brookings Institute graded papers, Greenspan deserved the dunce cap. Exhibit 18 conforms to his claim. The chart shows adjustable-rate mortgages peaking at a volume of $250 billion per quarter in early 2004 (data from the Mortgage Bankers Association). It does not show, nor does the Old Pretender mention, that in today's Dust Bowl sections of the country, the volume of adjustable-rate mortgages climbed after 2004. ARMs rose from 2% of mortgages in California in 2002 to 47% in 2004 to 61% in 2005.

It was Greenspan's speech on February 23, 2004, that stripped him of trustworthiness when discussing housing. On that date, he sounded like a shill for the National Association of Homebuilders when he claimed "[m]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade."

The reason adjustable-rate mortgage growth slowed in 2005 was a matter of affordability. By 2005, over 20% of Californians who bought houses in the previous two years had devoted over one half of their earnings to mortgage payments. Adjustable rates no longer affordable, the interest-only (IO) and negative amortization (NegAm) share of total U.S. mortgage originations rose from 6% in 2003 to 29% in 2005. (Negative amortization mortgages allow the borrower to decide whether or not to make a payment each month. If no payment is made, the principal rises.) Exhibit 18 does not show IOs or NegAms (the line would have looked like a rocket launch), nor, are the terms "interest-only" or "negative amortization" used in the 48-page paper.

Not that Greenspan was unaware of them. Adjustable-rate mortgages in decline, Greenspan pitched these new innovations in a September 2005 speech before the American Bankers Association Annual Convention: "The menu [!!! - Editor's note], as you know, now features a long list of novel mortgage products, not only interest-only mortgages but also mortgages with forty-year amortization schedules and option ARMs, which allow for a limited amount of negative amortization." The consequences of Alan Greenspan cling to us like barnyard odor: $134 billion of Greenspan-sanctioned NegAm loans will be reset this year, and 93% of NegAm borrowers have only made the "minimum payment," meaning, the mortgages will be reset at higher than 100% of the original principal. (Standard & Poor's Research, November 2009)

In this speech he also praised piggyback mortgages and HELOCs [home equity lines of credit] used as piggyback loans: "Highly leveraged home purchasers tend to use so-called piggyback mortgages; that is, second liens originated at the time of purchase." In the next sentence, Greenspan showed he was as familiar with current mortgage subtleties as the highest producers at Countrywide Credit: "These loans are popular, in significant part, because they avoid the non-deductible private mortgage insurance payments required on larger, single loans." Greenspan then told his listeners he was not "worr[ied] that homebuyers are especially exposed to reversals in house prices." If any banker present had doubts about making zero-equity home loans, the nation's top banking regulator had just expressed approval.

Alan Greenspan told the FCIC on April 7 that he warned about the housing bubble in 2002. (This is the same man who has been saying nobody could have predicted the housing bubble.) To prove his point, the worst equivocator since Pinocchio quoted from a Federal Open Market Committee (FOMC) meeting that year. From page 5 of his prepared Statement to the FCIC: "our extraordinary housing boom...financed by very large increases in mortgage debt, cannot continue indefinitely."

First, Greenspan uses ellipses rather than include the most compromising phrase of that sentence: "and its carryover into very large extractions of equity". Second, Greenspan completely misrepresents his intent. He was pleased in 2002 that Americans were cashing out home equity and spending it, but was worried this boost to the economy might be coming to an end. For full, compromising statements made by Greenspan at 2002 FOMC meetings, see April 8, 2010, blog: Greenspan Came Not to Save Consumers but to Bury Them.

We would all benefit if "The Crisis" had received a hostile rebuke from economists. The Great Collapse mystifies the American people. The characters involved and characterizations of their contribution are debated without resolution. But in the case of Alan Greenspan, not only his contribution but also his methods of deception have been catalogued and published. His continued presence as after-dinner speaker, television guest, and party-circuit celebrity in Washington is an affront and insults the American people. "The Crisis" was an opportune time for economists to make amends for their silence during the housing bubble. Maybe the FCIC undressing is the beginning of the end, but a sustained effort is required to quash Greenspan's attempts to upgrade his tattered legacy.

Instead, the most respected academics grovel before their betters and demonstrate their submissive loyalty. Greg Mankiw, Professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and author of internationally acclaimed college textbooks, opened his review of "The Crisis" with the official interpretation: "This is a great paper...."

Thursday, April 8, 2010

Greenspan Came Not to Save Consumers but to Bury Them

April 7 (Bloomberg) -- Former Federal Reserve Chairman Alan Greenspan defended the central bank’s record on consumer protection in the years before the financial crisis…. “The Federal Reserve, often in partnership with the other federal banking agencies, was quite active in pursuing consumer protections for mortgage borrowers,” Greenspan said in testimony for a hearing today of the Financial Crisis Inquiry Commission in Washington.

April 7 (Bloomberg) -- “There’s a lot of amnesia that’s emerging,” Greenspan said.

The attention Alan Greenspan devoted to consumer protection on April 7, 2010, was a strange diversion, which is what it was. The Financial Crisis Inquiry Commission had penetrated, to an uncomfortable degree, the shallow defenses Greenspan has dreamt up to justify his indefensible behavior. For instance, he offered a ridiculous response when asked if monetary policy was one failure during his tenure. Greenspan changed the subject, only – one suspects to Greenspan’s surprise – to be asked the same question again. He again ran off on a tangent. Maybe even Greenspan understood the emperor who wore no clothes had been exposed.

To those not suffering a bout of amnesia, his fidelity to the consumer was a surprise. That is, to those who have read the Greenspan Papers. We need only review transcripts of Federal Reserve Open Market Committee (FOMC) meetings in 2002. The man who built his reputation as a disciple of Ayn Rand (to be sure, a false claim) dearly wanted to drain the consumer of economic self-sufficiency. He succeeded.

The economy was emerging from recession, though imperceptibly. The mean household income declined in the United States every year from 2000 through 2004. To the Fed, consumer spending leads the economy. Since income from jobs was not boosting the GDP, innovative consumer finance was an FOMC obsession.

The Federal Reserve chairman spent the year not trying to protect consumers, but to bury them. At the March 2002 meeting, he stated: “[I]f the mortgage rate goes up, we will get some restraining effects on personal consumption expenditures because a goodly part of PCE has been financed by equity extraction from the appreciation in housing values.”

At 2002 meetings, Greenspan spent a good deal of time talking about consumers cashing out home equity from their houses and – it would only boost the GDP with the and – spending it. At the September FOMC meeting, Greenspan reported on the rising level of consumer cash from home sales and from cash-out refinancing.

First, from home sales: “We know, for example, that the current level of existing home turnover is quite brisk and that the average extraction of an existing home is well over $50,000. A substantial part of the equity extraction related to home sales, which is running at an annual rate close to $200 billion, is expended on personal consumption and home modernization, two components, of course, of GDP.” GDP growth, of course, is the Federal Reserve chairman’s popularity barometer.

Second, from refinancing extractions: “[A]pplications reported by the Mortgage Bankers Association [are showing] a very large increase in cash-outs. We estimate that they, too, are running in the $200 billion range at an annual rate, up very significantly from where they were a year or eighteen months ago.”

This was good news: “I think it’s fairly evident the unprecedented levels of equity extractions from homes have exerted a strong impetus on household spending.”

Also at the September meeting: “[T]here is no question that a goodly part of the robustness of household expenditures stems from [home equity cash outs]. Cars and light trucks which have been quite strong, are examples of large ticket items that are disproportionately purchased when equity is extracted from the sale of a home….”

In November, he thought “it’s hard to escape the conclusion that at some point our extraordinary housing boom and its carryover into very large extractions of equity, financed by very large increases in mortgage debt, cannot continue indefinitely into the future.” [Author’s italics.]

All to the good, as Edward Gramlich was told at the August meeting:

GRAMLICH: “I am just uncomfortable that the refinancing of housing should be the source of so much of the support for our recovery.”

GREENSPAN: “You sound like a true conservative.” So said the head banking regulator, responsible for the solvency of the banking system.

At the August 2002 meeting, Greenspan unrolled a theory, one that may actually work in the real world: the decline of interest rates plays an important role in trading, extracting and spending. (The Federal Reserve staff believed only the level of interest rates matter.) The chairman declared the “decline [in the 10-year Treasury yield] has had a major impact on thirty-year mortgage rates…. [W]e are seeing very significant churning in the mortgage markets, and as I have indicated previously, the increase in home equity is cumulative over a period of years because the prices of houses very rarely turn negative. What we are observing at this point is a very high rate of house turnover. Existing home sales are very high….”

This churning was as important as rising prices. A faster rate of house trading, multiplied by profits from house sales, prompted greater cash-out consumer spending.
At the November meeting, Greenspan once again pushed his decline-in-interest-rate theory: “In sum it strikes me that we are looking at an economy that potentially has significant upside momentum if it can get through the current soft spot. [M]y suggestion would be to lower the funds rate by 50 basis points – it is possible that such a move may be a mistake. But it’s a mistake that does not have very significant consequences.” The FOMC voted to cut the funds rate.

It might seem extraordinary, if we were not discussing Alan Greenspan, that the Federal Reserve chairman actively engaged in financial shenanigans with the specific intention of encumbering Americans with more debt at a time their incomes were falling.

The consequences today are most visible in Las Vegas, California’s Inland Empire and in southern Florida. As for Greenspan, the Fed had cut the funds rate 12 times in 2001 and 2002, from 6.5% to 1.25%. His theory was running out of ammunition. Greenspan’s manipulation of thirty-year fixed mortgage rates was nearly spent. (How does his 2002 theory square with his 2010 theory that short-term interest rates set by the Fed had no influence on the mortgage bubble?) By 2004 and 2005, he gave speeches exhorting Americans to buy adjustable-rate, interest-only and negative-amortizing mortgages.

The man never stops trying .

Monday, April 5, 2010

Advice to the Financial Crisis Inquiry Commission: How to Question Alan Greenspan on April 7.

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

The Financial Crisis Inquiry Commission is holding a public hearing from April 7-9, 2010. The topic is "Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs)."

The Commission subpoenaed former Federal Reserve Chairman Alan Greenspan, among others. He is scheduled to appear on Wednesday April 7, 2010, at 9 AM. (The FCIC website has a notice of all those scheduled to appear.)

Frederick Sheehan sent a letter to each of the ten members of the Commission along with his book, [Panderer to Power]. As the letter (more or less) states, Chapter 22 names the smorgasbord of parties who profited from the subprime crisis and how they were connected to each other. Round 'em up.

The letter below is to the chairman of the committee, Mr. Phil Angelides.

The other nine members are:

Hon. Bill Thomas, Commission Vice Chairman

Brooksley Born, Commissioner

Byron S. Georgiou, Commissioner

Senator Bob Graham, Commissioner

Keith Hennessey, Commissioner

Douglas Holtz-Eakin, Commissioner

Heather H. Murren, CFA, Commissioner

John W. Thompson, Commissioner

Peter J. Wallison, Commissioner


Frederick J. Sheehan
Website: AuContrarian.com

April 1, 2010

Mr. Phil Angelides, Commission Chairman
Financial Crisis Inquiry Commission
1717 Pennsylvania Avenue, NW
Suite 800
Washington, DC 20006-4614

Dear Chairman Angelides:

I am writing in regard to the Financial Crisis Inquiry Commission’s April 7-9, 2010, public hearing, “Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs).” Specifically, the following is written to help you examine Alan Greenspan.

Enclosed please find a copy of my book, Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession. I am also co-author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.

In preparation for writing these books, I read ten years of Federal Reserve Open Market Committee (FOMC) transcripts, Congressional and Senate testimony over the same period, and Chairman Greenspan’s speeches, interviews and articles that he wrote back to 1959 (New York Times, Wall Street Journal, Fortune, U.S. News and World Report, Newsweek, Time and others). I have followed much of his public self-vindication since his retirement from the Federal Reserve Board.

This letter addresses three areas. First, Alan Greenspan and the Government-Sponsored Enterprises (GSEs). This includes how the GSEs changed the American economy. Second, Alan Greenspan’s promotion of toxic mortgage products. Third, the Federal Reserve’s influence on the topics you are addressing on April 7-9. Although the role of the Federal Reserve is not, per se, the subject of the April 7-9 hearing, the Fed prints the nation’s money and, for the most part, has the ability to limit the amount of credit in the economy.

1 – Alan Greenspan and the Government-Sponsored Enterprises

Alan Greenspan deserves recognition for his attempts to harness Fannie Mae and Freddie Mac. His first warning about the GSEs explosive growth was on February 24, 2004, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs. He also urged reform at a conference sponsored by the Federal Reserve Bank of Atlanta on May 19, 2005. I quote and discuss the importance and timing of these warnings on pages 266-270 of my book Panderer to Power.

I think Alan Greenspan should explain to you why he waited until 2004 before issuing his first warning. If he is asked this question directly, Greenspan will state you are incorrect. He may cite a previous occasion or occasions when he issued such advice. If so, the speech or testimony should be read. This advice applies to any topic.

Chapter 22 of Panderer to Power lays out the reason I would ask why he waited until 2004. Without GSE expansion, the home mortgage market could not have grown to dominate the U.S. economy. (Northern Trust estimated that, between 2001 and 2006, 40% of new jobs were related to housing.) Fannie and Freddie were vacuum cleaners for the nation’s mortgage finance growth. In 1995, home mortgage debt increased by $153 billion; in 2000, by $380 billion; in 2005, by $1.1 trillion.

In 1990, the value of Fannie Mae’s and Freddie Mac’s combined mortgage portfolio was $132 billion. In April 2003 – a single month – Fannie Mae (alone) bought $139 billion of mortgages. The mutation of Fannie and Freddie played a large role in the mutation of the U.S. economy.

Chapter 22, “The Mortgage Machine,” integrates the parties who contributed to the housing wreckage: the non-bank mortgage companies, the commercial banks (writing and selling mortgages) the investment banks (securitizing mortgages and funding the growth of the non-bank mortgage companies), the GSEs (packaging mortgage securities and funding subprime lenders, banks and non-banks), the Office of Federal Housing Enterprise Oversight (which mishandled its role as GSE supervisor), members of Congress (who prevented OFHEO from performing its function), the Securities and Exchange Commission (which removed the 12:1 leverage limit on brokerage houses and allowed Lehman Brothers – among others – to expand their mortgage and mortgage-security holdings to a leverage ratio of over 30:1), technology (derivatives, accounting, and the ability to process loan requests in 12 seconds) and the negligence of all of the government agencies with authority over financial institutions (widespread fraud was front page news in the Wall Street Journal in 2001.) This is only a partial list of the parties discussed in Chapter 22.

In Panderer to Power, my exploration of the housing bubble veers towards the earlier years, 2001-2003. I did this to show that someone in a position of authority who picked up the morning newspaper had to know the Mortgage Machine should be reined in. Aside from fraud, the terms of loans and the incapacity of home buyers to pay their mortgages was a common newspaper topic by 2002. (I quote some of these in my book.)

I chose this emphasis after hearing Alan Greenspan state on 60 Minutes (October 3, 2007): “While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late. I really didn't get it until very late in 2005 and 2006.”

You might expect this sort of answer on April 7. It is not credible.

The absurdities in the housing market were already a source of laughter at FOMC meetings in 2002. On November 2, 2002, Atlanta Federal Reserve President Jack Guynn told the FOMC: “The south Florida housing market would have to be characterized as red hot. One director reported that when a moderately priced development on the west coast of Florida opened, demand was so great that sales had to be limited to three homes per customer. That’s a semi-true story. [Laughter]”

2 – Alan Greenspan Used his Position to Sell Toxic Mortgage Products

More important than his knowledge was how Greenspan used his testimony and speeches to sell the mortgage bubble. I will restrict my discussion to two of his sales talks.

On February 23, 2004, Greenspan spoke to the National Association of Homebuilders. He claimed the “traditional fixed-rate mortgage may be an expensive method of financing a home” and “[m]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade.”

Greenspan will deny this speech influenced the mortgage market. It did. He was still a demigod to a large part of America. The title of an article in the February 24th Wall Street Journal read: “Fed Chief Questions Loan Choices.” Quoting the first sentence of the story: “In a rare evaluation of the interest rate options that households face, Federal Reserve Chairman Alan Greenspan questioned whether homeowners are well-served by popular fixed-rate long-term mortgages.” Realtors quoted Greenspan in their sales materials. Adjustable-rate mortgages rose from 2% of mortgages in California in 2002 to 47% in 2004 to 61% in 2005. It is a fair though unanswerable question how much Greenspan contributed to the current fiscal problems in California.

Alan Greenspan has run away from this speech since retirement. Here is an excellent example of how he will dodge responsibility when he appears before the Financial Crisis Inquiry Commission.

An interviewer questioned Alan Greenspan about his February 23, 2004 speech at a January 2008 conference in Canada. Greenspan told the interviewer “I strongly clarified my remarks” regarding adjustable-rate mortgages in a speech on March 2, 2004 and “[s]o I plead not guilty.” The transcript of the March 2, 2004, speech to the Economic Club of New York shows no mention of mortgages. He may have discussed adjustable-rate mortgages after the speech, but this certainly did not clarify his remarks to the public.

Greenspan made another attempt to extricate himself in February 2008. Greenspan told an audience in Sweden his warning (or retraction or however he planned to style it) was not in New York but in Chicago on May 6, 2004. This trail was not worth pursuing.

When he responds to your questions in like fashion, the transcript of his original remarks should be read.

Another of Greenspan’s speeches worth reviewing is an address to the American Bankers Association on September 26, 2005. By this late date, it was not enough to encourage adjustable-rate mortgages. To sell mortgages, and feed the Mortgage Machine, Chairman Greenspan discussed “a long list of novel mortgage products” such as 40-year loans, option ARMs, piggyback mortgages and HELOCS used as piggyback loans. Greenspan told his listeners he was not “worr[ied] that homebuyers are especially exposed to reversals in house prices.”

This was quite a conclusion since he also told the American Bankers Association: “We can have little doubt that the exceptionally low level of home mortgage interest rates has been a major driver of the recent surge of home building and home turnover and the steep climb of home prices.”

It seems likely that the nation’s leading banking regulator made these speeches before the National Association of Homebuilders and the American Bankers Association for a reason. Builders and bankers received Greenspan’s implicit encouragement to continue to build and to lend.

3 – The Federal Reserve is Cause, Not Effect, for Abuses in Subprime Lending

There would have been no lending of any sort without the Federal Reserve. The Fed prints the money that enters the economy. It has a monopoly. Counterfeiters know that.

Credit springs from money. The commercial banking system produces credit, by and large. The Federal Reserve sets reserve requirements on commercial bank credit growth. If the Fed sets the bank reserve ratio at 10:1, a bank cannot lend more than $10 for every $1 on deposit. That effectively limits the growth of credit.

The Federal Reserve has the authority to increase or decrease bank reserve requirements at any time. During Alan Greenspan’s chairmanship, the Fed reduced bank reserve requirements several ways; it never increased them. The result of the Greenspan Fed’s money and credit expansion: commercial banks, having run out of proper projects to fund, lent to investment banks, hedge funds, private-equity funds, subprime mortgage lenders, and commercial property speculators. (An investment bank may have lent to a non-bank mortgage company, but it first had to borrow from the commercial banking system.)

The Federal Reserve, under Alan Greenspan, both printed every dollar that entered the economy and had sole authority to set bank reserve requirements. If the Fed had reduced reserve requirements, this would have restricted the lending that proved so destructive.

I would anticipate a rebuttal from Alan Greenspan. He spent his Federal Reserve chairmanship distracting committees by turning money and credit into a quagmire of confusion. There is, of course, much more than I have written above for a full understanding of money and credit, but Alan Greenspan will not attempt to enlighten the commission. The paper he recently presented at the Brookings Institute was a grab bag of unrelated hypotheses that never mentioned the relationship between the Federal Reserve, money and credit. The role and influence of the Federal Reserve can be explained in plain English.

He may attempt to respond to questions of money and credit with another argument, which could be phrased as follows: “We live in a global economy with a global financial system. The Federal Reserve does not have as much control as you claim.” This is a specious argument. In reality the dollar is still the world’s reserve currency. As the world’s reserve currency, it is only the United States that can print money in any quantity it so desires.

Greenspan has attempted to dodge his responsibility as Fed chairman by talking about housing bubbles in twenty different countries. No, there was a housing bubble in the United States that we exported by printing money that was then shipped overseas to pay for goods. When these dollars were converted into local currencies, the excess credit led to the twenty housing bubbles.

I hope my letter is of service. Please let me know if I can offer instruction or advice, either for the current or later hearings.


Frederick J. Sheehan