Explaining the Impact of Ultra-Low Rates to Greenspan

As noted last night, Alan Greenspan has blamed the crisis on a lack of regulation rather than ultra-low rates. (You can find his Brookings institute paper The Crisis here).

While the lack of regulatory enforcement — ironically, mostly notably by the Greenspan Fed — was no doubt a large part of the problem, his exoneration of ultra low rates is belied by history.

I detail all of this elsewhere; but perhaps the impact of low rates would be more easily understandable to the Maestro if we put it into numerical bullet point form:

1. Starting in January 2001, the FOMC began lowering rates, eventually to 1%. They kept rates below 2% for 36 months, and at 1% for over a year. This was unprecedented.

2. While these rates had myriad effects, lets focus on just two: The impact on Housing, and on global bond managers.

3. Since homes are (typically) a leveraged credit purchase, lowering the cost of that credit has an inverse effect on prices — i.e., cheaper mortgages = more expensive houses. Since most people budget monthly, carrying costs are more important than actual purchase prices. Hence, a big drop in interest rates can cause a spike in home prices, with monthly payments remaining fairly similar.

Bottom line: Ultra low rates were the initial fuel sending home prices higher.

4. At the same time, bond managers were scrambling for yield. Pension funds, trusts, foundations require a certain annual gain, and without it, they have issues. Note that most of these managers by their own charters cannot purchase junk, they can only buy investment grade paper.

5. Wall Street had been securitizing collateralized debt for years. They turned credit cards, student loans, auto financing, and of course, mortgages into paper.

6. Making loans to people with weaker credit scores, lower incomes, or more debt was a risky proposition, and hence, generated higher yields for that risk. By collateralizing these subprime mortgages, Securitizers could generate higher yielding paper for the managers of bond funds. And because the rating agencies — Moody’s, S&P, and Fitch were totally corrupt — the securitizers could purchase AAA ratings. Hence, all manner of unqualified junk paper could be sold to these funds that were only allowed to purchase investment grade paper.

Here is the first point where lack of oversight comes in (vis-à-vis the ratings agencies). But we never would have gotten to that issue BUT FOR the ultra low rates.

7. The triple AAA rated junk paper sells well, increasing demand for more of it. Huge Wall Street demand for more junk to feed into the maw of the securitization beast compels all manner of non-bank lenders to issue even more sub-prime mortgages. And since they was a finite number of people who afford mortgages, they got creative with ways to make mortgages even cheaper. First came the 2/28 variable loans, with a cheap teaser rate the first two years.

Then came Interest Only (I/O), where there was no principal repayment.  I called these loans “Rent with an option to default.”  Lastly, we had the Negative Amortization (Neg/Am) mortgages, where the borrower paid less than the monthly interest charges, with the difference added to the principal owed. Hence, with each passing month, the mortgagee actually owed more on the house than the month before, rather than less. These loans defaulted in enormous numbers.

8. The lack of regulation of these non bank lenders was a key factor. Ironically, it was the Fed’s job to regulate them, and moving beyond irony to surreal absurdity, it was then Fed Chair Alan Greenspan who called these non bank lenders “innovators” and refused to regulate them. (This was around the same time, with rates at record low levels, when he was advising people go for variable mortgages). Their innovative business model was lend-to-sell-to-securitizers.

9. Numerous states had on their books anti-predatory lending laws. These made it illegal to make loans to people who could reasonably not afford them (nor could they charge usurious rates or excessive fees that would make defaults much more likely).

The Bush White House issued its doctrine of “Federal Pre-emption,” which essentially told the States to step out of the way of these lenders. The data shows that states with anti-predatory lending laws had much lower defaults and foreclosures than states that did not; the Federal Pre-emption significantly raised default rates in these states.

Hey, where were all those States right advocates back then? My Spidey-Sense is tingling! I suspect these new states rights people are not at all concerned with states rights at all, and are more likely little more than hypocritical partisans.

10. The lack of regulatory enforcement was a huge factor in allowing the credit bubble to inflate, and set the stage for the entire credit crisis. But it was intricately interwoven with the ultra low rates Alan Greenspan set as Fed Chair.

So while he is correct in pointing out that his own failures as a bank regulator are in part to blame, he needs to also recognize that his failures in setting monetary policy was also a major factor.

In other words, his incompetence as a regulator made his incompetence as a central banker even worse.

~~~

Class dismissed.