Free-market maestro's reputation in tatters

ANALYSIS:SPARE A thought for Alan Greenspan. For years lauded as the "maestro", the subprime mortgage market meltdown and the ensuing financial crisis has seen his reputation torn to shreds.

"If anyone is to blame for the current situation, it is Mr Greenspan," said 2008 Nobel Prize-winning economist Paul Krugman, adding that the former US Federal Reserve chairman "pooh-poohed warnings about an emerging bubble and did nothing to crack down on irresponsible lending".

Italian finance minister Giulio Tremonti even asked last week whether Greenspan is, "after bin Laden, the man who hurt America the most".

Greenspan stands accused of keeping interest rates too low for too long, thereby fostering the housing bubble, as well as being ridiculously lax in his oversight of risky financial practices.

Last week, he finally admitted there was a "flaw" in his ideology and that he was "partially" wrong in opposing regulation of derivatives.

A self-confessed lifelong libertarian Republican, Greenspan said that "those of us who have looked to the self-interest of lending institutions to protect shareholders' equity are in a state of shocked disbelief".

Still, it didn't sound like Greenspan was lying awake at night pondering his mistakes. "We cannot expect perfection in any area where forecasting is required," he sniffed.

Very true, although a cursory examination of Greenspan's regulatory record - or lack of it - suggests he was a long way away from perfection.

"Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient," he said in 2003.

Two years later, he waxed lyrical about how "innovation has brought about a multitude of new products, such as subprime loans and niche credit programmes for immigrants".

Where "once, more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately", Greenspan eulogised.

As for derivatives, they are an "extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so", he said in 2003. Deeper regulation would be a "mistake".

Not even the tremors felt in the global financial system following the collapse of Long Term Capital Management in 1998 shook Greenspan's deregulatory zeal. "The off-balance sheet leverage was 100 to one or 200 to one - I don't know how to calculate it," a senior Fed official told Greenspan at the time.

Brooksley Born, the then head of the Commodity Futures Trading Commission, warned that the episode was a "wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the US economy and to financial stability around the world".

Greenspan responded by outlining his "grave concerns" at the thought of "casting a shadow of regulatory uncertainty over an otherwise thriving market".

Two years later, derivatives were exempted from all regulatory, supervisory or reserve requirements by the Commodity Futures Modernisation Act.

In 2004, financial authorities allowed the five investment banks an exemption from leverage rules. The old 12-to-one ratio was lifted and banks took advantage, levering up to 40 to one. "If anything goes wrong, it's going to be an awfully big mess," one official said.

It was. All five brokerages in the programme have filed for bankruptcy, been taken over or converted into commercial banks.

Greenspan also blocked proposals to increase scrutiny of subprime lenders.

These firms did not have to worry as to whether applicants could afford payments over a 30-year time span.

They could sell the mortgage on to firms that securitised them. As long as the borrower did not default during a set period - typically 90 or 180 days - the originator of the loan was safe.

The best way of ensuring people did not default was by offering them adjustable-rate mortgages, predatory loans which typically offered cheap "teaser" rates for a set period before an eventual large reset.

Despite this, Greenspan still insists that "it is not credible that regulators would have been able to prevent the subprime debacle".

What the US needed, as New York Times commentator Floyd Norris has said, was "a regulator who understood markets, rather than worshipped them".

US analyst Barry Ritholtz has also long been critical of Greenspan's almost religious attitude to deregulation.

The move away from the excessive regulation of bygone days was taken to "irrational extremes", he has written, lamenting that "effective and necessary safeguards were removed along with the costly ones".

Regulators can be populist and inconsistent, of course. In the aftermath of the dotcom bubble, day traders of US stocks were required to have a minimum of $25,000 (€20,100) in capital while being allowed to trade the heavily-leveraged futures markets with as little as $300.

The recent bans on short-selling have, if anything, increased market instability.

Still, with governments having forked out trillions of dollars in clean-up costs and a global recession looking likely, even Greenspan is having to reconsider his dearly-held beliefs.

The irony is that his reluctance to interfere with markets has led to intervention on a grand scale and essentially caused the nationalisation of the banking sector - hardly the legacy he expected when he departed office to general acclaim in 2006.