The origins of a housing credit bubble; Monday-morning quarterbacks are finding plenty to blame for the creation of a housing credit bubble that has dramatically brust. While there's a growing laundry list of causes, there appears to be emerging consensus on some primary drivers, such as monetary ploicy and the unchecked expansion of mortgage credit by non-banks. This two-part series examines the details

Mortgage Banking, Sept, 2008 by Robert Stowe England

Greenspan's defense led to some even sharper criticisms of both the Fed's policy and the role of the U.S. government in the housing credit bubble.

Christopher Whalen, co-founder of Institutional Risk Analytics, Torrance, California, began a comment to Greenspan's own defense by stating it was not Greenspan's monetary policy but his "dropping the ball" on bank supervision and market structure that was his "mortal sin."

"[T]he Fed's Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange into the opaque world of over-the-counter [OTC] instruments," Whalen wrote.

In an interview with Mortgage Banking, Whalen explained that the problem was the proliferation of a lot of different instruments that were not standardized. "There's a cottage industry of analysts who follow this stuff" who could model pricing based off trading in standardized instruments or even references to standardized instruments. The analysts, however, do not follow the exotic OTC bilateral instruments that began to proliferate, "because it's too complicated and each deal is different," he maintains.

Whalen argued in his comments that Bear Stearns failed "not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades that flow through the firm's books are bilateral rather than exchange-traded." Bear Stearns was "killed" not out of a lack of capital or liquidity, but from "the understandable fear of counterparty risk," Whalen wrote.

The conundrum

Some of Greenspan's arguments have merit and deserve a careful hearing, according to economist Jones. "Greenspan was correct in highlighting [that] inflation expectations [and thus long-term interest rates] were coming down, certainly in the [United States], and to some degree in Europe as well," he says. This was how Greenspan explained the "conundrum" of long-term interest rates continuing to fall even after the Fed began to raise interest rates in June 2004.

"And, you know, in the truly ironic sense, the Fed is almost a victim of its own success," Jones argues. "Fed officials have referred to something called The Great Moderation over the last 25 years, in which you can demonstrate the volatility in real GDP [gross domestic product] growth and inflation has come down ... and that we have been growing at a sustainable low inflation pace over this period," Jones says. "Thus, long-term rates were kept lower than they otherwise might have been, even when the Fed belatedly started tightening," he says.

"Greenspan also got into this global savings-glut argument, which is a little bit tricky," says Jones. "And there were some other Fed officials who bought into this, including [current Fed Chairman] Bernanke, when he was a governor, I think," he says. "The thesis is that the intended savings in the world exceeded the intended investment," Jones says. He thinks that Greenspan has a valid argument on this point.

"The simple fact is [that] if intended global savings exceeds intended global investments, long-term interest rates should come down." Jones notes that there are some, such as economist John Taylor at Stanford University, Stanford, California, who have criticized Greenspan on this point and who contend that ultimately savings and investment are equal. Jones responds to Taylor's argument as follows: "Well, yes--they are [equal], ex-post. They have to equate. The question is, what do interest rates have to do [in order] to equate them?" The answer, as Greenspan alleges, is that interest rates fall so that intended savings and intended investment are equal, Jones explains. "So, I give Greenspan some credit for coming up with that argument," he says.