Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (50 page)

In 2007, Greenspan came out talking. Speaking to a Hong Kong audience in late February, he warned of a possible recession in the United States. The Shanghai Stock Exchange fell 9 percent that day, and U.S. stock markets suffered their worst day of trading since they reopened after the September 11, 2001 respite.
¹
The oracle later clarified his prediction. He thought a 2007 recession was “possible” but not “probable.”
²
Still, he was at odds with the Federal Reserve’s position.

There is no reason that he should have agreed, but given his influence on markets, a better man would have discussed the weather. He could not

¹
Rachel Beck, “Greenspan Rocks Markets,” Associated Press, February 27, 2007.
²
Krishna Guha, “Greenspan Again at Odds with Fed over Recession Risk,”
Financial Times
, March 6, 2007.

327

restrain himself. The March 2 headline of the
Independent
(London) said it all: “Greenspan Uses ‘R’ Word Again; Someone Shut Him Up before He Does Serious Damage.”
³
But there was no stopping the man. A
Financial Times
headline on March 6 cited the freelance economist: “Greenspan Again at Odds with Fed over Recession Risk.”
⁴
(He now thought there was a one-third chance of a U.S. recession in 2007.
⁵
) Greenspan had more to say that day: “We are in the sixth year of a recovery, imbalances can emerge as a result.”
⁶
This was already the most imbalanced economy since the Emerald City of Oz.

Greenspan responded to his detractors: “I was beginning to feel quite comfortable that I was fully back to the anonymity I was seeking.” He added: “I try as much as I can to avoid comments relevant to what the Fed is doing. But I have a profession and I’m a private citizen. . . . I adhere to the law.”
⁷
His face was straight as ever, but he sounded like a stand-up comedian.

By the end of 2006, the Implode-O-Meter Web site listed nine defunct mortgage lenders.
⁸
By the end of March 2007, the list had grown to 49, including some of the largest vacuums that sucked in borrowers: HSBC Mortgage Services, Ameriquest, ACC Wholesale, New Century, and Wachovia Mortgage. Underwriting standards had collapsed and defaults were rising fast. It seems condescending to mention that this combination meant house prices had risen above an affordable level, but that comment was central to a Greenspan speech on March 15 as reported by MSNBC: “Greenspan said . . . subprime woes . . . seemed to result primarily from buyers coming into lofty housing markets late after big price run-ups that had left them vulnerable to hikes in adjustable mortgage rates.”
⁹
This was announced by newswires around the world.

³
Jeremy Warner, “Greenspan Uses ’R’ Word Again; Someone Shut Him Up before He Does Serious Damage,”
Independent
(London), March 2, 2007.
⁴
Guha, “Greenspan Again at Odds with Fed.”
⁵
Craig Torres, “Greenspan Sees One-Third Chance of Recession in 2007,” Bloomberg, March 6, 2007.
⁶
Ibid.
⁷
“Greenspan: Not Trying to Cause Trouble for Ben,” Reuters, March 8, 2007.
⁸
Implode-O-Meter. These were not necessarily bankrupt, but they had abandoned at least a major segment of their lending activities.
⁹
“Housing Advocates Warn of Default ‘Tsunami,’” MSNBC.com, March 15, 2007.

Greenspan was speaking in Boca Raton, Florida, where he was named the American Hero of 2007.
¹⁰
Greenspan might have made the same observation in 2004; instead, he recommended that Americans take advantage of adjustable-rate mortgages. He might have made the same comment in October 2006, at the time of the National Association of Realtors ad campaign. He made some other elementary observations at Boca Raton. The law-abiding American Hero told his audience that if house prices “would go up 10 percent, the subprime problem would disappear.”
¹¹
And if pigs could fly. Greenspan also predicted that subprime mortgage problems would not spread their troubles.
¹²

Greenspan’s cachet was more ambiguous by now.
USA Today
, referring to the speech, quoted Hugh Johnson, chairman of Johnson Illington Advisors, an investment advisory firm in Albany, New York: “I wish he’d just go away.”
¹³
This was less likely than house prices rising 10 percent. Greenspan had been talking from the moment he retired. It might be added that the chairman’s retirement party was on a par with Schwartzman’s splurge, the difference being that Greenspan’s farewell was in the Blue Room.

Subprime Lending

“Subprime” was soon to join “IPO” and “private equity” as an insider’s financial term that enters the national discussion.
¹⁴
It was no surprise that defaults were rising. Default rates remained near zero percent as long as houses could be sold at higher prices.

¹⁰
“Greenspan Revels in New Freedom of Speech,”
Palm Beach Post
, March 15, 2007. Also from the
Palm Beach Post: “Stocks, Futures and Options
magazine hosted the Boca Raton lunch and gave the 500 attendees money clips and coin-shaped paperweights emblazoned with the market maestro’s image.”

¹¹
“Greenspan: Subprime Spillover Unlikely,” Associated Press, March 15, 2007; http://
tinyurl.com/p8c9mo.
¹²
“Subprime Spillover Unlikely,” Associated Press, March 15, 2007.
¹³
“When Alan Greenspan Talks, People Listen,”
USA Today
, March 21, 2007.
¹⁴
One definition of subprime: “‘Prime’ lending was based on the idea that all three C– questions had to get at least a minimally correct answer before proceeding. . . . If you had, say, two of the three, you might qualify for a near prime (like FHA) or subprime loan. . . .” The 3 Cs are: 1—Credit: “Does the borrower’s history establish creditworthiness, or the willingness to repay debt?” 2—Capacity: “Does the borrower’s current income and expense situation (and likely future prospects) establish the capacity or ability to repay debt?” 3—Collateral: “Does the house itself, the collateral for the loan, have sufficient value and marketability to protect the lender in the event the debt is not repaid?” From “What Is ‘Subprime’?” Calculated Risk blog, November 25, 2007; calculatedrisk.blogspot.com.

New Century, one of the largest subprime lenders, depended on house prices to appreciate 4 percent a year. When house prices stopped appreciating in 2005, home buyers defaulted without making a single mortgage payment.
¹⁵
Separately, the Mortgage Asset Research Institute had already published a study of what were known as “liar’s loans”: those in which the borrower’s stated income is not verified by the lender. The institute found that 60 percent of those who received such mortgages had overstated their income by at least 50 percent.
¹⁶

Having run out of solvent home buyers, the percentage of highrisk loans came to dominate the marketplace. During the first nine months of 2006, 22 percent were subprime mortgages.
¹⁷
By February 2007, 6 percent of mortgages packaged into a security during 2006 were already delinquent.
¹⁸

Bernanke had used practically the same data in a November 2006 speech: “In 1994, fewer than 5 percent of mortgage originations were in the subprime market, but by 2005 about 20 percent of new mortgage loans were subprime.” In the same speech, Bernanke went on to discuss other data that should have caused a stir: “[T]he expansion of subprime lending has contributed importantly to the substantial increase in the overall use of mortgage credit. From 1995 to 2004, the share of households with mortgage debt increased 17 percent, and in the lowest income quintile, the share of households with mortgage debt rose 53 percent.” Reading the transcript, it appears Bernanke considered this to be good news. He did advise “greater financial literacy” for “borrowers with lower incomes and education levels.”
¹⁹
The former South Carolina seventh-grade spelling bee champion often urged self-improvement.

¹⁵
Paul Muolo and Matthew Padilla,
Chain of Blame, How Wall Street Caused the Mortgage and Credit Crisis
(Hoboken, N.J.: Wiley, 2008), pp. 170–171. In 2006, New Century made $60 billion in mortgage loans. Total mortgage loans in the U.S. had been $153 billion in 1995 (see chapter 22). New Century’s existence, and contribution to America’s GDP, was mostly a product of warehouse lines of credit from investment banks.

¹⁶
Gloom, Boom & Doom Report
, September 2006, p. 7.
¹⁷
Grant’s Interest Rate Observer
, March 9, 2007, p. 1.
¹⁸
Ibid., March, 2007, p. 1.

On May 17, 2007, Bernanke spoke for the Federal Reserve: “[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
²⁰
Bernanke had trouble seeing past the infield, but he should have known two thing: (1) his banking system was dangerously exposed to real estate, and (2) his banking system had never been this leveraged.

The mortgage mills were shutting down, yet Bernanke and Greenspan said problems were contained. In May 2007, house sales in Southern California dropped 35 percent from a year before.
²¹
Builders could not sell their inventory; first-time owners, many of whom bought with the intention of selling into a rising valuation were, in business terms, “cashflow negative.”

Springtime for Greenspan

In June, Greenspan spread the word that the great liquidity boom was near an end and offered fin-de-siècle advice: “Enjoy it while it lasts.” He claimed that the liquidity boom started with the end of the cold war.
²²
That was about the time Greenspan took up residence in the Eccles Building.

Central bankers dropped their gloves. Mervyn King, governor of the Bank of England (and former colleague of Ben Bernanke when they were both graduate student at MIT), announced: “I’m very grateful to Eddie George that he hasn’t been in the newspapers and on the radio all the time commenting on what the Monetary Policy Committee is doing. In due course I will do the same.”
²³
European Central Bank President Jean-Claude Trichet told an audience in Frankfurt: “I do not consider Alan to still be a member of the Fed.. . . I trust the Fed.”
²⁴

¹⁹
Ben S. Bernanke, “Community Development Financial Institutions: Promoting Economic Growth and Opportunity,”speech at the Opportunity Finance Network’s Annual Conference, Washington, D.C., November 1, 2006.

²⁰
Ben S. Bernanke, speech at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition, Chicago, May 17, 2007.
²¹
doctorhousingbubble.com June 14, 2007, citing data released the day before-so these were figures for May.
²²
Pedro Nicolaci da Costa, “Greenspan Not Worried Chinese Will Dump Treasuries,” Reuters, June 12, 2007.

In February 2007, an event of monumental importance went largely unnoticed: a new index of securities based on subprime mortgages was introduced. The securities in this index were each composed of bundles of mortgages that had been originated in the second half of 2006. The BBB-rated portion of the ABX.HE 07-01 dropped like a rock on the first day it was traded. The bonds in the index were still valued at par on bank balance sheets, mostly because CDOs were very rarely traded.
Grant’s Interest Rate Observer
thought the “rating agencies seem curiously detached” from the discrepancy between market prices and book values.
²⁵

The cocoon ruptured in the early summer of 2007. Bear Stearns slowly revealed that two of its aggressively managed hedge funds were worth very little. This was during June and July 2007. On June 15, 2007, Merrill Lynch, which had lent money to Bear Stearns (so that Bear Stearns could leverage its hedge funds), announced that it was seizing $400 million in collateral from the fund.
²⁶
After Merrill demanded its money back, some of the investors in Bear Stearns’s funds wanted to take their money out.
²⁷
What should they be paid? Since the value was calculated from a model and not from transactions, Bear Stearns did not know.
²⁸

The
Financial Times
reported: “These elaborately constructed securities … are designed to yield juicy returns while also carrying high credit ratings. . . . Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these new-fangled instruments have never been priced through market trading.”
²⁹

²³
Scheherazade Daneshkhu, “King Takes Greenspan to Task,”
Financial Times
, May 16, 2007.
²⁴
Jean-Claude Trichet, ECB press conference, Frankfurt am Main, Germany, March 8,
2007; http://tinyurl.com/pkpxn7.
²⁵
Grant’s Interest Rate Observer
, February 26, 2007, p. 7.
²⁶
Serena Ng and Kate Kelly, “Ills Deepen in Subprime-Bond Arena,”
Wall Street Journal
, June 18, 2007.
²⁷
Paul Muolo and Matthew Padilla,
Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis
, (Hoboken, N.J.: Wiley, 2008), p. 244.
²⁸
Ibid., p. 242.

It was ironic, but also necessary. Half of these houses could never have been sold (and would not have been built) without some form of illusory pricing along the conveyor belt. AAA ratings on CCC borrowers had accelerated the mortgage machine. The practice of holding derivatives at par value when there were no prices at all was essential.

America’s Best: A Tower of Babble

At the time Bear Stearns’s problems came to light, Bernanke saw clear skies: “[W]e have not seen major spillovers from housing onto other sectors of the economy.”
³⁰
Worthy establishment figures demonstrated no understanding of conditions. Bank of America President Ken Lewis said that the worst of the housing slump was just about over: “We’re seeing the worst of it.”
³¹
Stanley O’Neal, CEO of Merrill Lynch, earned his bonus the following day, stating that subprime defaults were “reasonably well contained.”
³²