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Greenspan: GSEs and Investors Caused The Crisis

Former Federal Reserve Chairman Alan Greenspan said (.pdf) today that the creation of subprime mortgages didn't cause the financial crisis -- the secondary market demand for these subprime mortgages drove the bubble that was to blame. He made these comments during a Financial Crisis Inquiry Commission (FCIC) hearing. Some blame Greenspan's easy monetary policy for beginning to inflate the housing bubble. His testimony makes clear that he sees the cause elsewhere.

There's a strong argument that the mere creation of subprime mortgage couldn't have inflated a housing bubble: such loan products had been around for many years. Why hadn't their origination been as great in the past as it was over the last decade? There was a demand shift. Secondary market purchases of subprime mortgages, including bonds resulting from securitization, became much more popular over that period. With ample funding for these risky mortgages, more were created and the subprime mortgage bubble began growing.

Greenspan sees Fannie and Freddie as a driving force. He says:

The firms purchased an estimated 40% of all private-label subprime mortgage securities (almost all adjustable rate), newly purchased, and retained on investors' balance sheets during 2003 and 2004. That was an estimated five times their share of newly purchased and retained in 2002, implying that a significant proportion of the increased demand for subprime mortgage backed securities during the years 2003-2004 was effectively politically mandated, and hence driven by highly inelastic demand.

Those are pretty compelling facts. The GSEs comfort with those loans likely also drove investors to purchase more of these securitized subprime mortgages on their own as well. Of course, rating agencies made matters worse by slapping AAA-ratings on many of the resulting bonds. Everyone began believing the same fallacy that home prices couldn't decline, so investor due diligence was inadequate to properly identify the risk inherent in these loans.

Phil Angelides, the FCIC Chairman, however, wasn't buying Greenspan's argument. He demanded to know why the Federal Reserve didn't act to create rules prohibiting abusive subprime mortgage products. Greenspan responded with an explanation that the Fed began worrying about subprime mortgages as early as 1998, and began providing guidance shortly thereafter (documented in the appendix of his prepared testimony - .pdf). But Angelides didn't think guidance was enough, and pressed that the Fed should have created stricter rules to prevent some of the practices that resulted.

Why didn't Greenspan engage in stronger regulation? Subprime mortgage products had been around for decades on a small scale and never posed a problem. They only became dangerous when underwriting standards declined and funding for them became too cheap, driven by the demand for their purchase by the GSEs and investors. Greenspan says that the Fed was not aware of the extent of the GSEs subprime mortgage exposure until September 2009 -- far too late.

In the retrospect, it's easy to say that the Fed should have acted to limit the growth of subprime mortgages. At the time, however, no one realized the massive problem they would eventually pose, particularly since they never had been much of an issue before. And even if these mortgages did go bad, the Fed believed any resulting losses would just fall on banks and mortgage companies, with little impact on the broader economy. That shows the more important lack in foresight on the part of the Fed: its failure to see how interconnected all facets of finance had become.