Friday, March 19, 2010

Greenspan says, je regrette quelque chose

The Crisis, by Alan Greenspan.

It sounds like an airport novel. But the 66-page paper is the closest we’ve ever gotten to a mea culpa from the former Fed chief, who chaired the US central bank in the midst of a growing housing bubble.

As the New York Times reports, Greenspan is due to present the paper at the Brookings Institution on Friday. And this is the bit, according to the NYT, where the sort-of-contrition comes into play:

For years the Federal Reserve had been concerned about the ever larger size of our financial institutions. Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. A decade ago, citing such evidence, I noted that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.” Regrettably, we did little to address the problem.

Fun fact; the word “regrettably” actually appears a total of four times in the paper.

Here:

The most pressing reform that needs fixing in the aftermath of the crisis, in my judgment, is the level of regulatory risk adjusted capital. Regrettably, the evident potential for gaming of this system calls for an additional constraint in the form of a minimal tangible capital requirement.

And here:

Bank regulators are perforce being pressed to depend increasingly on greater and more sophisticated private market discipline, the still most effective form of regulation. Indeed, these developments reinforce the truth of a key lesson from our banking history–that private counterparty supervision remains the first line of regulatory defense.” Regrettably, that first line of defense failed.

And this is our favourite:

We at the Federal Reserve were aware as early as 2000 of incidents of some highly irregular subprime mortgage underwriting practices. But regrettably we viewed it as a localized problem subject to standard prudential oversight, not the precursor of the securitized subprime mortgage bubble that was to arise several years later.

So, Alan Greenspan — no longer fighting back?

Not quite. In the paper, the erstwhile central banker also says he still thinks the Fed’s policy of low (overnight) interest rates was not to blame for the housing bubble, and associated excess risk-taking.

Academia — and rational thought — would suggest otherwise.

BTW, Is there a reason this chart — from Alan Greenspan’s Brookings paper — stops in September 2009?

The former Federal Reserve chairman is offering his explanation of the financial meltdown to the Institute, in a paper aptly called “The Crisis.” In it the erstwhile central banker makes this comment:

Our broadest measure of credit risk, the spread of yields on CCC, or lower, bonds (against 10- year U.S. Treasury bonds) fell to a probable record low in the spring of 2007, though only marginally so (exhibit 6). Almost all market participants of my acquaintance were aware of the growing risks, but also cognizant that risk had often remained underpriced for years.

And here’s the accompanying exhibit:

If the chart extended to today (March 2010) what one might see is something similar to the below.

From Bloomberg, the spread between Bank of America Merrill Lynch’s high-yield index and 10-year US Treasuries, between 2002 and March 2010. Click to enlarge:

The difference between the two — essentially the premium investors demand for holding `risky’ assets over US government bonds — is currently about 5.08. Which means it’s beginning to veer very close to the ultra “mispriced” days of spring 2007. It’s obscured on the chart, but it was circa 2.88.

The median figure for the whole eight-year period, is about 4.9.

Some analysts are calling for the spread to narrow to 4.0 by the end of 2010.

And that’s despite the whole financial crisis thing.

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