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As noted last night, Alan Greenspan has blamed the crisis on a lack of regulation rather than ultra-low rates. (You can find his Brookings institute paper The Crisis here).

While the lack of regulatory enforcement — ironically, mostly notably by the Greenspan Fed — was no doubt a large part of the problem, his exoneration of ultra low rates is belied by history.

I detail all of this elsewhere; but perhaps the impact of low rates would be more easily understandable to the Maestro if we put it into numerical bullet point form:

1. Starting in January 2001, the FOMC began lowering rates, eventually to 1%. They kept rates below 2% for 36 months, and at 1% for over a year. This was unprecedented.

2. While these rates had myriad effects, lets focus on just two: The impact on Housing, and on global bond managers.

3. Since homes are (typically) a leveraged credit purchase, lowering the cost of that credit has an inverse effect on prices — i.e., cheaper mortgages = more expensive houses. Since most people budget monthly, carrying costs are more important than actual purchase prices. Hence, a big drop in interest rates can cause a spike in home prices, with monthly payments remaining fairly similar.

Bottom line: Ultra low rates were the initial fuel sending home prices higher.

4. At the same time, bond managers were scrambling for yield. Pension funds, trusts, foundations require a certain annual gain, and without it, they have issues. Note that most of these managers by their own charters cannot purchase junk, they can only buy investment grade paper.

5. Wall Street had been securitizing collateralized debt for years. They turned credit cards, student loans, auto financing, and of course, mortgages into paper.

6. Making loans to people with weaker credit scores, lower incomes, or more debt was a risky proposition, and hence, generated higher yields for that risk. By collateralizing these subprime mortgages, Securitizers could generate higher yielding paper for the managers of bond funds. And because the rating agencies — Moody’s, S&P, and Fitch were totally corrupt — the securitizers could purchase AAA ratings. Hence, all manner of unqualified junk paper could be sold to these funds that were only allowed to purchase investment grade paper.

Here is the first point where lack of oversight comes in (vis-à-vis the ratings agencies). But we never would have gotten to that issue BUT FOR the ultra low rates.

7. The triple AAA rated junk paper sells well, increasing demand for more of it. Huge Wall Street demand for more junk to feed into the maw of the securitization beast compels all manner of non-bank lenders to issue even more sub-prime mortgages. And since they was a finite number of people who afford mortgages, they got creative with ways to make mortgages even cheaper. First came the 2/28 variable loans, with a cheap teaser rate the first two years.

Then came Interest Only (I/O), where there was no principal repayment.  I called these loans “Rent with an option to default.”  Lastly, we had the Negative Amortization (Neg/Am) mortgages, where the borrower paid less than the monthly interest charges, with the difference added to the principal owed. Hence, with each passing month, the mortgagee actually owed more on the house than the month before, rather than less. These loans defaulted in enormous numbers.

8. The lack of regulation of these non bank lenders was a key factor. Ironically, it was the Fed’s job to regulate them, and moving beyond irony to surreal absurdity, it was then Fed Chair Alan Greenspan who called these non bank lenders “innovators” and refused to regulate them. (This was around the same time, with rates at record low levels, when he was advising people go for variable mortgages). Their innovative business model was lend-to-sell-to-securitizers.

9. Numerous states had on their books anti-predatory lending laws. These made it illegal to make loans to people who could reasonably not afford them (nor could they charge usurious rates or excessive fees that would make defaults much more likely).

The Bush White House issued its doctrine of “Federal Pre-emption,” which essentially told the States to step out of the way of these lenders. The data shows that states with anti-predatory lending laws had much lower defaults and foreclosures than states that did not; the Federal Pre-emption significantly raised default rates in these states.

Hey, where were all those States right advocates back then? My Spidey-Sense is tingling! I suspect these new states rights people are not at all concerned with states rights at all, and are more likely little more than hypocritical partisans.

10. The lack of regulatory enforcement was a huge factor in allowing the credit bubble to inflate, and set the stage for the entire credit crisis. But it was intricately interwoven with the ultra low rates Alan Greenspan set as Fed Chair.

So while he is correct in pointing out that his own failures as a bank regulator are in part to blame, he needs to also recognize that his failures in setting monetary policy was also a major factor.

In other words, his incompetence as a regulator made his incompetence as a central banker even worse.

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Class dismissed.

spring2010_greenspan

Via the Brookings Institute

To IMF or not to IMF, that is the question that is still creating uncertainty with Greece and weighing on their debt market and raising the cost of money for them. After a German government official said yesterday that Greece should go to the IMF, the German finance minister today said he’s wary of going down that road. Greek 10 yr bond yields are rising another 7 bps to a 3 week high and 5 yr CDS are wider by another 20 bps to 330 bps. The US$ is higher vs the euro in response. In contrast, the US$ is again near parity vs the Canadian $ after Feb CPI in Canada rose more than expected both at the headline level and core. Canada has kept their benchmark rate at .25% and said they will likely hold them there until June but the pressure is growing on them to hike. With quadruple witch expiration and the quarterly S&P rebalancing today, volume will finally be brought to the marketplace, at least for a day.

Hilarious:

via flowing data

Apparently, Congress screwing around with SEC defunding goes back 20 years, if not further.

The villain of the discussion is (of course!) Phil Gramm, the intellectually bankrupt Texas Senator whose economic arguments  are invariably proven to be wrong, with grave economic consequences. Gramm argued in 1994 that SEC fees “made it too expensive to raise money in the capital markets, and thus deterred growth.”

As per usual, Gramm had it precisely backwards at exactly the wrong time:>

click for larger image

Hat tip Dan B, who adds:

“The post on the SEC and staffing levels today reminded me of the fight over SEC budgets for 1995. Congress has its fingerprints all over this. They bring people in and berate them under lights and in front of cameras. They cast their failings onto others.”

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Source:
Agency Funding Caught Up in SEC Budget Dispute
Rob Wells
Associated Press, August 15 1994
http://news.google.com/newspapers?nid=1957&dat=19940815&id=wXchAAAAIBAJ&sjid=kokFAAAAIBAJ&pg=1427,3574721

Good Evening: U.S. stocks finished mixed today after digesting a series of news stories that could hardly be described as bullish. The economic data released today (CPI, jobless claims, current account deficit, leading indicators, and the Philly Fed survey) were uneventful, but the news flow from Europe and Washington, D.C. was anything but. The non-bailout bailout for Greece is threatening to unravel, while lawmakers in the U.S. House of Representatives are hoping to pass some form of healthcare reform without really voting on it. For his part, Mr. Market seems unruffled by the games of chicken being played by politicians on both sides of the Atlantic. Both the Dow Industrials and Dow Transports hit new, post-crash highs today, thus confirming a “Dow Theory buy signal” for adherents to one of the oldest theories of technical analysis. The real question is whether investors are unwittingly playing chicken themselves with stock and bond prices at current levels.

Stocks traded in a narrow range on light volume all day on Thursday, even with the stories described above hitting the tape at odd intervals. Action in shares of FedEx reflected some of this disconnect after the company reported an earnings beat this morning. FDX swooned some 3% in early trading, only to recover and post a 3% gain by day’s end. The few remaining proponents of the “Efficient Market Theory” were unavailable for comment.

The major averages were somewhat higher mid day when a rumor floated around trading desks that the Fed would again boost the discount rate today. The resulting sell off didn’t last for long and the averages finished mixed. Led by FDX, the Dow Transports (+1%) fared best, while the Russell 2000 (-0.35%) lagged behind. Treasurys were modestly lower, with yields rising between 2 and 4 bps. The dollar eyed the commotion in Europe and rose 0.8%, a rally which tarnished silver a bit but oddly didn’t hurt gold. The yellow metal has been going its own way of late, a fact evident in not only today’s concurrent advance with the greenback but also in Thursday’s 0.25% drop in the CRB index. Perhaps gold is rightly starting to be viewed as a currency in its own right.

“The hard part about playing chicken is knowing when to flinch”. This piece of advice has been available on playgrounds for decades, but it was made memorable by Scott Glenn’s character, Commander Bart Mancuso, in the 1990 movie, “The Hunt for Red October”. As often happens in Hollywood, Commander Mancuso times his move perfectly, a feat some EU leaders have been hoping to pull off with Greece. Standing fully — if only vocally — behind their financially stricken member state, EU leaders no doubt intended to show global investors a resolve similar to that once displayed by 300 Spartans at Thermopylae. These assorted ministers were hoping bond investors would thus be impressed enough to finance Greece back to health without the need for official intervention.

As PIMCO’s Mohamed El-Erian states in the story you’ll see below, however, EU leaders will likely have to flinch and put real money behind their promises. What’s unfortunate about the way things are now turning out is that any aid package might now include the IMF. Having a member state go hat-in-hand to is not only embarrassing for official Europe, it picks the pockets of nations outside the EU and hurts the euro in the process. What the IMF calls its “resources” are comprised mostly of quota contributions from developed nations, with the size of the ding escalating with the size of a nation’s GDP. If you’re starting to wonder whether the U.S.A.’s rank in the IMF pecking order means that, in effect, U.S. taxpayers may help fund any bailout of Greece, please stop wondering. Leave it to the EU to play a game of chicken where both the participants AND the bystanders get hurt.

If U.S. taxpayers get nicked by an IMF bailout for Greece, we may soon be receiving a flesh wound courtesy of our Congress. I don’t wish to debate the pros and cons of any proposed legislation — at least until we find out what it looks like and whether it somehow passes via a parliamentary trick that the House has used before when playing games of chicken with minority opposition in the Senate. And, just in case you’re wondering whether you’re about to be hurt by a healthcare system that is supposed to be a source of healing, please gaze upon the last headline below. Only in America could spending almost a trillion dollars be considered deficit reduction.

Whether either of the political games of chicken described above come home to roost in the capital markets is a matter about which investors seem unconcerned. The major stock indexes are grinding higher; the latest Dow Theory signal is as green as St. Patrick’s day; and the U.S. government can finance itself out to 30 years at rates less than passbook savings accounts earned prior to financial deregulation. Risk premiums in both markets have shriveled as risk appetites have grown. It might be an open question whether investors are playing chicken with forward rates of return or not, but it seems like complacency is becoming more widespread.

The VIX is now at its lowest level since Warren Buffett himself declared the subprime mess largely over during the spring of 2008. What was missing then, as now, was a margin of safety built in to prices for what Met Life likes to call “the IF in life”. And it is indeed possible that investors need not worry about either Greece hitting the wall or healthcare reform hitting their pocketbooks. Similar cries of “wolf” have been issued before about these subjects and nothing has yet happened. I would emphasize the “yet”, especially since volatilities (i.e. the price of purchasing market insurance) are low and securities prices don’t seem to discount what may go wrong in the very near future. I hope I’m wrong, but investors might be playing chicken with Mr. Market and don’t even know it.

– Jack McHugh

El-Erian Says IMF to Aid Greece After ‘Chicken’ Game
Papandreou Seeks EU Aid Deadline, Challenging Merkel
Pelosi Tactic for Health-Care Vote Would Raise Legal Questions
Health-Care Bill to Cost $940 Billion, Reduce Deficit

Here’s a laugher:  “In a detailed review of the causes of the financial crisis, former Federal Reserve Chairman Alan Greenspan acknowledged a range of regulatory failures but strongly disputed the widely held view that the Fed left interest rates too low for too long.”

Oh, it gets even worse:

“In Mr. Greenspan’s 48-page review of the causes and consequences of the crisis, the text of which was released by Brookings, he acknowledged that the regulatory system failed, that Fed officials didn’t take seriously enough the risks building in the subprime mortgage market last decade, that regulators more broadly didn’t demand that banks hold enough capital and that he didn’t do enough to rein in “megabanks,” that posed a risk to the financial system.

He offered a full-throated defense of the interest-rate policies he championed. Low rates did play a role in spurring a housing bubble last decade, Mr. Greenspan said. But it wasn’t the short-term rates he controlled, he said. It was longer-term rates, which were driven lower by a flood of savings released by emerging markets into the global financial system.

The Fed pushed its benchmark interest rate—the federal-funds rate—to 1% in 2003, to fend off a dangerous bout of deflation. Some critics say this fueled adjustable-rate mortgage borrowing, bank risk-taking and the housing boom.

Mr. Greenspan says rates on 30-year fixed-rate mortgages drove the housing boom, not the overnight lending rates the Fed controls. Because of the flood of foreign capital, he said, longer-term rates became less closely linked to the federal-funds rate during the boom, something he described at the time as a “conundrum.”"

Discuss . . .

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Amusing Cartoon — I suspect the worst of the Greek scare is behind us, and push comes to shove, the ECB and the EU wont let the European Union spin a part:

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The US$ is at the high of the day vs the euro coincident with Greek CDS at the wides of the morning by 20 bps to 307 bps following the news this morning. This level is a 2 week high. In sympathy, CDS is wider in Spain, Portugal, Italy and Ireland. Bond yields are higher too and Greek stocks in particular closed down 3.4%. There is also an idiotic rumor out there that the Fed is again going to raise the discount rate after doing so a month ago. While they easily may but likely won’t anytime soon, there is zero chance the possibility of it would leak to a Wall St trading desk.