11. Other propensities—time preference, competitiveness, home bias, and optimism—relate to a far greater extent to people reacting individually to changes in their external environment.
12. Without outside guidance of one form or another, reality is too complex for the average person to handle. To function at all, most people require an instruction manual on how to respond to the myriad decisions required every minute of every day, from deciding what to wear to how to behave in any gathering.
13. It is revealing that the most drastic penalty for misbehaving prisoners is to place them in solitary confinement.
14. Daniel Kahneman, p. 255.
15. In some rare cases for those seeking status in their society’s pecking order, a higher price is an attraction to buy, though it might validly be argued that the product being purchased has a joint value including the value of a perceived rise in status achieved by exhibiting the resources to buy.
16. Letter to Dr. H. L. Gordon (May 3, 1949 - AEA 58–217) as quoted in Walter Isaacson, Einstein: His Life and Universe (New York: Simon & Schuster Paperbacks, 2007), p. 113.
CHAPTER 2: THE CRISIS BEGINS, INTENSIFIES, AND ABATES
1. Short-term debt as a share of total liabilities was close to the lowest levels since the end of World War II. Liquid assets relative to short-term liabilities were at exceptionally high levels historically, and the market value of net worth as a ratio to liabilities was close to its highest level in decades.
2. The closest example was the shutting down of the call-money market for one day at the height of the panic of 1907.
3. Hugo Bänziger, “Money Market Funds Need New Global Standards,” Financial Times (November 5, 2009). Bänziger was chief risk officer at Deutsche Bank at the time.
4. Trade finance soared to 600 basis points over Libor, effectively shutting down global trade. Exports fell sharply in unison in every major trading center. Goods in transit backed up, leaving long lines of ships at ports, unable to unload their canceled cargos. The backup was immediately evident everywhere. As a consequence, global industrial production was cut back sharply.
5. More than 4 percent of the nation’s seven thousand commercial banks failed or were assisted during 2009 and 2010, while all four major investment banks were on the ropes.
6. Global Shadow Banking Monitoring Report 2012; Financial Stability Board; November 18, 2012.
7. Alan Greenspan, “The Evolution of Bank Supervision.” Paper presented at American Bankers Association, Phoenix, October 11, 1999.
8. Allen N. Berger and David B. Humphrey, “Bank Scale Economies, Mergers, Concentration, and Efficiency: The U.S. Experience.” Working Paper 94–25. Wharton Financial Institutions Center (June 1994).
9. FDIC Quarterly Banking Profile, 2nd Quarter, 2006, p. 3.
10. I often maintained that because of this complexity, policy makers had to rely on an international “invisible hand” to bring equilibrium to such undecipherable markets. The high level of market liquidity appeared, erroneously, to confirm that the system was working.
11. In their excellent book, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2011), Ken Rogoff and Carmen Reinhart effectively documented the dangers of leverage.
12. In mid-September 2007, when home prices were still close to their highs, I did fear that the heavy overhang of vacant homes for sale would induce a significant price decline. (See Krishna Guha, “Greenspan Alert on US House Prices,” Financial Times, September 16, 2007.) But I had no expectation that prices would fall an additional 28 percent for a total decline of 33 percent from peak to trough, the largest decline ever.
13. From the end of 2002 to the end of 2007, commercial banks did add $277 billion (a 27 percent addition to equity capital), but it was clearly not enough to address what was about to occur.
14. Gerald P. Dwyer, “Credit Ratings and Derivatives,” Federal Reserve Bank of Atlanta, August 2009.
15. The Securities and Exchange Commission has argued against reserves not tied to specific loans because such leeway can affect reported earnings to shareholders. (True.) Company earnings have always been subject to shifting earnings from one quarter to the next. But such manipulation over the long run is obviously restrained by the underlying profitability of the firm. We will have to live with profit manipulation being constrained by outside audit.
16. See data in Chapter 4.
17. FOMC transcripts of May 1995, pp. 32–33.
18. Alan Greenspan; “Global Challenges.” Remarks at the Financial Crisis Conference, Council on Foreign Relations, New York, July 12, 2000.
19. The term “regression” derives from an early (nineteenth-century) application of this technique. It concluded that the heights of descendants of tall ancestors tended to regress toward the mean of their distribution.
20. A D-W in excess of 2.0 (extremely rare in economic time series) indicates negative serial correlation.
21. The t-statistic for an independent variable is calculated by dividing the variable’s regression coefficient by the standard error of that coefficient.
22. The independent variables in this regression are (1) the cyclically adjusted federal budget deficit as a percent of GDP, (2) the nonfarm business operating rate, and (3) the spread between the yields on 30-year and 5-year U.S. Treasury obligations. See Chapter 7 for a discussion of the relevance of this regression.
CHAPTER 3: THE ROOTS OF CRISIS
1. For a more detailed explanation see Alan Greenspan, The Age of Turbulence (New York: Penguin Press, 2007), chapter 20.
2. I had always been skeptical of such estimates. The state of disrepair in that most advanced economy of the Soviet bloc just didn’t square with the numbers. Having much of my life compared visual economic landscapes with statistics on standards of living, there was no way East Berlin, and by extension East Germany, had developed living standards anywhere close to those of West Germany. As a member of the President’s Foreign Intelligence Advisory Board in 1985, and being assigned to a project that brought me in close contact with upward-biased Soviet economic statistics, I could imagine that East Germany was not immune from the central planning bias. After the fall of the Berlin Wall it was exposed by more accurate appraisals of economic performance.
3. Foreign direct investment in China, for example, rose gradually from 1980 to 1990, but then rose thirty-ninefold by 2007, and contrary to global trends, moved higher through the crisis of 2008.
4. IMF, World Economic Outlook, April 2007, chap. 5, p. 162.
5. Although the decline in global interest rates indicated, of necessity, that global saving intentions were chronically exceeding global intentions to invest, actual global saving and investment rates in 2007, over all, were only modestly higher than in 1999. This observation suggests that the uptrend in the saving intentions of developing economies was being tempered by investment intentions in the developed world. That weakened global investment was a major determinant in the decline of global real long-term interest rates was also the conclusion of a March 2007 Bank of Canada study. (See Brigitte Desroches and Michael Francis. “World Real Interest Rates: A Global Savings and Investment Perspective,” Bank of Canada Working Paper 2007–16, Ottawa, March 2007.)
6. The path of the convergence is evident in the unweighted average variance of interest rates on ten-year sovereign debt of fifteen countries. That average declined markedly from 2000 to 2008 (Exhibit 3.2). The variance of the logarithms of the fifteen long-term interest rates exhibits similar trends.
7. For example, “Finance and Economics: Houses Built on Sand,” Economist, September 15, 2007, p. 104.
8. IMF, World Economic Outlook, April 2008, chap. 3, p. 113.
9. For the period 1991 to 2005, the R2 = .57 and the adjusted t-value for mortgage interest rates is a highly significant -8.7.
10. Neither survived the crisis intact as an ongoing firm.
11. That many of the investors were European was confirmed by the
heavy losses on U.S. mortgages reported by European investors. Euroarea banks, for example, exhibit a very high ratio of residential mortgage-backed securities write-downs to the residential mortgage loans they hold (IMF, Global Financial Stability Report, October 2009, p. 10). The size of the buildup of subprime securities holdings abroad, during the bubble years, is unclear. The U.S. Treasury’s annual Foreign Holdings Survey reports that by the end of 2006, foreign investors held $386 billion of privately issued U.S. mortgage-backed securities, some of which were commercial mortgage-backed securities, compared with $125 billion in 2002. By 2012, the total had reached $716 billion.
12. In October 2000, HUD finalized a rule “significantly increasing the GSEs’ affordable housing goals” for each year from 2001 to 2003 (Office of Policy Development and Research, 2001). In November 2004, the annual housing goals for 2005 and beyond were raised still further. Goals are still being set.
13. The size of the commitments was tied to the size of the GSEs’ portfolio of mortgage assets.
14. Federal Housing Finance Agency, 2008 Annual Report to Congress (revised), Historical Data Tables 5b, Part 2, and 14b, Part 2 (originally published May 18, 2009, and updated to include a significant reclassification effective September 3, 2009). Before the revision, I estimated the share at less than 30 percent. Data newly reclassified by Fannie Mae account for almost all of the revision.
15. Mortgage Bankers Association
16. Early Payment Defaults (EPDs): mortgages that go into ninety plus days delinquency or full default status within the first year.
17. Inside Mortgage Finance Publications, The 2009 Mortgage Market Statistical Annual, vol. I: “Mortgage Originations by Product,” p. 4; vol. II: “Non-Agency MBS Issuance by Type,” p. 13.
18. The remaining 20 percent was being held by investors presumably unwilling to sell them at prevailing market prices.
19. That extraordinarily receptive market arguably was driven to excess by purchases by Fannie and Freddie to meet their HUD obligations.
20. Alan Greenspan, “The Crisis,” Brookings Papers on Economic Activity, Spring 2010, p. 242.
21. After all, self-amortizing conventional mortgages had been designated by Basel II to be sufficiently safe for regulated financial institutions to put up regulatory capital at only a fraction of the requirements on unrated claims on corporate lending.
22. Alan Greenspan, testimony, “Government-Sponsored Enterprises.” Committee on Banking, Housing, and Urban Affairs, U.S. Senate; February 24, 2004.
23. Federal National Mortgage Association 10-K for fiscal year ended December 31, 2004. Filed on December 6, 2006; p. 146.
24. These covenants are restrictions put on a borrower by a lender that might, for example, restrict other borrowings, the level of working capital, or debt service cover.
25. Brown Brothers Harriman, where I worked in the summer of 1947, was a case in point. They eschewed the speculative markets of the dot-com and housing booms and therefore remained solvent. But their asset growth during those years hardly compared with that of Citi or JPMorgan.
26. Michiyo Nakamoto and David Wighton, “Citigroup Chief Stays Bullish on Buy-Outs,” Financial Times, July 9, 2007.
27. That outcome was most stark when interest rates on savings and loan (S&L) liabilities (mostly short term) rose sharply in the early 1980s, dramatically increasing the institutions’ cost of debt. Interest rates on new mortgages also rose, but because the maturity of the mortgage assets was quite long, only the few newly issued mortgages of the S&Ls increased their income. The income from the vast majority of their mortgages was unchanged. The effect was to squeeze earnings, and much of the industry filed for bankruptcy as a consequence.
28. Alan Greenspan, Remarks at the Economic Club of New York, February 17, 2009.
CHAPTER 4: STOCK PRICES AND EQUITY STIMULUS
1. Warren Buffett, perhaps the most successful investor of my generation, recently told me that he has followed that strategy for decades.
2. Interest rates, after all, in the fifth century B.C. were similar to those of modern times. I know of no other “time series” that has exhibited such stability.
3. Panic selling is an integral part of any bear market. But panic buying, excluding short covering, is rarely evident during bull markets. As the data show, the rate of price increase in bull markets tends to be importantly less than the average pace of decline in bear markets.
4. Rick Ferri, “Index Fund Portfolios Reign Superior,” Forbes, August 20, 2012.
5. While bear markets are far more implosive than bull markets are expansive, the number of days of stock price decline is far lower than the number of days of rise. Daily stock prices since 1955, after factoring out their long-term uptrend, fell 4 percent less often than they rose, and average daily declines were 4 percent larger than average daily gains.
6. The five-year maturity is long enough to eliminate expected business cycle fluctuations.
7. Unlike spending from wages and salaries, spending of capital gains requires a comparable increase in household debt, or a smaller increase in other assets than would otherwise have been the case.
8. The range is wide, however. An estimated 16 percent of consumption expenditures was attributable to changes in capital values during the first quarter of 2006, and as low as 10 percent during the fourth quarter of 1974.
9. Regression analysis over the years 1985 to 2012 indicates that a 5 percent rise/fall in prices will generate a change in starts of plus or minus 7.4 percent (Exhibit 7.4).
10. To estimate the overall effect of changing asset prices on total GDP would be a simple job merely of adding up the effects of asset prices on personal consumption expenditures and private and municipal capital investment. But that does not account for interaction between sectors.
11. The market value of U.S. companies, foreign companies, and homes rose by an annual average of 8.1 percent, 14.4 percent, and 6.1 percent, respectively.
12. Regrettably, there were few chairwomen in those days.
13. Alan Greenspan, “Stock Prices and Capital Evaluation,” in American Statistical Association, 1959 Proceedings of the Business and Economic Statistics Section (American Statistical Association, Washington, D.C., 1959), pp. 2–26.
14. This was a precursor to “Tobin’s q,” promulgated by James Tobin of Yale in 1969.
15. Some corporations use the weighted average of debt and equity capital.
16. For this calculation I include inventory change with fixed investment.
17. Net borrowing (which includes issuance of new stock) is equal to the net increase in liabilities less the increase in assets other than capital investments. This statistic is equivalent to what the Federal Reserve’s Flow of Funds account calls the “financing gap.”
18. Operating earnings less interest payments, and a few other adjustments, equals pretax earnings.
CHAPTER 5: FINANCE AND REGULATION
1. Much of this chapter has been expanded and updated from an earlier article, “The Crisis,” which I wrote for the Brookings Panel on Economic Activity (Spring 2010).
2. Moreover, it is a matter of ongoing dispute as to whether the outcomes of free markets are “just,” an issue I will address in Chapter 11.
3. I have witnessed too many stock and commodity price booms and crashes that exhibit very similar psychology-driven paths of expansion and contraction.
4. Alan Greenspan, “We Will Never Have a Perfect Model of Risk,” Financial Times, March 16, 2008.
5. Although depreciation is a debit on the income statements of households and businesses, the savings available to fund investment (household savings and business cash flow) are gross of that loss. Depreciated assets (for example, houses or plant and equipment, depending on which sector is being considered) have incurred a loss in value from regular use that does not materialize into an actual deduction from cash flow. (Any assets that have been completely depreciated are replaced, a realized cost that is already reflected in con
sumption expenditures and thus lower gross savings.)
6. Including the Federal Reserve, technically a financial intermediary.
7. Increased financial income shares of GDP are evident in the United Kingdom, Netherlands, Japan, Korea, and Australia, among others. The world’s most rapidly expanding (and increasingly market-oriented) economy, China, reports a rise in financial intermediaries’ share of GDP from 1.6 percent in 1980 to 5.5 percent in 2012.
8. The net foreign demand for U.S. financial services has grown significantly but has been largely offset by net imports of insurance services.
9. A recent study finds a markedly above-average rise in the salaries of those employed in finance since 1980. (See Thomas Philippon and Ariell Reshef, Wages and Human Capital in the U.S. Financial Industry: 1909–2006, NBER Working Paper 14644, January 2009.)
10. Economist, “Number-Crunchers Crunched,” February 13, 2010.
11. Household financial assets, which reflect most of the holdings of insurance and pension funds, can be taken as a proxy for the assets of the economy to be managed at a fee. The ratio of household financial assets to disposable personal income did rise through 2000, but has been trendless since.
12. Alan Greenspan, “Dodd-Frank Fails to Meet Test of Our Times,” Financial Times, March 29, 2011.
13. The Dodd-Frank Act reorganized the use of the 13 (3) authority.
14. Alan Greenspan; “Technology and Financial Services” (speech, Journal of Financial Services Research and the American Enterprise Institute Conference in Honor of Anna Schwartz, Washington, D.C.; April 14, 2000).
15. Yields on riskless longer maturities can fall below short-term riskless rates if tight money convinces investors that future inflation will be less and funds availability more.
The Map and the Territory Page 27