Making Sence of the Subprime Crisis

8/2/2019 Making Sence of the Subprime Crisis

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The Crisis [with Comments and Discussion]Author(s): ALAN GREENSPAN, N. GREGORY MANKIW, JEREMY C. STEINReviewed work(s):Source: Brookings Papers on Economic Activity, (SPRING 2010), pp. 201-261Published by: The Brookings InstitutionStable URL: http://www.jstor.org/stable/40930484 .

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ALAN GREENSPANGreenspanssociatesTheCrisis

ABSTRACT Geopoliticalchanges following he end of the Cold Warinduced worldwide eclinenreal ong-termnterestates hat,nturn,ro-ducedhomepricebubbles crossmore han dozen countries. owever,twas theheavy ecuritizationftheU.S. subprime ortgage arketrom003to2006that pawned he oxic ssets hat riggeredhedisruptiveollapseoftheglobalbubblen2007-08. Privateounterpartyiskmanagementnd offi-cial regulation ailed o set evels ofcapitaland liquidityhatwould havethwartedinancialontagionndassuaged he mpact f the risis.This woe-fulrecord as energized egulatoryeform ut lso suggestshat egulationsthat equire forecastre ikely o fail. nstead,heprimarymperativeas tobe increasedegulatoryapital, iquidity,ndcollateralequirementsor anksand shadowbanks like.Policies hat resumehat ome nstitutionsre "toobigto fail"cannot e allowed o stand. inally, range f evidence uggeststhatmonetaryolicywas not he ource f thebubble.

I. PreambleThebankruptcyfLehman rothersnSeptember008precipitatedhat,inretrospect,slikelyobe udged hemost irulentlobal inancialrisisever. o be sure, he ontractionneconomicctivityhat ollowedn tswakehas fallen ar hort f thedepressionf the1930s.But precedentforhe irtual ithdrawal,n soglobal scale, fprivatehort-termredit,the eadingdgeoffinancialrisis,s not eadilyvidentnourfinancialhistory.hecollapse fprivateounterpartyrediturveillance,ine-tunedover omany ecades, longwith he ailureftheglobal egulatoryys-tem, alls for he horougheview y governmentsndprivateiskman-agers owunder ay.

CopyrightAlanGreenspan201


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202 BrookingsapersnEconomicctivity,pring01The central heme fthis aper s thatntheyears eading pto thecrisis,inancialntermediationriedofunctionntoo hin layerf apital,owingo misreadingf he egreefrisk mbeddedn ver-more-complexfinancialroductsndmarkets.ectionI ofthe aper eviews he ausesof he risis.nsectionII the atureffinancialntermediationsprobed.nsectionVa set freformssproposedhat,trust,ddresshe hortcomingsof he xistingegulatorytructure.nsection the ole fmonetaryolicyinthe risis s examined.offerome onclusionsnsection I.

II. Causesof the CrisisILA. TheArbitragedlobalBondMarketnd theHousing risisTheglobal roliferationfsecuritized,oxicU.S. subprime ortgageswasthe mmediateriggerfthe risis. ut he riginsfthe risis eachback, s best can udge, othe ftermathf heColdWar.1 hefall f heBerlinWall xposedhe conomicuin roducedy he oviet loc'seco-nomic ystem.nresponse,ompetitivearketsuietly,ut apidly,is-

placedmuch fthe iscreditedentrallanningoprevalentn the ovietbloc nd he hen hirdWorld.A large egmentf he rstwhilehirdWorld ations,speciallyhina,replicatedhe uccessfulxport-orientedconomicmodel fthe o-calledAsianTigersHongKong, ingapore,outhKorea, ndTaiwan):fairlywell ducated,ow-cost orkforces,oinedwith eveloped-orld echnol-ogy ndprotectedy ncreasinglyidespreaddherenceo he ule f aw,unleashedxplosiveconomicrowth.2he nternationalonetaryund(IMF) estimatedhatn 2005 more han 00 millionmembers ftheworld'sabor orce ere ngagednexport-orientednd hereforeompet-itivemarkets,n ncreasef500million ince he all ftheBerlinWall.3Additionalundredsfmillionsecame ubjecto domesticompetitiveforces,speciallyn the ormerovietUnion.As a consequence,etween2000 and2007therealGDP growthate fthedeveloping orldwasalmost ouble hat f he eveloped orld.Consumptionn thedeveloping orld, owever,estrainedycultureand nadequateonsumerinance,ouldnotkeepupwith he urge fincome,ndconsequentlyhe aving ate fthedeveloping orld oaredfrom4percentfnominal DP in1999 o 34percenty2007,far ut-1. For a moredetailed xplanationee Greenspan2007, chapter 0).2. ForeigndirectnvestmentnChina,for xample,rosegradually rom 980 to 1990,butthen ose39-fold y2007.3. IMF, World conomicOutlook,April2007, chapter ,p. 162.


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ALAN GREENSPAN 203Figure1. Nominal Yieldson 10-YearGovernment ebt,Averagefor15 Countries,1999-2010aPercent

5 5" / *i fvv m5.0 // 'l' Unweighted, n

WeightedyGDP ' VI I | | | | | | | | | |_1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source:Various ountryources.a. ThecountriesreAustria, elgium, anada,Denmark,inland, rance,Germany,taly, heNetherlands,Norway, pain, weden, witzerland,heUnitedKingdom,ndtheUnited tates.

strippingts nvestmentate.With nvestmentlsewherentheworld lowtotake pthe lack, he esult as a pronouncedall rom 000to2005 nglobal ong-termnterestates, oth ominalfigure)andreal.Althoughhe eclinenglobalnterestatesndicated,fnecessity,hatglobal avingntentionsere hronicallyxceeding lobal ntentionsoinvest,xpostglobal aving nd nvestmentatesn2007,overall, ereonlymodestly igherhann 1999,suggestinghat heuptrendnthesavingntentionsfdevelopingconomiesemperedecliningnvestmentintentionsnthedevelopedworld.4 fcourse,whethert was a glut fintendedaving r a shortfallf nvestmentntentions,he onclusionsthe ame: eal ong-termnterestates ad ofall.Inflationnd ong-termnterestatesn lldevelopedconomiesnd hemajor evelopingconomies adby2006convergedo single igits,believe or he irstime ver. hepath f he onvergences evidentntheunweightedverage ariance f nterestates n10-yearovereignebt f15countries:hatverage eclinedmarkedlyrom 000to2005 figure).54. Thatweakened lobal nvestmentas a major eterminantn thedecline fglobalreal ong-termnterestateswas lso the onclusionf March 007Bank fCanada tudy(DesrochesndFrancis007).5. Thevariancef heogarithmsf he 5 ong-termnterestates xhibitsimilarrends.


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204 Brookingsapers n Economic ctivity,pring 010Figure2. Varianceof InterestRates:10- earGovernment ebt in 15 Countries,1999-2010a

0.10 -0.05 -

i | | | | | | | | | |_1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Source:Various ountryources.a. Unweightedverage or he15 countriesnfigure .

Equityndreal stateapitalizationateswerenevitablyrbitragedowerby he all nglobalong-termeal nterestates. sset rices, articularlyhome rices,ccordinglyoved ramaticallyigher.The Economist'surveys ocumenthe remarkableonvergencefnearly 0 individual ations' omeprice isesduringhepastdecade.6Japan, ermany,nd Switzerlandfordifferingeasons)were heonlyimportantxceptions..S. home rice ains, ttheireak,werenomorethan heglobal eak verage.7nshort,eopoliticalvents ltimatelyedtoa fall n ong-termortgagenterestates hatnturned,with lag, othe oomnhome rices lobally.II.B. Securitizationf ubprimes:heCrisistory nfoldsThe ubprime ortgage arkethat evelopednthe 990swas a smallbut enerallyuccessful arketf argelyixed-rateortgages.t servicedmainlyhose otentialomeownersho ouldnotmeethe own aymentrequirementf a primeoan,but tillhad ncome dequate o handlefixed-rateortgage.8nly modestmount adbeen ecuritized,utwith6. Forexample,TheEconomist, Financeand Economics:Houses BuiltonSand," Sep-tember 5,2007,p. 104.7. IMF, World conomicOutlook,April2008,chapter ,p. 113.8. As recentlys 2002,subprimemortgagesccounted or percentf total riginations.


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ALANGREENSPAN 205Figure3. MonthlyChangesinHome Prices,1976-201 0a

Source:Author'salculations asedon datafromoanPerformancendStandard Poor's,a. Both eries reseasonally djusted.

home rices aving isen t a quickeningacesince1997 figure), sub-primeending asseen s increasinglyrofitableo nvestors.Belatedlyrawn o thismarket,inancialirms,tartingnlate2003,began oacceleratehe oolingndpackagingf ubprime ortgagesntosecuritiesfigure). The firmslearly adfoundeceptiveuyers. eavydemandromurope,9nthe ormf ubprime ortgage-backedollater-alizeddebt bligations,asfosteredy ttractiveieldsnd foreclosurerate nthe nderlyingortgageshat adbeen ndecline or years.Anevenheavier emandwasdriven ytheneedofFannieMae andFreddieMac,themajorU.S. government-sponsorednterprisesGSEs),pressedbytheDepartmentfHousing ndUrbanDevelopmentnd9. Thatmanyf he nvestorsere uropean asconfirmedy he ecenteavyosseson U.S.mortgageseportedyEuropeannvestors.uro-areaanks,or xample,xhibitveryhigh atio fresidential ortgage-backedecurities rite-downsotheresidentialmortgageoans hey old IMF,GlobalFinancial tabilityeport, ctober 009,p. 10).

The sizeof thebuildupfsubprimeecuritiesoldingsbroad uringhebubble earssunclear.heU.S.Treasury'snnual oreign oldingsurveyeportshatymid-2006,or-eign nvestorseld 341billion fprivatelyssuedU.S.mortgage-backedecurities,omeofwhichwere ommercial ortgage-backedecurities.he essdetailedmid-2002urveyreportedtotal or llasset-backedecuritiesf$169billion,ompared ith594billionnmid-2006.


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206 BrookingsapersnEconomicctivity,pring01Figure . Issuance fSubprime ortgage-Backedecurities,995-20103Billions fdollars120 - /V*100 - h^ '80 - / '60 - I '40 - y/ '

'/ I | | | I I | | | | | | |Vy I |_19951996199719981999200020012002 20032004200520062007 2008 2009Source: nsideMortgage inance.a. Quarterlyata, easonallydjusted.

Congressomeetxpandedaffordableousing oals."10iven he izeoftheGSEs' expandedommitmentso fundow-andmoderate-incomehousing,hey ad few lternativesut o nvest, holesale,nsubprimesecurities.he GSEs accountedor nestimated2 and49 percentf allnewly urchasedubprime ortgageecuritiesalmost ll at adjustableinterestates) etainedn nvestors'alance heets uring003 and2004,respectivelytable ).11 hatwasmore han ive imesheirstimatedharein2002.Increasingly,he xtraordinaryemandressedgainsthe imitedup-ply fqualifiedotentialubprimeorrowers.o reach eyondhis imitedpopulation,ecuritizersnwiselyroddedubprimeortgageriginatorsoofferdjustable-rateortgagesARMs)withnitiallyowermonthlyay-

10. InOctober 000 HUD finalized rule significantlyncreasingheGSEs' affordablehousinggoals" foreach yearfrom 001 to 2003. In November2004 the annualhousinggoals for 2005 and beyondwere raised still furtherOfficeof Policy Development ndResearch2001).il. reaerai HousingMnanceAgency, uuoAnnualtteportocongress (jevisea;, nis-torical Data Tables 5b, Part2, and 14b,Part2 (originallypublishedMay 18, 2009, andupdatedto include a significanteclassificationffective eptember , 2009). Before therevision, estimatedhe hare t ess than 0 percent. ata newly eclassifiedyFannieMaeaccountfor lmost ll therevision.


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OreJZLOreucretOX^"^

l ^l- fi3 Set"! n ^ ^ ^ i ! 8 si Ufi **- '=" 1*1 4m ft st1 S g . 8M I > il4.| 11 ^OoMT7? =g.|i| 5 * .illS S 3 -3 I I s s s11 *if l-iiiil 3 1 SSSSSF^SjVfl2 S a s i Ie5* * Is i 8 . ^ looi!!#^loo #^^2 q i> os vq es q Tt Tt o, g o ^-2 osTtTtdoso


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208 Brookingsapersn Economicctivity,pring01ments. s loanunderwritingtandardseterioratedapidly,RMs soaredtonearly2percentffirst-mortgageubprimeriginationsythe econdquarterf2007.12y2005 nd2006,13ubprimeortgageriginationsadswelled o a bubbly 0 percentf all U.S. homemortgageriginations,almostripleheirharen2002.Bythefirstuarterf2007,virtuallyll subprime ortgagerigina-tionswere eing ecuritized,ompared ithessthan alfn2000, 4andsubprime ortgageecuritiesutstandingotaledmore han 800billion,almost even imes heirevel t the ndof 2001. Thesecuritizers,rof-itably ackaginghis ew ource fpaperntomortgageools nd rmedwithwhat urnedut, nretrospect,o be grosslynflatedredit atings,were ble o ell eeminglynlimitedmountsf hese ecuritiesntowhatappearedobe a vast ndreceptivelobalmarket.

U.C. A ClassicEuphoric ubble TakesHoldAs a measurefhowfar he ppetiteor isk akingeyondhe ecuri-tizedmortgage arket adgone, ong-sacrosanctebt ovenants ereeasedas a classiceuphoric lobalbubble ookhold.15 y 2007,yieldspreadsn debtmarketsverall adnarrowedoa pointwhere here aslittle oom or urthernderpricingfrisk. urbroadest easuref reditrisk,heyield pread f bonds ated CC or ower nd10-yearreasurynotes, ell o a probableecordow nthe pringf2007, lthoughnlymarginallyo (figure). Almost ll marketarticipantsfmy cquain-tancewere ware f thegrowingisks, ut lso cognizanthat iskhadoftenemainednderpricedor ears.hadraised he pecterf irrationalexuberance"ver decadebeforeGreenspan996),only owatch hedot-comoom, fter one-daytumble,ontinueo inflateor moreyears,nrestrainedy cumulativencreasef350basispointsnthe ed-eralfunds ate rom994 o 2000.Similarlyn2002, expressed y on-cerns eforeheFederal penMarket ommitteeFOMC) that . . . our

12. Data arefrom heMortgageBankersAssociationHaverAnalytics).13. We at the FederalReservewereawareearlierm the decade of incidents f somehighlyrregularubprimemortgage nderwritingractices. utregrettably,e viewed t asa localizedproblem ubject o standard rudentialversight,ot heprecursorfthe ecuri-tizedsubprimemortgage ubblethatwas toarise severalyears ater.14. Inside MortgageFinance Publications,The 2009 MortgageMarket StatisticalAnnual,vol. I, p. 4, and vol. II, p. 13.15. These covenants rerestrictionsutona borrowerya lender hatmight, or xam-ple,restrictther orrowings,he evel ofworking apital, rdebt ervice over.


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ALAN GREENSPAN 209Figure5. Yield Spreadof Bonds Rated CCC and Lower ver 10-YearTreasuryNotes,1988-201 0aPercent

i i i i i i i i i i i i i i i i i i i i i i1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009Source:Bankof AmericaMerrill ynch, ederalReserve.a. Averageyield n Bankof AmericaMerrill ynchhigh-yieldashpaybonds ated CC and owerminus

yield n 10-year reasuryotes t constant aturity.

extraordinaryousingoom . . financedyvery argencreasesnmort-gagedebt,annotontinuendefinitely."t asted ntil 006. 6Clearly, ith uch xperiencesnmind,inancialirms ere earfulhatshouldheyetrenchoo oon, hey ould lmosturelyosemarkethare,perhapsrretrievably.heir ears ere ivenxpressionnCitigrouphair-man nd CEO Charles rince's ow-famousemarkn2007, ustbeforethe nset f he risis: When hemusic tops,ntermsf iquidity,hingswillbecomplicated.ut s long s themusic splaying, ou'vegot ogetupanddance.We're till ancing."17Thefinancialirmscceptedhe isk hatheywould e unable oantic-ipate he nset f crisisntime oretrench.heybelieved, owever,hatthe eeminglynsatiableemand or heirrrayf xotic inancialroductswould nable hem o sell arge artsftheirortfoliosithoutoss.They

16. The failure o anticipate helength nd depthof theemerging ubbleshould nothave come as a surprise.Althoughwe like topretend therwise, olicymakers,nd indeedforecastersngeneral, redoingexceptionallywell ifwe can getmarket rojections ssen-tially ight 0 percent f the ime.Butthatmeanswe getthemwrong 0 percent f the ime.In 1 /2 ears t theFederalReserve, certainly admy hare f the atter.1 /. MichiyoJNakamotond David Wighton, CitigroupChiefStaysBullish on Buy-Outs,"Financial Times,July , 2007.


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210 Brookingsapersn Economicctivity,pring01weremistaken.heyfailed orecognizehat he onversionf balancesheetiquidityoeffectiveemands largely functionf thedegree frisk version.18hatprocessmanifeststselfnperiods feuphoriariskaversionallingelow ts ong-term,rendlessverage)ndfearriskver-sion isingbove ts verage). lesseningn thentensityfrisk versioncreatesncreasinglyarrowid-askedpreads,n volume theconven-tional efinitionfmarket,s distinctrom alance heet,iquidity.Inthis ontextdefine bubble s a protractederiod ffallingiskaversionhat ranslatesnto apitalizationates allingmeasurablyelowtheirong-term,rendlessverages.19alling apitalizationatesnturnpropel ne ormore ssetprices ounsustainableevels.All bubbles urstwhen isk version eachests rreducible inimum,hats,when reditspreadspproachero, lthoughuccess ttiminghe nset f he eflationhasprovedlusive.Somebubbles urst ithoutevere conomiconsequencesthedot-comboom ndthe apid un-upf stock ricesn the pringf1987, orexample. thersurst ith evere eflationaryonsequences.hat lassofbubbles,s Carmen einhartndKenneth ogoff2009) demonstrate,

18. I amdefiningisk versionmorebroadly ere han he tandardconomicdefinition,which tates t n terms futilityverdifferentutcomes.Riskaversion, s I use theterm,encompasses ll factorshat overnndividuals'willingnessoengage nrisky ctions.Mostnotably, tencompassesnotonlytheir referencesowardrisk,butalso their erceptionsofrisk.Risk aversion s theprimary umantrait hatgovernsthepricing f income-earningassets. When people become uncertain r fearful, heydisengagefromperceivedrisk.When their ncertaintyeclines, hey akeon new commitments. iskaversion, ydefini-tion, angesfrom eroto full.The extremes f zeroand fullrisk version, fcourse, reoutside ll human xperience.Zerorisk version thats,the bsenceofanyaversion t all toengagingnrisky ctionsimpliesthat n individualdoes not care about,or cannotdiscriminatemong, objectivestates frisk o life nd limb. Such individuals annot ordo notchoose to) recognize ife-threateningvents.To acquirefood, helter,nd theother ecessary ontributorso iferequires ction, hatis, thetakingof risks,eitherby an individualor by otherson the individual'sbehalf.Eschewingall objectiverisk s not consistentwith ife.Thus full riskaversion, ike zerorisk version,s a hypotheticaltate hat s never bserved npractice.Day-by-day xistenceoccurswell within heseouterboundariesofrisk aversionandcan be very approximatelymeasuredby creditrisk spreads. Creditspreads thatveryapproximatelyrack hanging isk version xhibit ittle o no long-termrend. rimerail-road bondsof the mmediate ost-CivilWaryearsreflectpreadsover U.S. Treasuries hataresimilar o thepost-WorldWar I experience.19. Yields on long-termreasuries, proxy orriskless apitalization ates, re essen-tiallytrendless.Real yieldsin recentyearsare notfar from henominalTreasurybondyieldsof1900,when ong-termnflationxpectationsunder hegoldstandard)wereeffec-tively ero.


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ALAN GREENSPAN 211appearso be a functionfthedegree f everagenthefinancialector,particularlyhen hematurityfdebt s essthan hematurityf he ssetsitfunds.Had the hare f financialssetsfundedy equity eensignificantlyhighern September008, t seemsunlikelyhat hedeflationfassetpriceswould avefostereddefaultontagion uch,f tall,beyondhatof thedot-comoom. t s instructiventhis egardhat ince he tart fthe risis, o unaffiliatededge und asdefaultedn tsdebt, espite erylargeosses hat ften orced undiquidation.

I .D. Why id theBoomReach uchHeights?Whydid the2007 bubble each entury-rareuphoria?heanswer,believe,ieswith he ot-comubble, hich urst ith eryittleootprintonglobalGDPand,ntheUnitedtates,roducedhemildestecessionnthepost-World ar I period. heprevious .S. recession,n 1990-91,wasthe econdmost hallow. oupledwith hefact hat he1987stockmarketrash eft o visiblempactnGDP,this xperienceedthe ederalReserve ndmany sophisticatednvestoro believe hat utureontrac-tionswould lsoprove o worse han typical ostwarecession.Theneed orarge ank apital uffersppearedncreasinglyesspress-ing n thisperiod fGreatModeration.s late as April 007,the MFnoted hat global conomic isks have]declined ince . . September2006. . . Theoverall .S. economysholding pwell . . [and] he ignselsewhere revery ncouraging"emphasisn original).20hebankingregulationsdoptednternationallynder heBasel Accords id nducemodestncreasencapital equirementseading ptothe risis. ut thedebatesnBasel over hepending lobal apital ccord hat mergedsBasel II were argely verwhetherokeepbankcapital equirementsunchangedrtoreduce hem. everage ccordinglyallooned.It s insuch ircumstanceshatwedepend n ourhighlyophisticatedglobal ystemffinancialiskmanagementocontainmarketreakdowns.How could thavefailed n so broad scale?TheparadigmhatpawnedseveralNobelPrize winnersn economics HarryMarkowitz,obertMerton,ndMyron choles andFischer lack,had he lived) was sothoroughlymbracedyacademia,entralanks,ndregulatorshat y2006 thadbecome he ore ftheglobal egulatorytandardsmbodiedinBasel I. Many uantitativenvestmentirms hosenumberrunchingsoughtoexposeprofitablearketradingrinciples ere uccessfulo20. IMF,Worldconomic utlook,pril 007,p.xii.


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212 Brookingsapersn Economicctivity,pring01long s risk version ovedncrementallywhichtdidmuch f he ime).But runchingata hatoverednly he ast or3 decades idnotyieldmodel hat ould nticipatecrisis.Mathematical odels hat alibrate isk,however,re surely etterguides o riskmanagementhan he rule f thumb"udgmentsf a halfcenturygo.To this ay t s hard o find ault ith he onceptualrame-work fourmodels,s far s they o.Black ndScholes' legant ptionpricing roofs no less valid odayhan decade go.The riskmanage-ment aradigmonethelessarboredfatal law.In thegrowingtateof higheuphoria,iskmanagers,he FederalReserve,ndother egulatorsailed ofully omprehendheunderlyingsize, ength,nd mpactfthenegativeail fthedistributionfrisk ut-comes hatwas about obe revealed s the ost-Lehmanrisis layed ut.Fordecades,withittleo nodata,most nalysts,nmy xperience,adconjecturedfarmoreimitedail isk. his ssumption,rguably,asthemajorource f he riticaliskmanagementystemailures.Onlymodestlyessof problem as the ast nd,nsome ases,virtu-allyndecipherableomplexityf he road pectrumffinancialroductsandmarketshat eveloped ith he dvent f ophisticatedathematicaltechniqueso evaluate isk.21n despair,nvestmentanagersubcon-tractedn nordinatelyarge art f heirask othe safeharbor"isk es-ignationsfthe reditatinggencies. o furtherudgment asrequiredof nvestmentfficershobelievedhey ere ffectivelyeldharmlessytheudgmentsfthese overnment-sanctionedatingrganizations.utdespiteheir ecades fexperience,he nalystst the reditatinggen-ciesproved omoredeptt nticipatinghe nset f risishan henvest-mentommunityt arge.Evenwithhe reakdownfour ophisticatediskmanagementodelsandthefailuresf the reditatinggencies,hefinancialystem ouldhaveheldtogetherad the hirdulwarkgainst risis ourregulatorysystemfunctionedffectively.ut under risispressure,ttoo failed.Alongwith hevastmajorityf marketarticipants,egulatorsailed oanticipatehe nset f risis.Theheavily raised .K. Financial ervicesAuthorityas unable oanticipate,ndthus oprevent,hebank un hat hreatenedne of thatcountry'sargestommercialanks, orthernock.Theveneratedredit

21.1 oftenmaintainedhatbecause ofthis omplexity,olicymakers ad torelyon aninternationalinvisiblehand"tobring quilibriumosuchundecipherablemarkets. hehighlevel ofmarketiquidityppeared, rroneously,o confirmhat he ystemwas working.


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ALAN GREENSPAN 213ratinggencies estowedatingshatmplied riple-Auturemoothail-ingformany highlyoxic erivativeroduct.he Basel CommitteenBanking upervision,epresentingegulatoryuthoritiesromheworld'smajor inancialystems,romulgatedsetofcapital ules hat ailed oforeseeheneed hat rose t theheightfthe risis ormucharger api-taland iquidityuffers.he Federal epositnsuranceorporationadnoted s recentlys the ummerf2006 that morehan 9percentfallinsurednstitutionset rexceeded he equirementsfthehighestegu-latoryapital tandards."22.S. commercialnd avings anks reexten-sively egulated,nd even houghoryears ur 10 to 15largest ankinginstitutionsavehadpermanentlyssigned n-site xaminerso overseedaily perations,anyf hese anks tillwere ble o ake ntoxic ssetsthat roughthem otheir nees.III. Financial Intermediation

IIIA. The urposefFinanceThe ultimateoalof a financialystemnd tsregulationna marketeconomys to direct henation'saving, lus ny aving orrowedromabroadthe urrentccount eficit),owardnvestmentsnplant, quip-ment,nd humanapital hat ffer hegreatestncreasesn thenation'soutput erworker our.Nonfinancialutput erhour, naverage, iseswhen bsolescentacilitieswithowoutput erhour) rereplacedwithfacilities hat mbody utting-edgeechnologieswithhighoutput erhour). hisprocess mprovesveragetandardsf iving or nation s awhole.ntheUnitedtates,he videntuccess ffinancen thedecades

before he risis ndirectingcarce avingsnto ealproductiveapitalinvestmentsppearsoexplainhegenerousompensationhat onfinan-cialmarketarticipantsadbeenwillingopay othe omesticroducersoffinancialervices.The hare fU.S.gross omesticroductccruings incomeofinanceand nsurance,ccordingo theBureau fEconomic nalysis,osefairlysteadilyrom.3percentn1947to 7.9percentn2006 figure). Manyother lobal inancialentersxhibitimilarrends.23nly small art fthe ise ntheUnited tates epresentedn ncreasennet oreignemand22. FDIC Quarterly anking rofile, ndQuarter 006, p. 3.23. Increased,ut esspronouncedlyo,financialhares re videntntheUnited ing-dom,heNetherlands,apan, orea,ndAustralia,mong thers. heworld'smost apidlyexpandingand ncreasinglyarket-oriented)conomy,hina, eports rise nfinancialintermediaries'hare fGDP from .6percentn1980 o5.4percentn2008.


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214 Brookingsapers n Economic ctivity,pring 010Figure6. Shareof the FinancialSector nGDP, 1960-2008Percent Percent8 " ^-^^'~ 147 /'y^^ ' n6 - Share f inance nd nsurance A ' ' V , N "10in nominal DP (leftcale)y / / l / V V -

^^ - , ' / Change n inance nd nsurance alue dded3 " ' ' v' as share f hangennominal DP (rightcale & "^2 - - 2

1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006Source:Bureau fEconomicAnalysis,a. Three-year ovingverages.

forU.S. financialnd nsuranceervices.24hedeclinen the hare o7.4 percentn2008reflectsrite-offsfsavings reviouslyresumedobeproductivelymployed.25Giventhehistoricreakdownfthe ast2 years, idnonfinancialmarketarticipantsver hedecadesmisreadhe fficiencyffinanceand nappropriatelyompensatehis mall egmentf our conomy?heprevalencef somany inancialroductailuresertainlyuggestso,forthedecade eading pto the risis.Nonetheless,t sdifficultomake hesameudgmentnthe ace f he airlyersistentise ffinance'share orthe reviousalf entury.oreover,inance'share fgrowthn nominalGDP hasbeen argelyrendlessince1990, veragingbout10percent(figure).Theproportionfnonfarmmploymentccountedor yfinancendinsuranceince1947hasrisen ar ess than he hare fgross ncomeoriginatingn that ector,mplyingsignificantpgradingfthe killsattractedofinancend heirompensation.recenttudyPhilipponndReshef 009)finds markedlybove-averageise n the alaries fthose24. The netforeign emandforU.S. financial erviceshas grown ignificantlyuthasbeen argely ffset ynet mportsf nsurance ervices.25. The shareof national ncome originatingm a somewhatbroadenedmeasureoifinancewas little hanged n 2009 from 008.


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ALAN GREENSPAN 215employednfinanceince1980,presumablyeflectinghegreaterkillsdrawno financenrecent ears. y2007 a quarterf llgraduatesfthevenerable alifornianstitutefTechnologyere nteringinance.26What re we to makeof these xtraordinarilyersistentnd stableuptrends?retheywhollyccidental?Afterll,theres no evidence fsuch trendntheprewar ears.)t is not hat hevalueof assets o bemanaged asbeenpersistentlyisingelativeoGDP.27 heanswerothisquestionmattersgreat eal.In the context f financial eform,he criticalssue thatmustbeaddresseds whetherhegrowinghare f financialervices ashappen-stance,revidence hat growinghare ffinancialervices asrequiredto ntermediaten evermore omplex ivision f abor. raise he ssuebecausemany ecent olicy ecommendationsould ower he hare ffinancialervicesncome nGDP.Would uchpolicies ffecthegrowthofU.S. nonfinancialroductivitynd ur tandardsf iving?Morempor-tant, iven he ecent ailuresf riskmanagementndregulation,ouldincreasedinancialegulationtthis imehwartr throughncreasedta-bility)nhance conomic rowth? e need far eeper nderstandingftherole of financialntermediationnpromotingrowtho answer hatquestion. ow financevolvesnthepostcrisis ears hould ring laritytomanyf oday's ncertainties.

III.B. Risky inancial ntermediationAsI notedarlier,he hape fthe istributionfthe xtremeegativetail iskwasunknowneforehe efaultfLehman. ince ail isk,nprin-ciple t east,sopen-ended,28here ill lways e some isk hat ank ap-ital annotover,ndhence ome, erhapsvenmany,ankswillfail.Butthat eednotbecome systemicroblemfequity apital nd iquidityrequirementsreraisedubstantiallynd significantart f n ntermedi-ary' debt akes he ormfmandatedontingentapital ondsseesectionIV.F). Still, herewillalways e thepossibility,oweveremote,f theprivateinancialntermediaryystemaltering,equiringovereignredittokeepvital ntermediationunctioning.26. The conomist,Number-Crunchersrunched,"ebruary3, 010,p.568.27. Householdetworthanbetakens a proxyorhe etworthf he conomyobemanagedt a fee.The ratio fthat etworth odisposable ersonalncomewaslargelyunchangedetween 952and1996.Since thent has beenvolatile, ith ecentuartersreturningotheong-termverage.28. Tail riskwould onvergeo zero nlyfrisk version ere obecome bsolute,nimpossibilityf ife stobe sustainedseenote 8).


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216 Brookingsapersn Economicctivity,pring01Central ankers ave ong een ware fthe otentialor breakdowninprivate inancial arkets.ndeed,ntheUnited tates s recentlys1991,ncontemplationfthe nthinkablend tthe rgingfthe ederalReserve oard fGovernors,ection 3-3 f he ederal eserve ctwasreconsiderednd amended y Congress. he section s revised rantsvirtuallynlimiteduthorityo theBoard o end n "unusual ndexigentcircumstances."Il .C TheHundred-YearloodAdecade go, ddressinghatssue, noted,There s a ... difficultroblemf riskmanagementhat entral ankers onfrontveryday,whether eexplicitlycknowledget or not:How much f theunderlyingiskn afinancial ystem houldbe shoulderedsolely] bybanks and other inancialnstitu-tions? . . [Central anks]have all chosen mplicitly,f not na more vert ashion,osetourcapitalandother eserve tandards orbanksto guard gainstoutcomes hatexclude hose nce or twice n a centuryrises hat hreatenhe tabilityf ourdomes-ticand nternationalinancialystems.I donotbelieve ny entral ank xplicitly akes his alculation. ut we have cho-sencapital tandardshatby anystretch f the maginationannotprotect gainst llpotentialdverse oss outcomes. here s implicitnthis xercise he dmissionhat,ncertain pisodes,problemst commercial anks andother inancialnstitutions,hentheirisk-managementystems rove nadequate, illbehandled ycentralanks.Atthesametime, ociety nthewhole hould equirehatwe set this arvery igh.Hundred-yearfloods omeonly nceevery undred ears. inancialnstitutionshould xpect olook to the entral ank nly nextremelyare ituations.Greenspan000a)At issue s whetherhecrisis hat rrived fewyears ater s that"hundred-yearlood." tbest, nce-in-a-centurybservationsield esultsthat re carcelyobust.utrecentvidenceuggestshatwhat appenedinthewake f he ehmanollapseslikelyhemost evere lobal inan-

cialcrisis ver. n theGreat epression,fcourse, he ollapse n eco-nomic utputndthe ise nunemploymentnddestitutionar xceededthe urrentnd,n the iew fmost, rospectiveuturetate fthe lobaleconomy. ndofcourse,hewidespreadank ailures arkedlyeducedshort-termreditvailability.ut hort-terminancial arketsontinuedtofunction.Financialrises re haracterizedy progressivenabilityofloat irstlong-termebt ndeventuallyhort-termndovernightebt s well.Long-termncertaintynd hereforeisk re lways reaterhan ear-termrisk,ndhence isk preadslmost lwaysncrease ith hematurityfthefinancialnstrumentnquestion.29hedepth f a financialrisis s

29. Yields on riskless ongermaturitiesan fall below short-termiskless ates ftightmoneypersuades nvestorshat uturenflation illbe less.


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ALAN GREENSPAN 217properly easuredythedegree fcollapse nthe vailabilityf short-term redit.Theevaporationfthe lobal upplyf hort-termredits ithinoursordays fthe ehman ailures, believe,withoutistoricalrecedent.run nmoneymarket utual unds, eretoforeerceivedo be closetoriskless, as underwaywithin ours fthe nnouncementf Lehman'sdefault.30ithin ays, hewithdrawalf trade reditet off spiral fglobal conomicontraction,nd he ederal eserve ad omove uicklytosupporthefailingommercialapermarket.ven the lmost acro-sanct,ullyollateralizedepurchasegreementarketncounteredevereandunprecedentedifficulties.One has todig very eep ntopeacetimeinancialistoryo uncoversimilarpisodes. hemarketor allmoney,hekey hort-terminancingvehicle fa centurygo, hut own t thepeakofthe1907panic, whenno callmoneywas offeredtall for neday ndthe bid]rate osefrom1to 125%" Homernd ylla1991, .340).Even ttheheightf he 929stockmarketrisis, he allmoneymarketunctioned,lthoughnnualinterestates id oar o20percent.n esser inancialrises,vailabilityffundsnthe ong-termarketisappeared,ut vernightndother hort-termmarketsontinuedofunction.The withdrawalfovernight oney epresentsinancialtringencytitsmaximum.nvestors illbewillingo end vernighteforehey eelsufficientlyrotectedy dequate apitaloreach ut ormore istant,ndhence iskier, aturities.TheevaporationnSeptember008of short-termredits as globaland all encompassing.ut t was thesameprocesswe hadpreviouslyobservedt a moremicroevel.31IV. RegulatoryReform

IVA. PrinciplesfReformGiven his pparentlynprecedentederiod fturmoil,ywhat tan-dard hould roposalsor eformfofficialupervisionndregulationejudged? know f no formfeconomicrganizationasedon a division30. HugoBnziger,MoneyMarket undsNeed New GlobalStandards,"inancialTimes, ovember,2009.Bnziger aschief isk fficert Deutsche ank tthe ime.31. As the redit fNewYorkCity, or xample,ecameuspectnthemid-1970s,hefirstailuref ssuancewasevidentn ong-termunicipalonds, ollowedyfailuresnprogressivelyhorter aturities,ntil ven vernightarketstartedocrumble. similarprogressioneduptotheMexican inancialrisis f1994-95.


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218 BrookingsapersnEconomicctivity,pring01of abor, romnfetteredaissez-faireooppressiveentrallanning,hathas succeedednachievingothmaximumustainableconomic rowthandpermanenttability.entral lanningertainlyailed,nd stronglydoubt hattabilitys achievablencapitalistconomies,ivenhatlways-turbulentompetitivearketsrecontinuouslyeing rawnoward,utneveruite chieving,quilibriumand hatt spreciselyhis rocesshatleads oeconomicrowth).People actingwithoutorethoughtannot e productivexceptbychance. dentificationf effectivennovations,ofnecessity,rationalact.Hence, egulation,y nhibitingrrationalehavior hen t can beidentified,an be stabilizing,s recent istoryas demonstrated.uttheres an nevitableost fregulationnterms feconomic rowthndstandardsf iving hen t mposesestraintseyond ontainingnproduc-tive ehavior.Regulationy tsnaturemposesestraintsncompetitivearkets.heelusive oint f balance etweenrowthndstabilityasalways eenpointf ontention,specially hen tcomes ofinancialegulation.Throughouthe ostwar earsntheUnited tates,with he xceptionof a limited umber f bankbailoutsContinentalllinois n 1984,forexample), rivate apitalproved dequate o covervirtuallyll provi-sionsforendingosses.As a consequence,herewas never definitivetest fwhat henonstitutedonventionalisdom,amely,hatnequitycapital-to-assetsatio f 6 to 10percentnaverage,he ange hat re-vailed etween 946 nd2003,wasadequateosupportheU.S.bankingsystem.Riskmanagers'ssumptionfthe ize ofthenegativeail fthe istri-bution f creditnd nterestate iskwas, s I noted arlier,fnecessityconjectural,nd forgenerationse never ad to test hose onjectures.Most f he hape f he istributionfperceivediskwasthoroughlyoc-umentedn theprecrisisears,s "moderate"inancialrises ndeupho-rias raced ut heirelevantartsf he urve. ut incemoderninancialdatacompilationegan,wehad never ada "hundred-yearlood" hatexposedhe ullntensityfnegativeail isk.Riskmanagers,fcourse, newnearlier ecades hatnassumptionofnormalityn thedistributionfriskwas unrealistic,utas a firstapproximationhatgreatly acilitatedalculation,t prevailed.Themathematicsmplied yfat ailswas alsowellunderstood,ut urnum-bercrunchingapabilitiesellfar hort fmakingherequiredalcu-lations oguideactions, xcept t prohibitiveost.That s no longerthe ase.


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ALANGREENSPAN 219Clearly hatweexperiencedntheweeks ollowinghe ehman efaultisexactlyhe ype fmarketeizure hat ail isk onjectureassupposedtocapture,nddidnot.Having xperiencedehman,iskmanagers illbefarmore autiousnevaluatingutureisk at east or while.Manynvestmentirmsre onstructingrobabilityistributionsfout-comes mploying,s thenegativeail, atabased n the xperiencefthelast years. singMonte arlo imulationsrotherechniques,hey aveconcluded, otunexpectedly,hat financial risis s severe s the nethat ollowed heLehman efault ouldhavebeenpredictedooccur armore ften hanndicatedymodelsnwhich isk sdistributedormally.Suchevidence uggestsheonset f a "hundred-yearlood" omewhatmore ften han nce na century.Indeed,he ftermathf he ehman risis raced ut startlinglyargernegativeail than lmost nybody adearliermagined. t leastpartlyresponsible ayhavebeen thefailure friskmanagersofully nder-standhempactfthe mergencef hadow anking,developmenthatincreasedinancialnnovationut, s a result,lso ncreasedhe evelofrisk. headded iskwasnot ompensatedyhigherapital.When isk remiumsre owover protractederiod,s theywere, orexample,rom993 o1998 ndfrom003to2007, nvestors' illingnesstobidfor lltypes ffinancialssets, speciallyhehigh-riskranchesfcollateralizedebtobligations,reates n illusion fpermanentarketliquidityhatnthe atestpisodeurnedut obe ntoxicating.t ed everalmajornvestmentanks o ttemptoweatherhe inancialtorm ithnlya thin eneer ftangibleapital.Themost ressingeform,nmyudgment,nthe ftermathf he risisis tofix he evelofregulatoryisk-adjustedapital,iquidity,ndcollat-eral tandardsequiredycounterparties.rivatemarketarticipantsrenowrequiringconomicapitalndbalance heetiquidityell nexcessoftheyet-to-be-amendedasel II requirements.heshadow anks hatsurvivedhe risis renowhaving omeet ignificantlyighter arketstandards,ith espectocapital,iquidity,ndcollateral,han xistedbefore he risis. hese remajor hangeshat eed obereflectednthenew setofregulatoryequirementsndstandardsurrentlyndergoingglobal eview.Onemajor allout fthe risiss a marked ise nthedegree fmoralhazardsee note 1),which equireshat ll financialntermediariesesubjectomaximumeverageatios. hese atios,swith llrisk-adjustedcapitaldequacymeasures,eed obebased nmore ealisticisk djust-mentactorsppliedotheirssets nd nthe roportionf heiriabilities


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220 Brookingsapersn Economicctivity,pring01funded ithvernightrotherhort-termebt. recrisisegulatoryapitalrequirements,lthoughasedon decades fexperience,ere learlyoolax: for xample, hey rroneouslyesignated oolsofself-amortizinghomemortgagessamonghe afest fprivatenstruments.nd surpris-inglyndunfortunatelyarge roportionf nvestmentortfolioecisionswere, y aw,accorded safeharbor"tatusftheydhered o the reditriskudgmentsorrather, isjudgments)f he reditatinggencies.To ensure hat inancialntermediariesaveadequate ash to meetongoingommitmentsn theevent f a shutdownnexternalunding,internationalankiquidityegulationhouldmatch he ighteninglreadyevidentnprivateiskmanagementaradigmsBaselCommitteen Bank-ingSupervision009).Collateral asshown tself articularlyubjectorapid ecapture.ear Stearns adnearly20billionnpledgeableiquidfundsweek eforet ollapsed.Morgan tanleyostmore han half ril-liondollars fpledgeableollateraluringheheightf the risis.n theUnitedtates,o ower he isk f "run nthe roker,"he mountf us-tomerssetscollateral)eld ybroker-dealershat annot ecommingledwith heir wn assetsneedsto be increased. hatwoulddecrease heamountffunds hat an "run." owever,uch ctionmust e measuredandcoordinatedith ther lobal egulatorso avoid egulatoryrbitrage(seeFrenchndothersorthcoming).Unaffiliatededge unds aveweatheredhe risis as extremereal-life tress est s one canconstructwithoutaxpayerssistancer, s Inoted arlier, efault. lthoughedge undsreonly ightlyegulated,much f theireveraged undingomesfrommoreheavily egulatedbanks.Moreover,s SebastianMallaby2010)writes,Mosthedge undsmakemoney ydrivingricesway romxtremesnd owardheir atio-nal level." n so doing, hey upplymuch-needediquidityofinancialmarkets hen therompetitorsavewithdrawn.egulationshatnhibitthe bilityfhedge unds osupplyuch ervicesre ounterproductive.Capital,iquidity,nd ollateral,nmy xperience,ddresslmostll ofthe inancialegulatorytructurehortcomingsxposed y he nset f hecrisis.nretrospect,here astobe a levelofcapitalhatwouldhavepre-vented he ailuref, or xample, earStearnsndLehman rothers.Ifnot10percent,hink0percent.) oreover,enericapital asthe egu-latorydvantagefnothavingoforecasthich articularinancialrod-ucts re bout o turnoxic. ertainlynvestorsidnot oreseehe utureofsubprimeecuritiesrthemyriadther roken roducts. dequatecapital liminatesheneedfor n unachievablepecificitynregulatoryfineuning.


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ALANGREENSPAN 221The erry-builtegulatorytructurehat asevolved ver he ecadesntheUnited tates asbecomemuch oocomplex. olicymakersailed orecognize, uringhedebates hat edtolegislationesultingn a badlyneeded pening poffinancialompetitiontheGramm-Leach-Blileyctof1999), hatncreasedompetition,speciallyhroughhadow anking,also ncreasedegativeailrisk.And ncreasedegativeailrisk ecessi-tates igherapital equirements.IV.B.Upward evisionsfBankEconomicapitalHowmuchapitalscurrentlyeing equiredffinancialnstitutionsytheirounterpartiesill tronglynfluencehe pcomingevisionsnreg-ulatoryapital equirements.t s too oon o havedefinitivenswers. utvery ough pproximationsorU.S. commercialanks an be inferredfromhe esponsefbank reditefaultwapsCDSs), a measure fbankinsolvencyisk, o postcrisisvents.32 ovementsn the CDS marketshould lsogiveus somedirectnsightntowhen hebankingystemsperceivedohave vercomehemarket'sear fwidespreadnsolvencyandbeyondhat,owhenmarketserceivehat ankswillfeel ufficientlysecure oreturnothe reeendingfthe recrisisears.Startingate n2008 and cceleratingnto he irstuarterf2009, heU.S. Treasury,hroughtsTroubled ssetRelief rogramTARP), dded$250billion obank quity,he quivalentf dding pproximatelyper-centage ointso the quity apital-to-assetsatio. ts mpactwas mpor-tant nd mmediate.As the inancialrisis ookhold nddeepened,he nweightedveragepriceof5-year DSs of sixmajorU.S. banks Bank ofAmerica, P

Morgan, itigroup,oldmanachs,WellsFargo,ndMorgan tanleyrosefrom 7 basispointsnearly 007 for -yearontracts,he verageannual rice f nsurance as 0. 17percentfthenotionalmount ftheunderlyingwap nstruments)o170 basispointsustbeforeheLehmandefault n September5,2008.In responseo theLehman efault,he5-yearDS average rice ose omore han00 basispoints yOctober.On thedaythe TARP was announcedOctober 4), thepricefell toapproximately00 basispoints,ressentiallyyhalf figure). That2-percentage-pointddition o the banks' bookequity apital-to-assets32. The sellerofa CDS insures heholder f a particularebt nstrumentgainst oss inthe vent f default. ricesof CDSs are thus hemost ensitivemeasure ftheprobabilityfbankdefault.


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222 Brookingsapers n Economic ctivity,pring 010Figure7. PriceofFive-Year reditDefaultSwaps3Basispointsb400 - I350 I l|300- i jyyi250 K fl. VVfl 'Aloo J 'f V^50- y'y

i i 12007 2008 2009 2010Source:Author'salculations;loomberg.a. Unweightedverage rices f CDSs issuedbyBankofAmerica, itigroup,oldman achs,JPMorgan,WellsFargo, ndMorgan tanley.b. Hundredthsf percentf thenotional alueof the nderlyingwapcontract.

ratio eversedoughlyalf he risis urgen theprice f5-year DSsimpliesnoverall dditional-percentage-pointise from 0percentnmid-2007o14percent)n the quityapital ushionequiredymarketparticipantsofundhe iabilitiesfbanks. hat, f ourse,ssumesinearextrapolation,n admittedlyerculeanssumption,nd,ofcourse, re-sumes hatheprobabilityfa TARP beforeheLehman efault as deminimis.heabruptnessfthemarketeactionotheTARP announce-mentppearsoconfirmuch presumption,owever.Currentook quity-to-assetsatiosrestill ar rom4percent.heaverage atio or ommercialanksas reportedytheFederal epositInsuranceorporation,DIC) was10.9percentn March 1,2010, om-paredwith 0.1percentn mid-2007. utunacknowledgedoanlosseswere stimatedythe MF lastOctobertheyrenow ess)to be inthehundredsfbillionsfdollars. rendsnrelevantiquidityre essreadilymeasuredut re ssumedoparallelhangesncapital.That anks till avemore quityapital oadd s also ndicatedy hefacthathe -yearDS price fMarch 1,2010 and ince) emainsver100basispoints,till ignificantlylevatedelativeo the17 basispointsthat revailedn early 007,when10 percentapitalwas apparently


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ALANGREENSPAN 223Figure8. Equity-to-Assetsatios at FDIC-lnsuredCommercialBanks,2004-09Percent20 - Atmarketvalue^---^^18 ^ ^ ^-^ ^^^^16 - '14 - '.

At ook alue ' /- ~""10 ^-A '"" /T i i i i i2005 2006 2007 2008 2009

Source:Federal eposit nsuranceorporation.a. Averages onstructedrom loombergataonthe ook nd marketquity alueof24 leading anks.

enoughovirtuallyliminatehe hreatfdefaultnd nduceoanofficersto end reely.There s little oubt hat heTARP's cash njection arkedlyeducedthe ear fbank efaulthrougharly 009. Moredifficulto udge s theimpact n bankCDSs ofthedramaticncreasenbank quitytmarketvalue elativeobank ssets tmarketalue. hat atio ose .5percentagepointsromhe ndofMarch 009tothe ndofDecember,rom .4per-cent o 11.9percentfigure).There anbe ittle oubthat his as mate-riallyncreasedhe olvencyfbanks,lthoughpparentlyesseffectively,dollar or ollar,han hemore ermanenthangenbook-valuequity.33Much fthe epaymentfTARP nvestmentso theU.S. Treasury asdoubtlessinancedynew quityssuance,madepossible y more hanone-half-trillionollarncreasenU.S. commercialank quityt marketvalue, ndbyborrowingsademuchasierand heaper)y hencreasedequity ufferngenderedy gains n market-valuedankequity. heparcelingfrelativeontributionsf he ARP nd f apital ains obanksolvencyndwillingnesso endmaynot efullylear ven nretrospect.33. Betweenhe ndofMarchndthe ndofDecember009, he verage DS pricefell rom69 to104basispoints, hile he atio f hemarketalue f quityothemarketvalue f ssets ose 50 basispoints.


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224 Brookingsapers n Economic ctivity,pring 010Table 2. CDS and LIBOR-OISSpreadsat VariousMaturities, eptember2009 andMarch 2010Basis pointsMaturity September 5,2009 March31, 2010CDS10years 129 1115 years 125 1073 years 129 881year 123 61LIBOR-OIS3 months 12 111month 7 8Sources: ritishankers' ssociation,loomberg,euters,ndHaverAnalytics.

The TARP notonly nsertedapital ut lso inducedmarketartici-pants o infer hat heU.S. Treasury ould, t leastfor while, tandbehindhe iabilitiesf thebankingystem.hismay xplain hediver-gence incemid-September009between hort-term1- and3-month)LIBOR-OISspreadsanalternativeo CDS spreadss a short-termea-sure fthe ikelihoodf bankdefault)nd 5- and10-yearDS spreads.Short-termIBOR-OISspreads adreturnedotheirrecrisisevelby heendofSeptember009.Long-maturityDS pricesreonly artwayack(table ). The1-yearIBOR-OISspread allsn between. learly,ithermarketsrediscountingome f he ank apitalushiontmarketalueand 10years ence, wing o thevolatilityfstock rices,nd/orheyquestionhe olitical illingness,rability,ftheU.S. government,ftermarketseturnonormal,o nitiatenotherank ailout.34Given heforegoinget offragilessumptionsndconclusionsandtheyre ll wehave), wouldudge hat egulatoryquityapital equire-mentsn the ndwillbe seen o haverisen romhe10percent recrisislevel interms f bookvalue) o 13or14percenty2012, nd iquidityand ollateralequirementsill oughenommensurately.

IV.C. WhatRegulation anDoWhat,nmy xperience,upervisionnd xaminationan doas a back-uptocapital equirementsndcounterpartyurveillances promulgate

34. As fear fcontagion rom heEuropean overeign ebtcrisismountednthe pringof2010,CDS and LIBOR-OIS spreads osemarkedly.


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ALAN GREENSPAN 225rules hat repreventativend do notrequire nticipatingn uncertainfuture.upervision- can audit nd nforceapital nd iquidityequirements35- can require hatfinancial nstitutionsssue somedebt thatwillbecome quityhould quity apital ecomempairedseesectionV.F)- can, ndhas,put imits rprohibitionsn certainypes f concen-trated ankending- canprohibitomplexffiliatendsubsidiarytructureshose olepurposestax voidance rregulatoryrbitrage- can nhibithe econsolidationf ffiliatesreviouslyold o nvestors,especiallytructurednvestmentehiclesSIVs)36- canrequirelivingwills" n which inancialntermediariesndicate,onanongoingasis,how heyan beliquidatedxpeditiouslyithmini-mummpactncounterpartiesndmarkets.

IV.D. SomeLessonsfRegulatoryapitalHistoryInthe ate19th entury,.S. banks equiredquity apital f 30 per-cent fassets o attracthe iabilitiesequiredo fundheir ssets.nthepre-CivilWarperiod,hat igureopped 0percentfigure). Given herudimentaryature f 19th-centuryaymentystemsndthepoorgeo-graphicalistributionf reservesnwhatwas then nagriculturalcon-omy, ompetitionorbank reditwas largelyocal. t enablednationalbanks n average o obtain eturnsnet ncome) n their ssets f wellover 00basispointsn the ate1880s, ndprobably ore han 00basispointsnthe1870s compared ith 0 basispoints centuryater).Increasingfficiencyffinancialntermediation,wingoconsolidationof reserves nd mprovementsnpaymentystems,xertedompetitivepressurenprofitpreadsonarrownd llowed apital-to-assetsatios odecline.nmarkedontrast,he nnual verage et ncome ate f returnonequity as mazinglytable,arelyallingutsiderangef5 to 10per-cent,measurednnually,uringhe enturyrom 869 o1966 figure0).Thatmeant hat et ncome s a percentagef assets ndthedegree fleverage ere pproximatelynverselyroportionaluringhatentury.

35. Increasedapital equirementsangoa longway owardontainingarge ompen-sation ackages. herecentigher rofitsillbeneeded o fulfillhe apital equirements,especiallyfglobal ompetitorsave imilarapital equirements.36. When, uringhe risis,uch ssets ppearedbout ofail, ponsoringompanies,fearfulfreputationiska new nsight?),eabsorbedegally etachedffiliatestsubse-quent reatoss.


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226 Brookingsapersn Economicctivity,pring01Figure9. Ratio ofEquityCapitalto Assets n theBanking ector,1834-2009Percent

hj' State banks

i A/^'f^ National banks30 - ' 'A-''''20 - V.^

vj N^ H'*-. All commercialbanks10 - t, ,.


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ALANGREENSPAN 227Rates freturnnassets nd quitydespitehe eclinen everagehatresulted rom ising aselcapital equirements)ovedmodestlyigherduring 966-82owing o a rapid xpansionnnoninterestncome, orexampleromiduciaryctivities,ervicehargesndfees, nd ecuritiza-tionsand ater romxpansionntonvestmentankingndbrokerage).Noninterestncome ose ignificantlyetween982 nd2006, ncreasingnet ncome onearly 5percentfequity,s a consequencef a markedincreasen thescopeofbankpowers.That ncreasenpart eflectedthe mergencenApril1987 of court-sanctionednd FederalReserve-regulatedSection 0" nvestmentankingffiliatesfbank oldingom-panies.37hetransferf uch usinesssclearly isible nthe ccelerationofgross ncome riginatingn commercialanking elative o thatninvestmentankingtartingn2000 Bureau fEconomic nalysis).38I tentativelyoncludehat hehistoricalelativetabilityf verage etincome-to-equityatios ating ackto thepost-CivilWaryears eflectsanunderlyingx antemarket-determinedate freturnn ntermediation.In summary,hecrisiswill eave in itswake a significantlyigher

capital-to-assetsatio equirement,oth conomic ndregulatory,hatmust e reachedf ntermediationstobe restoredo he ointwhere anksand therinancialnstitutionsre onfidenthey ave sufficientlyecurecapitalushion o end reely.IV.E.LimitsoRegulatoryapitalRequirementsIfweaccept s a benchmarkhe emarkabletabilityf he atio fbanknet ncome oequity apitalrangingetween and 15percent)hat asprevailed, ith are xceptions,ince he ndoftheCivilWar figure0),wecan nferhehighestverage atio fcapital o assets hat bankingsystemantolerate efore significantumberfbanks rerequiredoraise heirmargin,r hrinkheirize, rboth. assume 5percentnnual37. Thisdevelopmenteanthat he epeal,nder heGramm-Leach-Blileyct, f he1933Glass-Steagallct,which ad eparatedommercialnd nvestmentanking,hangedveryittle.rom he nactmentfGramm-Leach-Blileyn 1999totheFederalReserve'sacceptancefGoldmanachs ndMorgantanleys financialervicesoldingompaniesat theheightfthe risis, oapplicationsoemployhe reaterowerswere orthcoming.

That orbearancepparentlyeflecteddesire ostay lear f he ederal eserve's egula-torymbrace.38. Rates freturnrashed uringhe irst alf f2009,with eclinesmatchedonanannual asis)onlybythose nthedepressionears 932-34.Both asesreflectedraresharp reakoutrom hehistoricalange, esultingostlyromargewrite-offsnprevi-ously xtendedoans.


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228 Brookingsapersn Economicctivity,pring01average ate freturnthe ower imit fthe ange) s a proxyor he ulldistributionfthe housandsf banks hatwouldmakeupthe verage.Accordingly,or his xerciset semployeds the x ante ompetitivelyrequiredverageminimumeturnn intermediation.assume s a firstapproximationhat ll variablesre ndependent.fso,thehighestatio fcapital o assets hat heU.S. bankingysteman toleratend till upplythenonfinancialectorwith dequate inancialervice apacityan beinferredromhe ollowingdentity:

K _ n A~c~~x~c'where is net ncome, is equity apital,ndA is total ssets.fn/C0.05, hen = 20x -.A AItcanbe shownhat /A (rrrp- k)w n-e-a, where rs the ateof nteresteceivedromarningssets, ps thenterestate aidon earn-ing ssets, s the atio f osses oearningssets,w s the atio f arningassets ototal ssets, s the atio fnoninterestncomeoassets, is theratio fnoninterestxpenseo total ssets,nd is the atio ftaxes ndminor therdjustmentsototal ssets.As canbeseenfromable ,virtu-ally llofthe ise nn/Andn/C orU.S. banks s a groupince1982 sdue othemarkedise nnoninterestncome.In theyearsmmediatelyeforeheonset f the risis, IAaveraged0.012,andthereforehe nferred aximumverage egulatoryapital,C/A,s a firstpproximation,as 0.24.A ratehigherhan .24,all elseequal,39 ould ut he verage ate freturnnequity elow he ritical5 percentevel. fn/Awere o revertackto itsaverage or1950-75(0.0074), hen IA= 0.15,marginallybove he 2to14percentresumedmarket-determinedapital equirementhatwould nduce anks o lendfreely.These alculations,s I noted,ssume staticmodeln whichll vari-ablesare ndependent.utclearlyherequiredate freturnnequitycannot e independentf thecapital-to-assetsatio. ncreased apital

39. I do notdenythat ll else is notequal, and hencesuchconclusions remore llus-trative han xplanatory. dynamicmodelis beyondthescope ofthispaper.Net interestincome has enough of a history o effectivelymodel,butnoninterestncome arguablydoes not.


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230 BrookingsapersnEconomicctivity,pring01reduceshe isk f he alance heet ndhencewill ttractquitynvestorsdespite lower ate freturn.his mplieshatwing othe ecentise nTil y he ctual egulatoryapital eiling an thus eadilyxceed he ta-ticceiling fCIA= 0.24. In anyevent,ncreasedapital equirementswillsurelyeduce hemarginalendinghat ccurrednrecent ecadesowing othe ailureofullyund ailrisk.Much fthatmarginalendingwasineffecteing ubsidizedy taxpayers.hat ubsidy ecame ullyfundedn2008by overeignredit. emovinghe ubsidyhroughighercapital equirementsill,ofcourse, hrink inancialntermediaryal-ance sheets.Muchof this ending asevidently onproductive,nd tsloss s not pt obe a problemor ur omplexconomy's equiredevelof ntermediation.

IV.F. TooBigtoFailBeyond ignificantlyncreasedapital equirementss thenecessityof ddressinghe roblemf omefinancialirmseing toobigtofail"or,more ppropriately,too nterconnectedo be liquidateduickly."Theproductivemploymentf thenation's carce avings threatenedwhen inancialirms t the dgeoffailure resupported ith axpayerfunds nddesignateds systemicallymportantnstitutions.agreewithGary tern,heformerresidentftheFederalReserveBankofMin-neapolis,whohas ongheldthat creditors ill continueounderpricethe isk-takingfthese inancialnstitutions,verfundhem,ndfail oprovideffective arketiscipline.acingprices hat re too ow, ys-temicallymportantirms ill ake n toomuch isk"Stern 009,p.56).Thesefirms bsorb carce avings hat eed to be investedncutting-edgetechnologies,foutput erhour nd tandardsf iving reto con-tinue orise.After allowingn the ackwatersfeconomicsoryears,toobigtofail"hasarisen s a major, isible hreatoeconomic rowth.tfinallybecame n urgent roblemwhenFannieMae andFreddieMac wereplacednto onservatorshipnSeptember,2008.Beforehen, .S. pol-icymakerswith ingersrossed) ouldpoint o thefact hat annie ndFreddie,ystatute, erenotbacked ythe full aith ndcredit f theU.S. government."arket articipantsowever, id notbelievethedenial,nd heyonsistentlyffordedannie ndFreddie special reditsubsidyPassmore,herlund,ndBurgess 005).OnSeptember,2008,marketarticipantsere inallyindicated.FannieMae andFreddieMac need o be split p nto mallerompa-nies,noneof them toobigtofail," ndthen econstructednto tand-


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ALANGREENSPAN 231alone securitizers.heirfutureolvencyandthethreat fcontagion)requireshat heseGSEs beprohibitedromccumulatingarge ortfoliosof assets hat dd no useful acking o theprocess f securitizationrthemortgage arkets ore enerally.hoseportfolios'olepurposestoprofitrom he ubsidyhatmarketarticipantsranto theseGSEs(Greenspan004b).Onehighly isturbingonsequencef the oo-big-to-failroblemhathas mergedince he eptember008federalakeoverfFannieMae andFreddieMac is thatmarketlayers illnowbelieve hatveryignificantfinancialnstitution,hould he ccasion rise,s subject obeing ailedoutwith axpayerunds.t is going obe very ifficultor egislatorsopersuadeuturenvestorstherwise.Businesses hatre ubjectobeing ailed uthave ompetitivearketandcost-of-capitaldvantages,utnotnecessarilyfficiencydvantages,over irms ot houghtobesystemicallymportant.oryearshe ederalReserve asconcernedbout he ver-growingizeofour argestinancialinstitutions.ederalReserve esearch adbeenunable o findconomiesofscale nbanking eyond modest ize (BergerndHumphrey994,p. 7; see alsoBerger 994).A decade go, citinguch vidence, notedthatmegabankseing ormedy growthndconsolidationre ncreas-ingly omplex ntitieshat reate hepotentialorunusuallyarge ys-temic isksnthenationalnd nternationalconomyhould hey ail"(Greenspan999).Regrettably,e did ittle oaddress he roblem.How todeal with ystemicallyhreateningnstitutionss among hemajor egulatoryroblemsorwhich here renogoodsolutions.arlyresolutionfbank roblemsnder he ederal epositnsuranceorpo-rationmprovementct of 1991 (FDICIA) appeared o haveworkedwith maller anks uring eriods fgeneral rosperity.utthenotionthat isks anbe identifiedna sufficientlyimelymanneroenable heliquidationf a large ailing ankwithminimumossproved ntenableduringhiscrisis, ndI suspectwillproveuntenablen futurerisesas well.40The solutionhat,nmyudgment,as at east reasonablehance freversinghe xtraordinarilyarge moral azard"hat asarisen ver he

40. TheFDIC has xperiencedargeosses n he alue f ssets akenvernresolutionduringhe ast years.


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232 Brookingsapersn Economicctivity,pring01pastyear nd more41s torequire anks ndpossiblyll financialnter-mediaries o issuecontingentapitalbonds, hat s, debt hat s auto-maticallyonvertedoequitywhen quity apital allsbelowa certainthreshold.uchdebtwill, f ourse, e more ostlyn ssuancehan im-pledebentures.However,houldontingentapital onds rovensufficient,eshouldallow argenstitutionsofail nd, fassessed y regulatorss too nter-connectedo iquidate uickly,e takennto special ankruptcyacility,whereuponhe egulatorouldbegrantedccess totaxpayerunds or"debtor-in-possessioninancing"f thefailed nstitution.ts creditors(when quityswholly iped ut)would e subjectostatutorilyefinedprinciplesfdiscountsrom ar "haircuts"),nd the nstitutionouldthen erequiredosplit p nto eparatenits, one fwhich hould e ofa sizethats toobig ofail. hewhole rocesswould e administeredypanel fudges xpertnfinance.I assume hat ome f he ewlyreated irms ould urvive,nd thersfail. f, fter fixedhort eriod ftime, o viable xitfrom hebank-

41. Moralhazard, nan economic ontext,riseswhen n institutions notdebitedwiththefull osts of tsactions nd therefore ill tend, npart t least, o actcontraryo how itwould act were it pressured olelyby unfetteredompetition, here the externalitiesfpotential ailout costs are fully nternalized y competitors. he institutionccordinglyrequires ther arties o suffer ome of the osts of tsactions.An interestingpeculation s whether he crisis that merged nAugust2007 from heextraordinaryeverage as much s 20 to 30 times angible apital)taken nbyU.S. invest-mentbanks would haveoccurredhad these firms emained hepartnershipshat heywereupto a quarter entury go. The 1970ruling hat llowedbroker-dealersoincorporatendgain permanent apitalseemed sensibleat the time.Nonetheless, s partnerships,ehmanBrothers nd Bear Stearns lmostsurelywould not have departed rom heirhistoricallylow leverage.Before ncorporation,earful f the ointand several iability o whichgen-eral partnershipsre subject, hoseentities hiedaway from irtuallynyriskthey ouldavoid. Their oreunderwritingf new ssuesrarely xposedthem ormore han fewdays.To be sure,the seniorofficers f Bear Stearns nd LehmanBrothers ost hundreds fmillions f dollarsfrom hecollapse of their tocks.Butnone,tomyknowledge,has filedforpersonalbankruptcy,nd their emainingwealth llows them o maintainmuchof theirprevious tandard f iving.Replicatinghe ncentive tructurefpartnershipshouldbe a goalwhenever easible nfuture eform. hatgoal will doubtlessnotbe alwaysmetgiventhat he orporate tructureis seen as required oraisecapitalon a scale perceived s necessaryntoday's globalmar-ket.To eliminatemoralhazard, t should notbe necessary o followHughMcCulloch,ourfirst omptrollerf theCurrencyn 1863,who went omewhat ver theedge inproposingthat he NationalBank Act "be so amendedthat he failure f a nationalbankbe declaredprima aciefraudulent,ndthat heofficersnddirectors,nderwhoseadministrationuchinsolvency halloccur,be madepersonallyiablefor hedebtsofthebank, nd be punishedcriminally,nless t shallappear,upon nvestigation,hatts affairswerehonestly dminis-tered."Under uch a regime,moralhazardsurelywouldnotexist.


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ALAN GREENSPAN 233ruptcyppearsvailable,he inancialntermediaryhould e iquidatedsexpeditiouslys feasible.

IV.G.RegulationsmbodyingForecast ailwith egularityThecrisis asdemonstratedhat eitherank egulatorsor nyonelsecanconsistentlyndaccuratelyorecast hether,or xample, ubprimemortgages ill turn oxic, r to whatdegree, r whether particulartranchef collateralizedebt bligationilldefault,r venwhetherhefinancialystems a wholewill eizeup.A large ractionf uch ifficultforecasts ill nvariablyeprovedwrong. egulatorsanreadilydentifyunderpricedisk ndthe xistence fbubbles, utmostmportant,heycannot,xcept y hance,ffectivelyime he nset f risis.42his houldnot ome s a surprise.Afinancialrisis sdefineds anabruptnd harp eclinenthe rice fincome-producingssets, suallynduced ya dramaticpikenthedis-count ate nexpectedncome lows s marketarticipantswing romeuphoriao fear.mplicitnany harp rice hanges that t s unantici-pated ythemassof marketarticipants,orwere totherwise,hepriceimbalances ould avebeen rbitragedway.Indeed,or earseading ptoAugust007, twaswidelyxpectedhatthe recipitatingvent f he next"risiswould ea sharp all nthe ol-lar, s theU.S. currentccount eficit,tartingn2002,had ncreasedra-matically.he dollar ccordinglyameunder eavy elling ressure.herise nthe uro-dollarxchange ate romround .10 nthe pringf2003to1 30 atthe nd f2004appearsohavegraduallyrbitragedwaythepresumedollar riggerfthe next" risis. heU.S. currentccountdeficitidnot lay prominentirectole nthe imingf he 007crisis,althoughecause f hat,tmaynthenext.Intheyearshead, orecastersillreadilydentifyisks hat reunder-priced or at leastpriced t less than heir istoricalverage.Butininstancefternstance,s I notedarlier,isk asremainednderpricedoryears. orecasterss a groupwillalmost ertainly iss he nset fthenext inancialrisis,s they ave o oftennthepast, nd presumenynewly esignatedsystemicegulator"ill lso.Many nalystsrguehat orecastings not equired. systemicegula-tor, heyhold, ouldeffectivelyine-tuneapital ndliquidityequire-

42. There asbeen onfusionnthessue, owhichmay avebeen party. ith areexceptionsthasprovedmpossibleo dentifyhe ointtwhich bubblewillburst,ut tsemergencenddevelopmentrevisible ncreditpreads.


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234 BrookingsapersnEconomicctivity,pring01ments omatch he tage f thebusinessycle. roperlyalibrated,uchrequirementsresumablyouldbe effectivenassuagingmbalances.utcycles renot niform.nreal ime, here e are nthe ycles a forecast,and ycles ary. or xample,he owof he nemploymentate tcyclicalpeaks as identifiedytheNational ureau fEconomic esearch)ince1948hasranged etween .6 and 7.2 percent.Wouldwe have udgedturnnthe usinessyclewhen, or xample,he nemploymentate oseto5.8percentnApril 995, pfrom .4percentnMarch?nthe vent,theunemploymentate soon reversedtself nd continuedo fall for5 more ears.It sbest ofix egulatoryarametersnd etmonetaryolicy arryhediscretionaryoad. The FederalReservewilltightenf t observesisingeuphoriahatignalsmountingnflationaryressuresas itdid nFebruary1994 ndJune004)or frisk remiumsall nordinately.Moreover,iscretionaryegulatoryuleswould aiseuncertaintieshatcouldundesirablyurb nvestment.hus, nthe urrentnvironmentfcomplexity,see no ready lternativeo significantlyncreasingandfixing regulatoryapital equirementsnd iquidityndbeefingp ndi-vidual anks' ounterpartyisk urveillance.The Federal eserve as been oncernedoryears bout he bilityfregulatoryupervisorsnd examinerso foreseemergingroblemshathave eluded nternalank uditingystemsnd ndependentuditors.remarkedn2000before heAmericanankers ssociation,Inrecentyears apidlyhangingechnologyasbegun o renderbsoletemuch fthe ank xaminationegimestablishednearlierecades. ankregula-torsreperforceeing ressedodependncreasinglyngreaterndmoresophisticatedrivatemarketiscipline,he tillmost ffectiveorm fregulation.ndeed,hese evelopmentseinforcehe ruthfa key essonfromurbanking istorythat rivateounterpartyupervisionemainsthefirstineofregulatoryefense"Greenspan000b).Regrettably,hatfirstine fdefenseailed.A centurygo,examinersouldappraisendividualoansand udgetheiroundness.43ut ntoday's lobal endingnvironment,owdoesaU.S. bank xaminerudgethe reditualityf, ay, loan toa Russianbank, ndhence fthe oanportfoliof that ank?That n turnwould

43. In 1903,O. Henry W. S. Porter),whohad morethan passingrelationship ithbanking henanigans,wrote n "A Call Loan" about a fictional ankexaminerfrom heOffice f theComptrollerftheCurrencywhowas obsessedwith hecollateralbacking$10,000loan. Suchdetailed crutinys exceptionallyare ntoday's arger anks.


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ALAN GREENSPAN 235require ettingheRussian ank'scounterpartiesnd those ounterpar-ties'counterparties,llto udgethe oundnessf a single inancialrans-action.n short, bank xaminerannot,nd neitherana credit atingagency.Howdeep nto hemyriadayers fexaminations enough orcertification?Thecomplexityf our financialystemnoperationpawns,n anygivenweek,many lleged endingrises hat,n the vent, ever appen,and nnumerablellegationsf financialmisconduct.o examine achsuch ossibilitytthe evel fdetail ecessaryoreachmeaningfulonclu-sionswould equiren examinationorcemanymultiplesargerhan hosenow nplace nany fourbankingegulatorygencies. rguably,tsuchlevelsofexamination,ound ank endingnd tsnecessaryisk akingwould e mpeded.The FederalReserve nd other egulators ere, ndare,thereforerequiredoguesswhich f the ssertionsfpending roblemsrallega-tionsfmisconducthould esubjectofull crutinyy regulatoryork-forcewithnecessarilyimited xaminationapacity. ut thisdilemmameans hatnthe ftermathf n actual risis, ewillfind ighlyompe-tent xaminersailingohave potted BernieMadoff. ederalReservesupervisionnd valuations as good s itgets, ven onsideringhe ail-ures fpastyears. anks tillhave ittle hoice ut orely pon ounter-partyurveillances their irstine f risis efense.44V. The Role ofMonetaryPolicy

VA. Monetary olicy nd Home PriceBubblesTheglobalhome rice ubble fthe astdecadewas a consequenceflower nterestates, ut t was long-termnterestates hat alvanizedhome sset rices, ot he vernightates fcentralanks,s hasbecomethe eemingonventionalisdom.n theUnited tates,hebubblewasdriven ythedeclineninterestates n fixed-rateong-term ortgageloans,45elativeotheirmid-2000eak, monthseforehe OMCbeganeasing he ederal unds ate nJanuary001.

44. Havingerved nJPMorgan'soard or decadeustbefore y oininghe ederalReserve,had nextendednsightnto he ffectivenessfthatompany'sounterpartyur-veillancefCiticorp,ank fAmerica, ellsFargo,ndothers,elativeothe egulatorysurveillanceyFederal eserve anks.45. Theirveragematuritys more han 6yearsFederal ousing inance gency).


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236 Brookingsapersn Economicctivity,pring01Between 002 and2005, hemonthlyixed-rateortgageate loselytrackedhangesnU.S. homeprices 1monthsarlieras measuredythe 0-city&P/Case-Shillerome ricendex), ith nadjusted2 n theregressionf 0.500 and a f-statisticf -6.93. Thus ong-term ortgagerateswere far etterndicatorfhome riceshan he ederal unds ate:a regressionfhome ricesnthe atterxhibitsnadjusted2 f0.205 nda -statisticf 3.62withnlyn8-monthead.46egressingome rices nboth he ixed-rateortgagewithn11 monthead) nd he ederal undsratewith n 8-monthead)yields highlyignificant-statisticor hemortgageate f 5.20,but n nsignificant-statisticor he ederal undsrate f 0.51.This hould ot ome s a surprise.fterll,theprices f ong-livedassets ave lways eendeterminedydiscountinghe low f ncomeorimputedervices)singnterestates n assets f omparable aturity.oone, omyknowledge,mploys vernightnterestates such s the ed-eral unds ate todeterminehe apitalizationate freal state, hetheritbe the ashflows f an officeuildingrthemputedentf a single-familyesidence.It s understandablehy, efore002, he ederalunds atewould avebeenperceiveds a leadingndicatorfmany tatisticshatnfact redriveny onger-termnterestates. he correlationetween hefederalfunds ate nd he ate nfixed-rateortgageoans rom983 o2002, orexample, adbeen tight.86.47 ccordingly,uringhose ears, egres-sionswith ome rices s thedependentariablewouldhave eeminglyworkedquallywellwith itherong-termates rovernightates s theexplanatoryariable.46. Bothregressions, owever, speciallythatusingthe funds ate, xhibit ignificantserial orrelation,uggestinghat her-statisticsre ikely oohigh.47. As a consequence, heFederal Reserveassumed that he term remiumthediffer-ence between ong- ndshort-termates)was a relativelytable, ndependentariable.Thefailuren2004 and 2005 of the325-basis-pointise n thefunds ateto carry heyieldonthe 10-yearTreasurynote along with t (as historicallyt almost invariablyhad) wasdeemeda "conundrum." hatepisode has dramaticallyhangedthelong-heldview thatU.S. long-termnterest ates were significantlynfluenced,f not largelydetermined,ymonetary olicy.The emergence fgloballyarbitragedong-termateshas largelydelinkedU.S. long-term atesfrom ederalReservepolicy. t has accordingly hanged he "conundrum" romwhy he10-year reasury oteyieldunexpectedlyailed orespond ochanges nthefundsrate n2004, towhythe nterestate erm tructure as so stablethroughhe atter art fthe 20thcentury. nynotion hat heFederal Reservehad of that tability einga funda-mental haracteristicf U.S. financewas dashedwith he mergence fglobally rbitragedlong-termates.


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ALAN GREENSPAN 237But thefixed-rate ortgagelearly elinked rom hefederal undsratenthe arly art fthis entury.hecorrelationetween hem ell oan insignificant.10 during002-05,theperiodwhen hebubblewasmostntense,nd s a consequence,he unds ate xhibitedittle,f ny,influencen home rices.Thefunds atewas owered rom/2 ercentnearly 001to VA ercentin ate 001, nd henventuallyo1percentnmid-2003,rate hat eldfor year. heFederal eserve iewed he oweringo1percents an actof nsurancegainsthe allingate f nflationn2003,which adchar-acteristicsimilar o theJapaneseeflationf the1990s.Wethoughtheprobabilityfdeflationmall, ut he onsequences,houldtoccur, an-gerous. n the ther and,werecognizedhat funds ate eld oo owfortoo ongmightncourageroductricenflation.thoughttthe ime hatthe ate ecrease onethelesseflectednappropriatealancingfrisks.still o.To myknowledge,hatoweringf thefederal unds atenearlydecadeago was notconsidered keyfactorn thehousing ubble.Indeed, s late sJanuary006,Milton riedman,istoricallyhe ederalReserve's everestritic,valuating onetaryolicy rom 987to2005,wrote,Theresnoothereriodf omparableengthnwhich he ederalReserve ystem asperformedo well. t is more han differencefdegree;t pproachesdifferencefkind."48It thus ame s somewhatf surprisehen,nAugust007, tanfordUniversity'sohn aylorwithwhom rarelyisagree)rguedhat ed-eralReserve olicynthe ftermathfthedot-com ubblewas theprin-cipalcauseof the mergencef theU.S. housing ubble.Accordingo

Taylor2007),had thefunds ate ollowed iseponymousule, ousingstarts ouldhavebeen ignificantlyower nd theU.S. economy ouldhave voided much f thehousingoom" ndprice ubble. isconclu-sion, ftenopied nd epeated,eems,fear,ohavebecome lose o on-ventional isdom.49As evidence, aylornotesfirsthe"significant"nverse orrelation,with lag,frommid-959 omid-2007 etweenhe ederalunds ate nd48. Milton riedman,The Greenspantory:He Has Set a Standard,'WallStreet

Journal anuary1,2006.49. For xample,recenturvey y heWall treet ournalJon ilsenrath,BernankeChallengednRates'Role nBust," anuary4, 010)foundhat8percentfWallStreetandbusinessconomistsurveyednd 8percentf cademicconomistsurveyedhought,"ExcessivelyasyFedpolicynthe irstalf fthe ecadehelped ause bubble nhouseprices."


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238 BrookingsapersnEconomicctivity,pring01housingtartsnd rgueshatccordingohisrulea useful irstpproxi-mation o a central ank'smonetaryolicy tance),heFederalReservehad set ninappropriatelyowfunds ate uring002-05. 0As a conse-quence, eclaims,housingtartsumpedo 25-year igh. . .The urgeinhousingemanded toa surgenhousing ricenflation.The]ump nhousing rice nflationhen cceleratedhe demand orhousingn anupwardpiral"Taylor007).Taylor ostulatesousingtartss theprimaryriverfhome rices.Theevidence, owever,uggestshat t s not tartshat rive rices ndinitiatehe upward piral," ut he therway roundfigure1).Homeprice hanges, ith 6-monthead,have ignificantxplanatoryower orsingle-familytartsrommid-976 o2009:the djusted 2 s0.36, nd he-statistics 15.0.Americanome uilders,nmy xperience,espondohomeprice hanges, ot hefederalunds ate, odetermineowmany"homes or ale"theytart. nd hehome rice hange,s I notedarlier,is a functionf agged ong-termortgageates.Housingtarts,nany vent,hould e extraneousoTaylor's xplana-tion f he ubble.t semployedecause he aylorule y tselfsstruc-tured o indicate proper ederal unds ateto balance the trade-offbetweennflationndunemployment.here re no assetprice nputs,especiallyome rices,alledforntheTaylor ule.Homeprices annotbe substitutedilly-nillyor he onsumerricendexCPI) or the orepersonalonsumptionxpendituresPCE) pricendexntheTaylor ara-digm. he CPI could tand s a proxy orhome ricesf the orrelationbetween he wowerevery igh.But t s not.The correlationetweenhome ricesnd onsumerrices,ndbetweensset ricesngeneralndproductrices,s small onegligible,nd noccasion egative.heTaylorrule learlyannot eappliedo sset rices,specially hen enign rod-uctpricenflations almosturely necessaryonditionor n income-producing-assetrice ubble.51The correctnterpretationf a Taylor uleas applied o theperiod2002-05 hattipulateshat he ederalunds ates too ow s thatroduct

50. TheTaylorulendicated,ccordingo chartnTaylor2007), hat he undsateshould ave een et t anaveragef3.7percenturing002-05, ompared ith nactualaverage ate f 1.8percent.aylor's alculationsmployhe onsumerricendex s theinflationariable.mployinghe orepersonalonsumptionxpendituresricendex,heFederal eserve's referredeasure,arrowshe ap ignificantly.51 Moreover,he sual ulpritsehindithersset rproductricenflationeremiss-ing.GrowthntheM2 measuref hemoneytock,or xample, as wellbehaveduring2002-05.


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ALAN GREENSPAN 239Figure11. Home Prices nd HousingStarts, 976-2009Percent Thousands30 - Change n home rices'"leftcale) 'Vu' - 140

io? ''u/L } /wVifs h'A '/^m/V 1 1 In100i I il J u/" VI,

-io


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240 BrookingsapersnEconomicctivity,pring01Figure12. Home Prices nd Originations fAdjustable-RateMortgages, 000-093Billions fdollars Index,Jan. 000= 100On Originationsleft cale)A ,./VV^^"N. -200200 / 'L''*'' 'V ' N


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ALAN GREENSPAN 241HereTaylorsemployingxpostdata o refutenalysis asedon ex antesaving nd nvestmentntentionssee section LA above), n argumentmost conomistshould induzzling.

V.B. Could heBreakdownaveBeenPrevented?Couldthebreakdownhat o devastatedlobalfinancial arketsavebeenprevented?ivennappropriatelyow financialntermediaryapital(thats,excessiveeverage)nd twoprevious ecades fvirtuallynre-lenting rosperity,ow nflation,nd ow ong-termnterestates, verymuch oubtt.Those conomiconditionsre he ecessary,nd ikelyhesufficient,onditionsor he mergencef a bubblen ncome-producingassets.To be sure, entralankmonetaryighteningas the apacityobreak heback ofanyprospectiveash flow hat upportsubblyssetprices, ut lmosturelyt the ostof a severe ontractionfeconomicoutput,ithndeterminateonsequences.hedownsidef hatrade-offsopen-ended.52Butwhynottightenncrementally?here re no examples, omyknowledge,f successfulncrementalefusingf bubble hateft ros-perityntact.uccessfulncrementalighteningycentralanks ogradu-allydefuse bubble equires short-termeedbackesponse.53utpolicyaffectsneconomy ithong ndvariableagsof s much s 1to2 years.54How does theFOMC,for xample, now n real time f ts ncrementaltightenings affectinghe conomyt a pacethepolicy equires? owmuch nadvancewill t have otighteno defuse hebubblewithoutis-ablinghe conomy?utmore elevant,nless ncrementalighteningig-nificantlyaises isk versionand ong-termnterestates) rdisables he

52. Tight egulationsnmortgageending for xample,own aymentequirementsof30percentrmore,he emovalf hemortgagenterestaxdeduction,r liminationfhomemortgageonrecourserovisionswould urely everelyampennthusiasmorhomeownership.ut hey ould lso imit omeownershipo he ffluent,nlesswnershipby ow- ndmoderate-incomeouseholds ere ullyubsidizedygovernment.inceJan-uary 008 the ubprime ortgageriginationarket asvirtuallyisappeared.ow willHUD' s affordableousing oals seenote 0)beachievednthe uture?53. Some econometricodelsmplyuchcapabilityor ssetpricesngeneralndhome ricesnparticular.hey chieve his y ssumingstable ermtructure,hich,fnecessity,ields tightelationshipetweenhe ederalunds ate nd ong-termates. helattersthenmployedocapitalize flow f ncomeimputedousingervicesnthe aseofhomes).54. See,for xample, lan . Blinder,TheCasefor ptimismn the conomy," allStreet ournal ecember6, 009.


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242 BrookingsapersnEconomicctivity,pring01economynoughoundercuthe ashflowhatupportshe elevantssetprices,see ittlerospectf uccess.The Federal eserve's neattemptt ncrementalighteningailed.nearly 994we embarkedn a 300-basis-pointighteningo confronthatweperceivedt the ime sgrowingnflationaryressures.t was a policythat ouldhavebeenustas easily eadbythemarkets anincrementaltighteningodefuse he hen-incipientot-com ubble.We not nly ailed o defuse henascenttockmarketubble hatwasevidentn ate1993, ut rguablynhancedt.Theabilityfthe conomyto withstandseveremonetaryighteningn 1994 nadvertentlyemon-stratedhat he mergingoomwasstrongerhanmarketsad nticipatedand,as a consequence,aised heequilibriumevel of theDow JonesIndustrialverage.55his uggestedhat tighteningar reaterhan he1994 pisode rthe ighteningn2000would avebeen equiredoquashthe ubble. ertainlyfunds ate ar igherhan he /2 ercenthatwasreachednmid-2000 ould avebeen equired.At ome ate,monetaryolicyancrushny ubble.f6/4 ercents notenough,ry0percent,r50percentor hatmatter.ut he tate fpros-perity illbe an inevitableictim.56n 2005 we at theFederalReservedid harbor oncernsbout hepossible esolutionf thehousing ubbleeuphoriahat rippedhenation.n 2005 noted,Historyasnotdealtkindlywith he ftermathfprotractederiods f lowriskpremiums"(Greenspan005,p.7).However,we at theFederalReserve everhad a sufficientlytrongconvictionbout he isks hatould ieahead.AsI notedarlier, e hadbeen ulled nto state fcomplacencyytheonlymodestlyegativeeconomic ftermathsfthe tockmarketrash f1987andthedot-combust.Given hathistory, e believed hat nydecline n homepriceswouldbe gradual. estabilizingebtproblems erenotperceivedoarise nderhose onditions.Forguidance, e looked o thepolicy esponseo theunprecedentedone-daytock-bubbleust fOctober9,1987, nd he 000bearmarket.Contraryopriorxperience,arge njectionsfFederal eserveiquidity

55. Fordetails ee Greenspan2004a).56. Such actionswouldobviouslyprovoke n extreme oliticalresponse.Althoughhedecisions of the FOMC are not subjectto legal reversal, herangeof monetary olicychoiceshas beenpolitically onstrainedowhat onstitutesonventionalwisdom n acade-mia. As recent videncereaffirms,he FederalReserve'sdegreeofpolicy ndependencesfixed ystatute,nd t canbe altered r eliminated ystatute.


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ALAN GREENSPAN 243apparentlyidhelp tabilizehe conomy previouslyuch rashes adledtoeconomicetrenchment.Unless heres a societal hoice o bandonynamic arketsnd ever-agefor omeform fcentrallanning,fear hat reventingubbleswillinthe ndturn uttobe infeasible.ssuagingheir ftermatheems hebestwe canhopefor. olicies, oth rivatendpublic,hould ocus namelioratinghe xtentfdeprivationndhardshipaused ydeflationarycrises. ut f neffectiveay, therhan ubstantialncreasesncapital,odefuseeveragedubbleswithout major mpact n economic rowthwere iscovered,twould e a major tep orwardnorganizingurmar-ket conomies.VI. In SummaryInthis aper have ndeavoredotrace he owerfulconomic orces hatemergednthe ftermathf he oldWar nd edto dramaticeclinendconvergencefglobalreal ong-termnterestates. hat n turnngen-dered, irst,dramaticlobal ome rice ubble eavilyeveragedydebt,and econd, delinkingfmonetaryolicy romong-termnterestates.57Theglobalbubblewas exacerbatedythewidespread ackagingfU.S. subprimend alt- mortgagesnto ecurities,hich oundwillingbuyerst home especiallyheGSEs) andabroad,manyncouraged ygrosslynflatedreditatings. ore han decadeofvirtuallynrivaledglobalprosperity,ow nflation,nd ow ong-termnterestates educedglobal isk version ohistoricallynsustainableevels.Thebubble tartedo unravelnthe ummerf2007.Butunliken the"debt-lite"eflationhat ollowed he arlierot-comoom, eavyever-aging etoff erial efaults,ulminatingnwhat s likelyobe viewed sthemost irulentinancialrisis ver.Themajor ailure f both rivateriskmanagementincludingreditatinggencies)ndofficialegulationwas to significantlyisjudgehe size of the tail risks hatwere aterexposednthe ftermathfthe ehman efault. adcapital nd iquidityprovisionso absorb ossesbeen ignificantlyigher oingnto he risis,contagiousefaultsurely ould avebeenfar ess.Thispaperhasargued ccordinglyhat heprimarymperativeoingforward as to be increasedegulatoryapital,iquidity,ndcollateral

57. Whetherhe atter ill ontinue ith less rbitrageablenternationalondmarketremainsobe seen.


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244 BrookingsapersnEconomicctivity,pring01requirementsor anks nd hadow anks. have lso noted numberfless mportanteformnitiativeshatmay e useful.But henotion f an effectivesystemicegulator"s part f a regula-toryeformackages lladvised. hechronicadstate f conomicore-castinghould ive governmentsauseon that ssue. Standardmodels,exceptwhen eavily djusted yad hoc udgments,ouldnot nticipatethecurrentrisis,et alone tsdepth.ndeed,models arely nticipaterecessions,nless,gain, he ecessionsartificiallyorcednto hemodelstructure.

Inclosing,etme reiteratehat he undamentalesson f this risis sthat, iven hecomplexityfthedivision f laborrequiredf modernglobal conomies, e needhighlynnovativeinancialystemso ensurethe roperunctioningf hose conomies.ut lthough,ortunately,ostfinancialnnovations successful, uch s not.And t s notpossiblenadvance o discernhefutureuccess f each nnovation.nly dequatecapitalnd ollateralanresolve his ilemma.fcapitalsadequate,hen,bydefinition,ofinancialnstitutionilldefaultnd erial ontagion illbe thwarted.eterminingheproperevelofrisk-adjustedapital houldbe the entralocus freformoing orward.We canlegislate rohibitionsn thekinds f securitizedssets hataggravatedhe urrentrisis. utmarketsornewly riginatedlt-A ndadjustable-rateubprime ortgages,yntheticollateralizedebt bliga-tions,ndmany reviouslyighly opulartructurednvestmentehiclesno ongerxist.Andprivatenvestorsave hown o nclinationorevivethem. he next risiswillno doubt xhibit plethoraf nnovativeewassets, omeofwhichwillhaveunintendedoxic haracteristicshat oonecanforecastn advance. ut fcapital nd collateralreadequate,losseswillbe restrictedo those quityhareholdershoseek bnormalreturnsut n the rocessxpose hemselveso abnormalosses.Taxpay-ers hould ot e atrisk.ACKNOWLEDGMENTS I wish o xpress y ratitudeo he ditorsndtoGregoryankiw,eremytein,ndWilliamrainardor heirmost on-structiveommentsnd uggestions.he onclusionsf his aper,f ourse,aremy wn.


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ALAN GREENSPAN 245ReferencesBasel CommitteenBanking upervision.009. "InternationalrameworkorLiquidity iskMeasurement,tandardsndMonitoringConsultativeocu-ment." asel: Bank or nternationalettlementsDecember).Berger, llenN. 1994. TheRelationshipetweenapital ndEarningsnBank-ing."Workingaper 4-17.WhartoninancialnstitutionsenterFebruary).Berger,AllenN., and David B. Humphrey.994. "Bank Scale Economies,Mergers, oncentration,nd Efficiency:he U.S. Experience."WorkingPaper 4-25.WhartoninancialnstitutionsenterJune.)Desroches, rigitte,nd MichaelFrancis. 007."WorldReal Interest ates:AGlobal avings nd nvestmenterspective."ank fCanadaWorkingaper2007-16. ttawaMarch).Dokko,Jane, rian oyle,Michael . Kiley, ndothers.009."Monetaryolicyand heHousing ubble." inance ndEconomics iscussion eries.Washing-ton: ederal eserve oardDecember2).French,enneth.,Martin eilBaily,John . Campbell,ndothers. 010. TheSquam akeReport: ixinghe inancial ystem.rincetonniversityress.Greenspan,lan.1996. TheChallengefCentralankingn Democraticoci-ety." rancis oyer ecture, mericannterprisenstituteor ublicPolicy

Research, ashingtonDecember ).. 1999. TheEvolutionfBank upervision."peech eforeheAmericanBankers ssociation,hoenixOctober 1).. 2000a."TechnologyndFinancial ervices."peech efore heJournalof Financial ervices esearchndtheAmericannterprisenstituteonfer-ence nHonor fAnna chwartz, ashingtonApril 4).. 2000b."Banking upervision."peechbefore heAmerican ankersAssociation, ashingtonSeptember8).. 2004a."Risk ndUncertaintynMonetaryolicy." peech t theMeet-ings f heAmericanconomic ssociation,anDiego January).. 2004b. "Government-Sponsorednterprises."estimonyefore heCommitteenBanking, ousing,ndUrban ffairs,.S. Senate,Washington(February4).. 2005."ReflectionsnCentral anking."peech ta symposiumpon-soredby the FederalReserveBank of KansasCity,Jackson ole,Wyo.(August6).. 2007.TheAgeofTurbulence: dventuresn a NewWorld. ew York:Penguin.Homer,idney,ndRichardylla.1991.AHistoryf nterestates, rd d. Rut-gersUniversityress.Mallaby,ebastian.010.MoreMoney hanGod:HedgeFunds nd theMakingof NewElite. ondon: loomsbury.OfficefPolicyDevelopmentndResearch,epartmentfHousingndUrbanDevelopment.001. "HUD's Affordableending oals for annieMae andFreddieMac." ssueBrief o.5.WashingtonJanuary).


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246 BrookingsapersnEconomicctivity,pring01Passmore, ayne,haneM. Sherlund,ndGillian urgess.005. TheEffectfHousing overnment-SponsorednterprisesnMortgageates."Real EstateEconomics3,no.3:427-63.Ph

Making Sence of the Subprime Crisis

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