News Release

Speech by Dr. Alan Greenspan

Federal Reserve of Chicago Bank Structure Conference

May 7, 2010

The bankruptcy of Lehman Brothers in September 2008 precipitated what, in retrospect, is likely to be judged the most virulent global financial crisis ever. To be sure, the contraction in economic activity that followed in its wake has fallen far short of the depression of the 1930s. But the virtual withdrawal, on so global a scale, of private short term credit, the leading edge of financial crisis, is not readily evident in financial annals. The widespread bank failures in the 1930s did reduce short term credit availability. But short-term financial markets continued to function.

Only in retrospect do we now know that in the years leading up to the current crisis, financial intermediation tried to function on too thin a layer of capital, the result of a misreading of the degree of risk embedded in ever-more complex financial products and markets.

Central bankers had long been aware of the potential of a shortfall in capital, precipitating a breakdown in private financial markets. A decade ago, addressing that issue, I noted, “There is [a] . . . difficult problem of risk management that central bankers confront every day, whether we explicitly acknowledge it or not: How much of the underlying risk in a financial system should be shouldered [solely] by banks and other financial institutions? “[Central banks] have chosen implicitly, if not in a more overt fashion, to set capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

“I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred-year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.”[1]

At issue is whether the current crisis is that “hundred year flood.” Peacetime financial crises have developed over the generations almost always the result of an inability to float, first long term debt, and then progressively, overnight debt.[2] The depth of financial crises is usefully measured by the degree of contraction in the availability of short term credit.

The evaporation of the supply of such credits on so global a scale within hours or days of the Lehman failure is, I believe, without historical precedent. A run on money market mutual funds, heretofore perceived as being close to riskless, was underway within hours of the Lehman announcement of default.[3] The Federal Reserve had to move quickly to support the failing commercial paper market. Unsupported, trade credit withdrawal, within days, set off a global trade collapse. Even the almost sacrosanct fully collateralized repurchase agreement market encountered severe unprecedented fear of counterparty insolvency.

We need to dig very deep into peacetime financial history to uncover similar episodes. The call money market, that era’s key short term financing vehicle, shut down at the peak of the 1907 panic, but only for one day “when no call money was offered at all and the [bid] rate rose from 1 to 125%.”[4] Even at the height of the 1929 stock market crisis, the call money market functioned, though rates did soar to 20%. In lesser financial crises, availability of funds in the long-term market disappeared, but overnight and other short-term lending continued to function.

I noted in a paper presented to the Brookings Panel on Economic Activity last month that, while the roots of the crisis reach back to the geopolitical aftermath of the Cold War, its immediate trigger was the major increase, during 2003 and 2004 (exhibit 1), in the demand for securitized American subprime mortgages.

The subprime market that developed in the 1990s was a small, but generally successful, market of largely fixed rate mortgages that mainly serviced those potential homeowners who could not meet a 20% down payment requirement, but still had income to handle a fixed rate mortgage.

Heavy demand from Europe, in the form of subprime backed collateralized debt obligations, was fostered by attractive yields and a declining foreclosure rate on the underlying mortgages. An even heavier demand was driven by the need of Fannie Mae and Freddie Mac to fund their exceptionally large “affordable housing” mandates.[5] During the years 2003 and 2004, an estimated 45% of the overall increase in private conduit issued subprime mortgage securities outstanding were purchased, and retained, by Fannie Mae and Freddie Mac (exhibit 2).

The unexpected overwhelming demand pressed securitizers to reach out to marginal credits that were beyond the limited, but viable, subprime homeowner population. In the process, they converted the successful, largely fixed rate subprime market into an increasingly toxic adjustable rate market. By the spring of 2006, more than 50% of subprime mortgages outstanding were adjustable rate, compared with only 20% in early 1998. Compounding the problem, Fannie Mae and Freddie Mac subprime securities portfolios were 99% adjustable rate by the end of 2004.

As a measure of how far the appetite for risk-taking, beyond the securitized mortgage market had gone, long sacrosanct debt covenants[6] were eased as a classic euphoric global bubble took hold. By 2007, yield spreads in the overall debt markets had narrowed to a point where there was little room for further underpricing of risk (exhibit 3). Market participants, however, were also cognizant that risk had often remained underpriced for years. Financial firms were thus fearful that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably.

Their fears were formalized by Citigroup’s Charles Prince’s now famous remark in 2007, just prior to the onset of the crisis, that “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”[7]

Bankers risked being able to anticipate the onset of crisis in time to retrench. The firms believed the then seemingly insatiable demand for their array of exotic financial products would enable them to sell large parts of their portfolios on short notice, without loss. They were mistaken. They failed to recognize that market liquidity is a function of the level of risk aversion. Time and time again, seemingly robust degrees of market liquidity have disappeared literally overnight when euphoria abruptly changed to fear, even though excess reserves at depository institutions, or other bank balance sheet liquidity, remained unchanged.

Risk aversion is the primary human trait that governs the pricing of income earning assets.[8] When people become uncertain or fearful, they disengage from perceived risk and since all stocks, bonds, and real asset markets are, of necessity, net long, asset prices fall. Conversely, when uncertainty declines, people take on new commitments. Risk aversion can thus range from zero to full.[9]

Day by day trading, however, occurs well within these outer boundaries of risk aversion, and can be very approximately measured by credit risk spreads. Credit spreads that track changing risk aversion, exhibit little, to no, long term trend (see, for example, exhibit 3). The highly prized railroad bonds of the immediate post-Civil War years reflected spreads over U.S. treasuries that are similar to our post-World War II experience.

As risk aversion and credit spreads decrease, the growth of market liquidity appears inexhaustible. A lessening in the intensity of risk aversion creates increasingly narrow bid-asked spreads, in volume, the conventional definition of market liquidity.

Falling risk aversion, of course, is the primary characteristic of bubbles since it creates falling capitalization rates and falling capitalization rates, by definition, eventually propel one or more asset prices to unsustainably high levels. As risk aversion and risk premiums approach zero, the declines must slow down, undercutting the momentum of asset price rise. As the boom fades, uncertainty turns to fear.

All bubbles deflate when risk aversion reaches its irreducible minimum, though analysts’ ability to time the onset of deflation has proved illusive.

Some bubbles burst without severe economic consequences, the dotcom boom and the rapid run-up of stock prices in the spring of 1987, come to mind. Others burst with severe deflationary consequences. That class of bubbles, as Reinhart and Rogoff data demonstrate,[10] appears to be a function of the degree of debt leverage in the financial sector, particularly when the maturity of debt is less than the maturity of the assets it funds. It is not the average degree of leverage, but the extent of concentration in certain debt instruments whose default engenders serial contagion.

In September 2008, had the share of financial assets funded by debt been significantly less concentrated in U.S. highly leveraged mortgages, it is questionable whether the deflation of asset prices would have fostered a default contagion much, if any, beyond that of the dotcom boom. It is instructive in this regard that, to my knowledge, no large independent hedge fund has defaulted on debt throughout the current crisis, despite very large losses that often forced the fund’s liquidation.

Why did the 2007 bubble reach century-rare euphoria? The answer, I believe, lies with the dot-com bubble that burst with very little footprint on global GDP, and in the U.S., the mildest recession in the post-World War II period. And indeed the previous U.S. recession (1990-1991) was the second most shallow. Coupled with the fact that the 1987 stock market crash left no visible impact on GDP, it led many sophisticated investors, regulators, and credit rating agencies to believe that future contractions would also prove no worse than a typical post-war recession.

Large bank capital buffers appeared increasingly less pressing in this period of Great Moderation. As late as April, 2007 the IMF noted that “. . . global economic risks have declined since . . . September 2006.. . . [T]he overall U.S. economy is holding up well . . . [and] the signs elsewhere are very encouraging.”[11] Basel regulations did induce a modest increase in capital requirements leading up to the crisis. But the debates in Basel over the pending global capital accord, which emerged as Basel II, were largely between stable bank-capital requirements and less bank capital, not more. Leverage accordingly ballooned.

It is in such circumstances that we depend on our highly sophisticated global system of financial risk management to contain market breakdowns. How could it have failed on so broad a scale? The paradigm that spawned several Nobel Prize winners in economics[12] was so thoroughly embraced by academia, central banks, and regulators that by 2006 it became the core of global regulatory standards (Basel II). Many quantitative firms whose number crunching sought to expose profitable market trading principles were successful so long as risk aversion moved incrementally - which it did most of the time. But crunching data that covered only the last two or three decades prior to the current crisis did not yield a model that could anticipate a crisis.

Mathematical models that calibrate risk, however, are surely superior guides to risk management than the “rule of thumb” judgments of a half century ago. To this day it is hard to find fault with the conceptual framework of our models, as far as they go. Fisher Black and Myron Scholes’ elegant option pricing proof is no less valid today than a decade ago. The risk management paradigm nonetheless, harbored a fatal flaw.

In the growing state of high euphoria, risk managers, the Federal Reserve, and other regulators failed to fully comprehend the underlying size, length, and impact of the negative tail of the distribution of risk outcomes that was about to be revealed as the post-Lehman crisis played out. For decades, with little, to no, data, most analysts, in my experience, had conjectured a far more limited tail risk than 2008 exposed. This was arguably the major source of critical risk management system failures.

Only modestly less of a problem was the vast, and in some cases, the virtual indecipherable complexity of a broad spectrum of financial products and markets that developed with the advent of sophisticated mathematical techniques to evaluate risk. I often maintained that because of their complexity, we had no choice but to rely on an international “invisible hand,” rather than national regulators, to bring equilibrium to such opaque markets.

Unable to cope with such complexity, an inordinately large segment of investment management was subcontracted to the “safe harbor” risk designations of the credit rating agencies. No further judgment was seen as being required of investment officers who believed they were effectively held harmless by following the judgments of government sanctioned rating organizations. But despite their decades of experience, the analysts of the credit rating agencies proved no more adept at anticipating the onset of crisis than the investment community at large. The second bulwark against crisis failed.

Even with the breakdown of our sophisticated risk-management models and our credit rating establishments, the financial system would have held together had the third bulwark against crisis—our regulatory system—functioned effectively. But, under crisis pressure, it too failed.

U.S. commercial and savings banks are extensively regulated, and even though for years our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still were able to take on toxic assets that brought them to their knees. The heavily praised U.K. Financial Services Authority was unable to anticipate, and prevent, the bank run that threatened Northern Rock. The venerated credit rating agencies bestowed ratings that implied Aaa smooth-sailing for many a highly toxic derivative product. The Basel Committee on Banking Supervision, representing regulatory authorities from the world’s major financial systems, promulgated a set of capital rules that failed to foresee the need that arose at the height of the crisis for much larger capital and liquidity buffers.

The woeful record of regulators, and virtually all others, in anticipating this crisis (or any other crisis), suggests that regulators should not be required to forecast. A financial crisis, by definition, is an abrupt and discontinuous fall in asset prices. But that cannot happen unless it is unanticipated by the vast majority of market participants. If broadly anticipated, a crisis will be arbitraged away.[13]

Indeed for years leading up to August 2007, it was widely expected that the precipitating event of the “next” crisis would have been a sharp fall in the U.S. dollar as our current account deficit, starting in 2002, increased dramatically. The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have gradually arbitraged away the presumed dollar trigger of the "next" crisis. The U.S. current account deficit did not play a prominent direct role in the timing of the 2007 crisis, though because of that it may in the next crisis. 

What regulators can do is set capital and liquidity requirements, the amount of collateral a broker/dealer can commingle with customer assets, mandate contingent capital, and require “living wills.” These can be successfully implemented with regulations that do not need to fathom an unknown future.

As I point out in the aforementioned paper for the Brookings Panel on Economic Activity, the pricing of U.S. banks’ credit default swaps during the crisis indicates that, if banks are to lend freely again, bank equity capital will need to rise to 14% of assets, four percentage points higher than the equity capital held by U.S. commercial banks prior to the crisis.

All regulations presuppose that the underlying purpose of finance in a market economy is to structure a system that directs a nation’s saving, plus any saving borrowed from abroad (the current account deficit), towards investments in plant, equipment and human capital that offer the greatest increases in a nation’s output per hour.

Nonfinancial output per hour, on average, rises when obsolescent facilities (with low output per hour) are replaced with facilities that embody cutting-edge technologies (with high output per hour). This process improves average overall standards of living for a nation as a whole. For decades prior to the onset of this crisis, finance presumably had been quite successful in directing our scarce savings into real productive capital investments. This is suggestive by the ever-increasing pace that nonfinancial market participants had been compensating producers of U.S. financial services.

According to the Bureau of Economic Analysis, the share of U.S. gross domestic income accruing to finance and insurance, had risen fairly steadily from 2.3% in 1947 to 7.9% in 2006 (exhibit 4). Only a small part of the rise was the result of an increase in net foreign demand for U.S. financial and insurance services.[14] The decline in the share to 7.4% in 2008 apparently reflects write-offs of previously presumed productively employed saving.[15]

Given the historic breakdown of the last two years, did non-financial market participants over the decades misread the efficiency of finance and inappropriately compensate this small segment of our economy? The prevalence of so many financial product failures certainly suggests so, for the decade leading up to the crisis. Nonetheless, it is difficult to make the same judgment in the face of the fairly persistent rise of finance’s share for the previous half century.

The proportion of nonfarm employment accounted for by finance and insurance since 1947, has risen far less than the share of gross income originating, implying a significant upgrading of skills and compensation attracted to finance.[16] By 2007, for example, a quarter of all graduates of the venerable California Institute of Technology entered finance. [17]

The vexing problem that these data raise is whether finance’s growing share of the nation’s output has been required by the increasing complexity of our economy. The share of growth in finance to the growth in nominal GDP has been largely trendless since 1990, averaging about 10% (exhibit 4). Does this imply that the complexity of the American economy that emerged in the last two decades requires 10% of gross domestic income to finance it? Does the fact that the share of gross domestic income going to finance is also rising in many other countries[18] underscore the global nature of this question?

More generally, do modern global economies require highly innovative financial systems to assure their proper functioning? I suspect so, but proof is illusive. Fortunately, much financial innovation is successful, but much is not. And it is not possible in advance to discern the degree of future success of each innovation.

With adequate capital and collateral, such forecasts are unnecessary. Losses, by definition, will be fully absorbed by equity shareholders. If capital is adequate, no debt will default and serial contagion will be thwarted. Determining the proper level of risk-adjusted capital should be the central focus of reform going forward.

We can legislate prohibitions on the kinds of securitized assets that aggravated the current crisis. But markets for newly originated Alt-A and adjustable-rate subprime mortgages, synthetic collateralized debt obligations, and many previously immensely popular structured investment vehicles, no longer exist. And private investors have shown no inclination to revive them.

The next crisis will no doubt exhibit a plethora of innovative new assets, some of which will have unintended toxic characteristics that no one, including a committee of “systemic regulators,” can foresee in advance. But if capital and collateral are adequate, losses will be restricted to equity shareholders who seek abnormal returns, but in the process expose themselves to abnormal losses. Adequate risk-adjusted capital assures that taxpayers would not be at risk.

[1] Alan Greenspan, “Technology and Financial Services,” Before the Journal of Financial Services Research and the American Enterprise Institute Conference, April 14, 2000.

[2] We experienced vivid instances of such a progression, for example, in the New York City funding crisis of 1974, the Mexican financial crisis of 1998, and the Thai baht crisis of 1997.

[3] Hugo Bänziger, chief risk officer at Deutsche Bank. Financial Times, November 5, 2009.

[4] Sidney Homer and Richard Sylla, A History of Interest Rates 3rd Ed, Rutgers University Press, 1991.

[5] In October 2000, the U.S. Department of Housing and Urban Development (HUD) finalized a rule “significantly increasing the GSEs’ affordable housing goals” for each year 2001 to 2004. In November 2004, the annual housing goals for 2005 and beyond were raised still further. (Office of Policy Development and Research, Issue Brief No. V and others).

[6] These 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.

[7] Financial Times, July 9, 2007.

[8] Note that I am defining risk aversion more broadly than the narrow economic definition in terms of utility over different outcomes. My use of the term differs from its conventional use in that it encompasses not only preferences toward risk, but also perceptions of risk.

[9] Economists have been arguing for generations whether there is a business cycle, that is, an endogenous, self generating, consistent economic wave that has stable characteristics. At first cut, the answer has been no. Each episode of expansion and contraction is essentially idiosyncratic, whose characteristics depend on demographics, the extent of government intervention endeavoring to alter the path of the economy, the relative political power of unions and management, the initial state of debt leverage at the beginning of the cycle, among others. But there is no denying that beneath all of those factors is a path of expansion and contraction that is deeply rooted in human nature which exhibits definite characteristics of a cycle. Indeed, a consolidation of work at the National Bureau of Economic Research in 1946 by Wesley C. Mitchell and Arthur F. Burns evolved into a series of business cycle indicators that are employed to this day.

[10] Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.

[11] IMF World Economic Outlook, April 2007, p.xii.

[12] Harry Markowitz, Robert Merton, Myron Scholes, and Fisher Black, had he lived.

[13] Those few market players who shorted the housing boom in 2006 could not have successfully done so, unless there were counterparties to their trades, willing to pay the then high market prices.

[14] The net foreign demand for financial services has grown significantly, but has been largely offset by net imports of insurance services.

[15] The national income originating in finance, insurance, and real estate was little changed in 2009 from 2008.

[16] See also, Thomas Philippon and Ariell Reshef, “Wages and Human Capital in the U.S. Financial Industry: 1909-2006,” NBER Working Paper, December 2008.

[17] The Economist. February 13, 2010.

[18] Increased, but less pronounced, financial shares are evident in the U.K., Canada, Germany, and Japan, among others. The most rapidly expanding, and increasingly market-oriented economy, China, reports a rise in financial intermediary shares of GDP from 1.6% in 1980 to 5.4% in 2008.