Tuesday, February 9, 2010

Greenspan's Insights on the Financial Crisis

CNN has a nice piece on Alan Greenspan's thoughts about what went wrong and what to do in terms of regulatory change. Here are some excerpts:
The reality of bubbles cannot be escaped, Greenspan believes. A central element of his worldview is that "bubbles are built into human nature." But why were the effects of this bubble so much more devastating than almost any other? The reason strikes at the heart of Greenspan's beliefs.

This bubble was catastrophic because self-interest failed. At Bear Stearns, Lehman Brothers, AIG (AIG, Fortune 500), Citigroup (C, Fortune 500), Merrill Lynch, and others, the firm's interest in its own profits should have stopped the housing bubble insanity. That's how the system is supposed to work. It didn't.

For America's most famous libertarian, an Ayn Rand acolyte, that is more than troubling. It's foundation-shaking. It put him into "shocked disbelief," he told Henry Waxman's House Energy and Commerce Committee in October 2008.
Self-interest failed, Greenspan believes, mainly because no one, including himself, understood the costs of the extremely unlikely risks the big banks faced. "This is a once-in-a-century event," he says.

It may seem unsurprising that in those rare circumstances the banks disastrously misjudged their counterparties, mainly other institutions that owed them payments. But a central element of Greenspan's belief system was that such things don't happen. "Counterparty surveillance failed to protect the system this time," he says. "I always thought it would. I held that belief for 60 years."

Yet he doesn't believe tougher regulation by the Fed could have saved the banks. The problem in his view is that regulators would be much worse than the banks themselves at judging banks' counterparty risk. "I was on the board of J.P. Morgan (JPM, Fortune 500) prior to becoming Fed chairman," he says. "I knew what J.P. Morgan knew about Citi, Bank of America (BAC, Fortune 500), Wells, and others. When I arrived at the Fed, I quickly learned that J.P. Morgan's knowledge of those organizations was far greater than what the Fed knew."

Greenspan isn't opposed to more regulation, mostly fine-tuning. But on the central issue of self-interest, the safeguard that failed, he isn't giving up. He wants banks more exposed to market discipline by making sure that the "too big to fail" doctrine disappears. "Counterparty surveillance will remain the regulators' first line of defense," he says. The banks may have blown it, but now they've learned how to do it better, and that's what they must do.