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Greenspan legacy bulletin, 2004

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[Jun 24, 2004] Greenspan Should Respond to Housing Bubble, a column by Mark Weisbrot

This was distributed to newspapers by Knight-Ridder/Tribune Information Services (without the footnotes). If anyone wants to reprint it, please let me know.

Greenspan Should Respond to Housing Bubble

Everyone knows that Federal Reserve Chairman Alan Greenspan, along with his colleagues at the Fed's policy-making body, is going to raise interest rates next week. The Fed has held short-term interest rates at 1.0 percent for the past year. With the economy now growing and inflation running at a 5.5 percent annual rate over the last three months, no one expects the Fed to keep interest rates at a 46-year low.

But the country faces a far more serious economic imbalance than the recent jump in inflation: a housing bubble. This bubble, when it bursts, is likely to smack the economy about as hard as the collapse of the stock market bubble in 2000-2002. But can Mr. Greenspan do anything about this? Should he?

Until now most of the experts have answered no, at least to the second question. Sure, the Fed could have raised interest rates earlier, in order to prevent housing prices from rising so fast as they have. But that would risk curing the disease by killing the patient. To slow the economy by raising interest rates -- in order to affect housing prices -- does not make sense. And even less when the economy was in recession, as in 2001, or recovering from the downturn.

But there has always been another alternative, and now it has actually been put into practice. Last week Mr. Greenspan's counterpart in England sent shock waves through the country's financial press by warning about that country's housing bubble.

"[I]t is clear that the chances of falls in house prices are greater than they were," said Mervyn King, Governor of the Bank of England. He also noted that house prices were "now at levels which are well above what most people would regard as sustainable in the longer term."

This sets a new standard for the responsibility of someone in Alan Greenspan's position. Mr. Greenspan has developed a habit of making public pronouncements and recommendations on a range of economic topics: not only inflation and interest rates, but on tax and budget policy, economic forecasting, and even Social Security.

On many of these topics he has proved to be dead wrong. In January of 2001, Mr. Greenspan played a major role in helping to win Mr. Bush's tax cuts: he told Congress that without the tax cuts the nation faced long-term budget surpluses so huge that we would pay off the national debt too quickly. Before long we were swimming in a sea of red ink. And in 2000, he missed the onset of the recession.

But bubbles should be an easier target. The housing market, like the stock market bubble in the late 1990s, has reached the point where it is clearly overvalued. Since 1995, the increase in home prices has exceeded the overall inflation rate by more than 40 percentage points. This is without precedent; from 1951 to 1995, housing prices rose at the same rate as other prices. There is no way of explaining this phenomenon other than as a bubble. The stock market bubble spilled over into housing, and this continued after stocks crashed and people looked for other assets that were rising rapidly in price. The same investment advisors that got people to lose much of their retirement savings in the stock market at the bubble's peak by telling them that they could not lose in the stock market if they were "in for the long haul," began to tell people similar things about housing.

Our economy is still feeling the fallout from the collapse of the stock market bubble. The bigger the housing bubble grows, the greater will be its negative impact on the economy when it bursts.

That Mr. Greenspan can move markets with just a mumble or two has been amply demonstrated. And as someone who believes in markets with religious fervor, he must know that markets function best when participants have full information.

The Fed Chairman is supposed to be the country's most fearless economic watchdog, appointed to be independent of political pressures, willing to speak the truth and take the heat for "pulling the punch bowl away just as the party is getting started." If he won't warn the public of dangerous bubbles in asset prices, who will?

[Feb 23, 2004] FRB Speech, Greenspan--Understanding household debt obligations

Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.

American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

Don't take mortgage advice from Alan Greenspan - MSN Money by Bill Fleckenstein

The Fed boss says homeowners should switch to adjustable-rate loans and save the difference. His record is full of dangerous moments like this when he's been way, way off.

Last week, Alan Greenspan was a study in contradiction. On Monday, he extolled the virtues of the levered-up homeowner to a credit union conference. The next day, in a speech to the Senate Banking Committee, he was singing a different tune altogether. Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), the giant providers of mortgage capital, he warned, "are expanding at a pace beyond that consistent with systemic safety," and that "preventative actions are required sooner, rather than later."

For a Federal Reserve chairman who has demonstrated that he couldn't identify reckless behavior if it ran him over, it was rather surprising to hear him chide Fannie and Freddie for their recklessness. (I should state, however, it's an opinion I tend to share.)

His scolding might better be directed inward. What he advocated last Monday should send cold shivers down the spine of anyone so engaged. I already thought that what was going on in real estate was dangerous, but what he now cites as a good thing is not only dangerous, it will be disastrous -- guaranteed.

All hail, Al's paper trail
Before quoting from the above, I would just note that Greenspan's latest comments reminded me of a speech he gave on March 6, 2000, which I have dubbed "An Ode to Technology." In the speech, he waxed on about the wonders of technology and how it had brought us a new era and all that other stuff. Folks may not remember that date, but it was four days before the Nasdaq Composite (COMPX) hit its all-time high of 5,048.62. Despite the recovery over the past year ago, the composite is still down nearly 60% from the March 2000 peak.

This is not the first time Easy Al has been way off. On March 7, 2000, I wrote a column called ⌠Alan Greenspan: Friend or Foe" that chronicled some of his prior quotes, speeches and the like. It includes his Jan. 7, 1973, utterance (right before the recession that ranks as our worst, at least until we get through the one we're in but haven't completed): "It is very rare that you can be as unqualifiedly bullish as you can be now."

That, coupled with his ode to technology and cluelessness about bubbles (which folks have seen real-time), is a pretty fair indictment.

And, there are other examples prior to his latest "Ode to Real Estate." For instance, in 1984, he wrote a letter to Edwin Gray, then-chairman of the Federal Home Loan Bank Board, advising the regulator to exempt Charles Keating's Lincoln Savings & Loan, a Greenspan client, from harsh federal regulations about its investments. He told Gray he should "stop worrying so much" about such things as junk bonds, and that "deregulation (of the savings & loan industry) was working just as planned."

Lincoln Savings failed rather spectacularly a few years later. And it's worth noting that within four years, 15 of the 17 thrifts he mentioned in this letter were broke, costing the old Federal Savings & Loan Insurance Corp. some $3 billion.

What if adjustable-rates ratchet up?
Now onto his latest comments. The first was set up in a rather glowing Wall Street Journal article by Greg Ip on Feb. 24. Called "Fed chief questions loan choices," it begins: "In a rare evaluation of interest-rate options that households face, Federal Reserve Chairman Alan Greenspan questioned whether American homeowners are well served by popular fixed-rate long-term mortgages."

I realize that fixed-interest-rate mortgages tend to have slightly higher rates than adjustable-rate mortgages (ARMs). Unless one either believes rates will collapse or plans to move fairly soon, however, fixed-rate mortgages are always the right way to go. You know what you're getting into, so you're not gambling with your house payment. And of course, if rates drop, you can do as everyone has done: You can refinance.

The notion of the whole country piling into ARMs when rates are at multi-decade lows is a truly destabilizing concept to contemplate. What happens if rates go up (because my view is incorrect) and the economy roars ahead?

Twisted logician makes short shrift of bankruptcy
Turning to a more objective analysis in The New York Times of Feb. 24, titled "Greenspan says personal debt Is mitigated by housing value," I note some even more outrageous comments. (I would call them guffaws, were it not so serious.)

"Bankruptcy rates are not a reliable measure of the overall health of the household sector," Greenspan said, ⌠because they do not tend to forecast general economic conditions." (The emphasis is mine.) So, the fact that we have had record and near-record bankruptcies in the last couple years is immaterial, since bankruptcies don't forecast the future!

Similarly, he reached into his linguistic bag of tricks to say why homeowners' increased leverage doesn't count: "An extended period of low interest rates and extra cash from mortgage refinancing has given borrowers flexibility (again, my emphasis) to better manage their debt." So you see, this cash-out-mortgage-facilitated debt assumption is termed "flexibility" on his part, not an increase in leverage. Rather than fun with numbers, he has fun with definitions.

The Times article then paraphrases him thusly: "Mortgage refinancing and the rise in home values have helped to bolster economic spending in economic hard times, as well as better periods." That is, of course, what has happened, as folks have groped around to get through the aftermath of the 1990s stock market bubble. We have postponed the inevitable via this leveraging of home values and aggressive lending tactics to keep the housing market alive and percolating. But we are running out of steam.

'Assets are contingent; debt is forever'

Now think back to what Easy Al had to say about Keating's Lincoln Savings and other S&Ls. The chairman has forgotten something that everyone who went through the period should have learned: Assets are contingent; debt is forever. Granted, folks get around that pretty easily these days with the bankruptcy laws but -- oops -- we don't have to talk about that because it doesn't mean anything, because it's not a forecasting tool.

So the most irresponsible central banker in the history of the world created the biggest bubble in the history of the world, which had disastrous consequences for the stock market and the economy. In order to ameliorate that, he has created bubble-like conditions and absurd financing schemes in real estate. Meanwhile, we've seen an enormous concentration of risk develop inside the financial system: We are down to just a handful of big banks and government-sponsored entities that are using his other favorite toy, derivatives, to theoretically manage away all their risks.

Fed prudence takes a powder

The summation of these variables has only increased the risk of something bad happening. And, of course, that risk has been heightened by the tanking of the dollar. The dollar's decline has been promoted by Greenspan's irresponsible policies and attempts to continually bail out his most recent mistake. He has been doing this serially since junk bonds and bad lending nearly took down the financial system at the end of the 1980s and wiped out the savings and loan industry in 1990-1991.

I believe we are at the end of the string, and things are in the process of slowly deteriorating once again. The pace of that deterioration may pick up speed over the course of the year.

Perhaps we will look back on the speech Greenspan made last week and say that the Fed chairman in essence nailed the top of the housing market -- just as he did with technology in 2000 and the economy in 1973. And he's probably just as wrong about what happens next.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money.

There Goes the Neighborhood by Benjamin Wallace-Wells Why home prices are about to plummet--and take the recovery with them. By Benjamin Wallace-Wells

Washington, where words are the currency, where imprecise verbs threaten the loss of a political career and misapplied nouns can doom a movement, there remain a few figures who get a general pass not just for a certain degree of verbal imprecision, but for a fairly deep-seated degree of intellectual wackiness, a penchant for regularly saying very odd things. Newt Gingrich is one of these public figures, Robert Byrd another; Helen Thomas has her moments, too.

You'll be sitting in the audience listening to a sensible speech by, say, Gingrich, and all of a sudden you get the notion that aliens have captured his brain. Befuddled, you'll turn to your friend next to you, the libertarian true-believer, and he'll shrug his shoulders and whisper back: "Oh, it's just Newt." And then, a few minutes later, the speaker's episode will subside, the aliens return the brain, and the speech continues on its before-we-were-so-rudely-interrupted track. No one says a word. The capital's press gives these folks a pass from its usual lawyerly scrutiny because they are regarded as sages who can be relied upon to speak some kind of unusual and valuable truth, whose occasional episodes of profound intellectual oddness are thought to stem from the same deep source as their general brilliance.

One of these spells flared up during the last week in February, when Greenspan recommended that the home-owning public take a good hard look at switching from fixed-rate mortgages, under whose terms payments stay the same no matter what interest rates do, to adjustable rate mortgages (ARMs), where payments fluctuate along with interest rates--which, right now, makes close to zero sense. Interest rates are lower than they've been in 30 years, and, with all economists predicting a general economic upturn, and Bush's budget deficit and the weak dollar sucking up capital, little doubt exists that interest rates must rise, in which case, switching from a fixed-rate to adjustable-rate mortgage would be pretty costly for any family naпve enough to take Greenspan at his word. The episode did not pass completely without critical notice. It was "the strangest bit of advice ever to be proffered by an American central banker," Jim Grant, publisher of Grant's Interest Rate Observer, told the San Francisco Chronicle. Then the press moved on: "Oh, it's just Greenspan."

But sometimes wacko ideas can betray deeper truths. It is tempting to ask what stake the chairman might have in trying to convince millions of people to do something so contrary to their own interest. One theory floated by Fed-watchers is that the chairman is trying to help out his classic institutional constituency, the big banks, which hold trillions of dollars in fixed-rate mortgage paper. There may be something to that theory, but there is almost certainly a deeper and more important motive behind this curious advice. Quite simply, Greenspan is trying to keep a wobbly and fragile recovery alive--and using mortgage refinancing to do it.

There are many strange things about the choppy recovery we're in, but among the most curious is that it is being fueled largely by consumer spending. Why consumers should continue to spend, and why they've done it throughout the recession, is not immediately obvious. After all, average income growth has been puny in the last few years. There's been a big falloff in jobs. Health care and tuition costs have only been going up. And the stock market has spent the last three years unsuccessfully huffing and puffing to get back to the level where it was in early 2001. Why have consumers been spending so much?

Economists have advanced two main reasons. One is that Americans have so lost their moorings that they've had few qualms about going deep into debt. That's certainly true. The average person's debt as a percentage of his income is now higher than it's ever been. But there's another reason, too: Americans have been using their homes as ATM machines, refinancing their mortgages in order to fund their spending. This, of course, makes sense. The one sector of the economy that has consistently swelled has been housing prices. This has intrigued and surprised many economists, because housing is supposed to operate in sync with the economy, expanding during flush times and contracting when things go poorly. But even in a down economy, prices have soared.

Because of these rising prices, people have felt that despite all the ups and downs in stocks and salaries, that their overall situation was okay. Homes are the biggest asset most families own, and their value has been rising nicely. For that reason, Americans have felt more comfortable buying big-ticket items, from SUVs to new computers to Disney World vacations. Much of that spending has gone right onto the VISA card. But that debt has been kept somewhat manageable by another factor in housing prices: mortgage refinancing.

With home prices rising and the Fed keeping rates low, a mortgage refinancing industry that barely existed 15 years ago exploded into one of the fastest growing sectors of the financial services industry. Last year, one-third of all homeowners used cash-out mortgages to refinance their homes, a rate roughly consistent over the past five years. Savvy investors, says Harvard economist William Apgar, are likely to have refinanced "two or three times in the last two years." Each time they do, they have either been able to lower their monthly payments, or walk away with a chunk of cash. And where does that extra cash go? The ubiquitous Ditech TV ads say it all: "I just refinanced my home and paid off my credit cards!" American homeowners have gained $1.6 trillion in cash from refinancing in the last five years, and those gains have flowed almost wholly into purchases of consumer goods. The resulting spending, says Wharton's Susan Wachter, is "propping up" the American economy.

Greenspan has played enabler to this boom. But with the Fed fund's rate at 1 percent, the chairman can't do much more to sustain it. Tens of millions of Americans have already refinanced their mortgages, and at current rates, can't be induced to do so again. This small window is closing, fast: For six months, refinancing has been tapering off, and economists expect it to narrow further--many economists have argued the gains from refinancing are likely to halve ths year. Moreover, as soon as interest rates rise (as Greenspan himself has said they will within the next year), virtually all refinancing will cease.

Greenspan's rather ham-handed effort to get them to go for ARMs, is a sign not of the chairman's own eccentricity or advanced age, but, instead, of the economy's current unsteadiness. Greenspan knows, perhaps better than anyone, that this economy is perched nervously on top of a wobbly, Dr. Seuss-like tower. Our recovery is propped up by consumer spending, which is in turn propped up by mortgage refinancing, and if that refinancing dries up before more props can be put in, the whole edifice could fall. "Since long-term interest rates cannot fall low enough to facilitate another wave of fixed-rate refinancings, he is trying to encourage homeowners to refinance one last time: fixed to ARM," Peter Schiff, president of Euro Pacific Capital in Los Angeles told the San Francisco Chronicle.

Let's assume for a moment that enough people get fooled, and the refinancing boom gets extended for another year. Then what? The real problem hits. Because if you think Greenspan's being cagey on refinancing, the truth he's really avoiding talking about is that we're in the midst of a huge housing bubble, on a scale only seen once before since the Depression. Worse, the inflated housing market is now in an historically unique position, as the motor of the rest of the economy. Within the next year or two, that bubble is likely to burst, and when it does, it very well may take the American economy down with it.

House bound

Whether or to what extent American home prices will plummet soon is open to some debate, but not much. Even the professionally optimistic housing economists employed by the real-estate industry are now admitting that the good times may be over: "What we would ask for is kind of a slow slowdown," Jeff Culbertson, president of Coldwell Banker-Northern California, told Knight Ridder at the beginning of March. Virtually every housing economist is concerned that prices may be unstable, and growing numbers are becoming outright alarmed. To understand why that is--and why warnings of a coming housing collapse haven't been front-page news--just look at the numbers.

Truth is, in most of the country there's no housing bubble. Perhaps the crucial ratio from which economists determine whether housing markets are out of whack is the ratio of home prices to annual income. In most of the country, it is modest, 2.4:1 in Wisconsin, 2.2:1 in Kentucky, 2.9:1 in Illinois.

Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic. The bad news is that those areas contain roughly half the housing wealth of the country. In California, the price of a home stands at 8.3 times the annual family income of its occupants; in Massachusetts, the ratio is 5.9:1; in Hawaii, a stunning, 10.1:1. To some extent, there are sound and basic economic reasons for this anomaly: supply and demand. Salaries in these areas have been going up faster than in the nation as a whole. The other is supply: These metro areas are "built out," with zoning ordinances that limit the ability of developers to add new homes. But at some point, incomes simply can't sustain the prices. That point has now been reached. In California, a middle-class family with two earners each making $50,000 a year now owns, on average, an $830,000 home. In the late 80s, the last time these eight states saw price-to-income ratios this high, the real estate market collapsed.

By other measures, too, the market is badly bloated. One index of housing inflation is the difference between house prices and rents. In a healthy market, driven by demand, rents and sale prices ought to track roughly together. But while sale prices have soared, rents have stayed flat; and in some of the most overheated markets, like San Francisco and Seattle, they have actually been declining. Such a gap, the economist and New York Times columnist Paul Krugman has written, suggests "that people are now buying houses for speculation rather than merely for shelter," evidence that he called a "compelling case" for a housing bubble. "Within the next year or so," The Economist argued in a May 2003 editorial, these regional "bubbles are likely to burst, leading to falls in average real home prices of 15-20 percent" across America. And, of course, in the most heated markets the drop is likely to be steeper yet.

When housing bubbles burst, they can hurt more than their sector of the economy. Studies have shown that they exercise twice the effect on consumer spending as comparable declines in stock prices. So, a 20 percent drop in housing prices would have the same, shriveling effect on the economy as a 40 percent crash in the stock market. When investors lose value in their houses, many of them pull money out of other investments, like stocks. Then, too, jobs in construction, real estate, and other fields that depend on new home sales die off.

What can Alan Greenspan or anyone else do about this? The answer is, not much. Prices are so stratospheric that even modest hikes in long-term interest rates could burst the bubble. And with federal deficits soaking up so much capital, interest rates are likely to rise as the economy heats up and demand for capital increases. Of course, Greenspan could argue for rescinding some of President Bush's tax cuts, which he's long defended, to bring down the deficit. But even that probably won't forestall a collapse in home prices.

Given the lateness of the hour, and the near-inevitability of the coming crash, there's really only one thing left for concerned citizens to do. Start assigning blame.

Blowing bubbles

Fortunately, the bad actors responsible for this manic inflation are pretty easy to recognize. They look remarkably like the ones who puffed up the tech bubble in the late 90s. In both cases, the unfettered optimism of the buying public was fueled by a brokerage industry almost wholly concerned with making a sale, independent analysts with an incentive to hype prices, and major accounting fraud.

What drives most appreciation in housing prices is the universal human desire to own a slightly larger and more expensive place than one can really afford; a desire restrained in normal times by the universal desire of those who lend money to get paid back.

Getting a home loan used to be a particularly nerve-wracking and unpleasant process. A stern loan officer behind a big mahogany desk would pore over your income and credit, suspiciously probing your portfolio for weaknesses. And sensibly enough: The bank that lent you the money would have to collect on the mortgage for the next 30 years and had to make sure you were really good for it. It hired independent appraisers to make sure the price was in line. This process was a little stingy, and meant some people on the low end of the income scale couldn't buy a home and many others got less home than they might have wanted, but the system usually kept prices in check.

The one exception to this general process was mortgages sold on the secondary market. In the 1930s, Congress created the Federal National Mortgage Corporation (Fannie Mae) to encourage banks to make loans to low-income Americans by agreeing to purchase those mortgages from the banks. In 1970, Congress created a second agency, the Federal Home Loan Mortgage Corporation (Freddie Mac), to do much the same thing. By the late 1980s, these two entities, which belong to the category known as Government Sponsored Entities (GSEs), were buying up and reselling 30 percent of new mortgages and packaging the mortgages to be sold as securities.

Fannie and Freddie's market share was limited by their ability to attract investment capital. But in 1989, Congress instituted some modest-seeming technical changes that made Freddie and Fannie much more attractive to investors, and able to draw much more capital. Under the new rules, for instance, they were allowed to customize securities at different levels of risk and return to meet more precisely the demands of different sectors of the capital market. Then, too, bank regulators let pension funds and mutual funds class Fannie's debt as low-risk. As a consequence, during the 1990s, investors practically threw money at Fannie Mae and Freddie Mac, which became enormously, steadily profitable. The GSEs used the new capital to buy up every mortgage they could, and banks were only too happy to sell off the mortgage paper. The price cap on the mortgages Fannie and Freddie could insure was raised. As a result of all these changes, Fannie and Freddie went from buying mostly mortgages for low-end homes to those of the middle- and upper-middle class. And the share of the nation's conventional mortgage debt which they insure has swelled, to more than 70 percent today, double its share in 1990.

This shift has had two crucial, if under-appreciated, consequences. First, in little more than a decade, Fannie Mae and Freddie Mac have gone from handling one trillion dollars in mortgages to four trillion, with virtually no changes in oversight. Second, their dominance of the mortgage market has profoundly undermined the discipline that once kept housing prices in check.

Once banks knew they could automatically hand off the mortgages they wrote to Fannie and Freddie with basically no risk, the old incentive system dissolved. "Banks and other mortgage lenders are not watching home prices carefully because they rarely hold onto the mortgage paper they create--they just sell it upstream to mortgage investors," John R. Talbott, a housing researcher at UCLA's Anderson School of Business, has argued. "It is a dangerous situation indeed when neither home buyers nor the institutions that finance them are concerned with the ultimate price being paid for the housing asset."

In most markets, buyers and sellers rely on independent experts to bring sanity to prices. In the stock markets during the 1990s, that role had traditionally been played by stock analysts, whose opinions were famously bought off by the investment banks they worked for. Something similar has happened to appraisers, the independent contractors banks hire to determine the worth of a home for the purposes of a mortgage loan. In a recent survey conducted by the October Research Group, more than half of all appraisers said that they personally felt pressured to overstate loans, and "nearly all" said they knew a colleague who had actually done so. The pressure to inflate, October's publisher Joe Casa said, "is much worse now than it's ever been." Industry analysts have estimated that between 15 and 30 percent of houses nationally are over-valued.

It's not just the discipline of banks that keeps people from buying more than they can afford, but also the buyers' own fear and guilt. But in an environment where home prices continue to spiral up, fear and guilt are replaced by a sense that you're a fool not to buy the most house you can possibly get away with.

A particular kind of speculative frenzy ensues, captured in a recent story in The Washington Post which detailed a new phenomenon: home buyers camping out overnight for the chance to be the first in the next morning's open house, ready to buy $700,000 houses in built-out, lush-lawned suburbs like Arlington. The phenomenon has created temporary, yuppie tent cities. The story's authors interviewed several buyers in the tented line who planned to sell their purchases back into a steadily rising market, and concluded, dryly: "There is an element of speculation to the lines."

What makes the current frenzy especially dangerous is that every relevant institution has an incentive to play along. Who, after all, is likely to say stop? Not the realtors. Not the banks, any longer. Not Fannie and Freddie or the private secondary-mortgage operators, who are turning vast profits on the backs of the bubble. Certainly not the Federal Reserve or the Treasury Department, while the economy depends on a sustained housing boom.

By 2000, some acute observers, like Jane D'Arista, a former chief economist for the House Financial Services committee and now a federal funds researcher with the Financial Markets Center, had begun to warn that the situation was untenable. By 2002, a few major players, like Steve Roach, Morgan Stanley's chief economist, had picked up on the concerns about a bubble and Fannie and Freddie's sprawling influence. But Greenspan, Treasury, and GSE officials, in interviews and testimony, denied that housing inflation posed a problem. And, sure enough, in the next year, not only did the bubble fail to deflate, but it also expanded--the housing sector posted its best year ever.

Then, last summer, came a warning no one should have missed: news of major accounting fraud at Freddie Mac. In stocks, corporate accounting scandals appeared after the market plunged, too late to signal danger. But the fraudulent accounting at Freddie Mac was, or should have been, a wake-up call, though the details of this scandal were distinctly different. Instead of hiding losses, as happened at Worldcom and Enron, the accountants at Freddie Mac had been hiding embarrassingly large profits. They feared that higher-than-expected returns might incite more risk-taking and a more volatile housing market than investors in Freddie Mac would like. A number of senior executives were canned, and spooked foreign investors sold off Freddie and Fannie's debt. A sense was emerging, among politicians as well as economists, that Fannie and Freddie were not just running amok, says Tom Stanton, an attorney specializing in government sponsored enterprises, but that they "were showing a combination of high leverage, fast growth, and weak oversight of just two companies that held or guaranteed several trillion dollars of mortgages between them and posed potential systemic risk to the American economy."

Testifying before Congress on July 16, Greenspan did not discuss any of this, nor did he mention a bubble. Instead, he chose to praise the economic benefits of low interest rates and home refinancing. The boom continued unabated. By October, homebuyers were able to refinance to a 30-year fixed-rate loan with a rate of just 4.99 percent.

Eleventh-hour warnings

Still, the accounting scandals, carrying with them a vague, unsavory whiff of Enron, made reforms in the housing market impossible to ignore. Even Franklin Raines, Fannie Mae's chairman, admitted that the GSEs needed to be reined in. In the fall, the House dipped its toes into the water, with a bill that established a single regulator in the Treasury Department with broader authority to make sure the GSEs had their finances in order. At the White House's behest, the Senate Banking Committee began hearings on the same issue in February. The goal of most of the debate in Congress has so far been how to ensure the GSEs financial viability; there has been very little talk about how to reduce their role in the housing markets.

That job fell to Greenspan: Finally, on Feb. 24, testifying before the Senate Banking Committee, he came clean about the risks of the housing market, in a speech reminiscent of his 1996 warning about "irrational exuberance" in the stock market. In his familiar, glum posture, his bald head slouching low over the table, he warned that the GSEs weren't just unstable, but also posed a "systemic risk" to the economy of the United States. He suggested debt caps, to reduce Fannie and Freddie's role in the market, and urged stricter regulation.

The chairman's proposals were both brave and right, the best plan for resolving the structural problems with GSEs that's been put forward yet. But given the political situation, his reforms won't be enacted anytime soon. The day after his testimony, his suggestions were brushed off by everyone from Fannie and Freddie's chief executives to Republicans and Democrats on the Hill. Oh, it's just Greenspan.

Both political parties have bought into the idea that a vast, unfettered Fannie and Freddie are good for the country, and have only amplified the GSEs' "American Dream" rhetoric. Republicans are still invested in the deregulation of Fannie and Freddie they helped engineer in the late 1980s. Democrats, generally the party of more regulation, have historically been Fannie and Freddie's best friends, and the GSEs' lush executive suites are packed with former Democratic staffers: Raines was Clinton's director of the Office of Management and Budget, and his predecessor, James A. Johnson, a longtime aide to Walter Mondale, is now leading John Kerry's search for a running mate. In the hearings on the Hill, neither Democrats nor Republicans have seemed favorably disposed to strict regulation of Fannie and Freddie, and American Banker has concluded that the GSEs' lobbying power is strong enough that no regulatory bill will pass without their okay.

Greenspan, of course, knows all this. He knows his reform initiatives stand little chance politically right now, and he knows that even if, miraculously, they were put into place, they likely won't keep the housing market from crashing. Why even bother to bring it up? Two reasons, say Fed-watchers. First, though he didn't explicitly warn against the housing bubble, Greenspan wants to be able to claim, after the bubble bursts, that he gave fair warning, even though these warnings came at the eleventh hour. But at a less cynical level, the chairman knows that in the American political process real reforms only get put into place after a crisis and not before, but that you stand a better chance of getting them if you publicize them early.

So, why then didn't he bring these issues up even earlier? The answer may be that he simply couldn't afford to--he was relying on a supercharged housing sector to get the economy as a whole through the recession. Indeed, he still is. On the very day that he suggested his reforms of the secondary market, he was trying to squeeze a little more juice out of refinancing with his bizarre advice to consumers about ARMs. And that, ultimately, is the ironic and uncomfortable position that this economy has forced Greenspan into. To get out of the recession, he had to rely on, stay mum about, and even encourage a housing bubble. Now, that very bubble may be the thing that destroys the recovery he has sought to create.

Benjamin Wallace-Wells



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