Thanks Mr. Greenspan!

by Justin Weinger on August 11, 2007

Let me preface everything I’m about to write by reminding you that despite having a degree in business/finance, I am nothing more than an arm-chair economist. I find economic theory to be completely fascinating, but at the same time, I’m not exactly well versed in it.

That being said, I don’t think it takes a PhD in economics to realize that both the United States and the world’s economies are in a very, very tight spot right now. Credit markets are seizing up, world indices are swinging wildly each and every day and there appears to be a lack of credible and feasible solutions to the problems.

In short, I think we are on the verge of a very significant international recession. While I don’t think we’re going to see anything like the Great Depression, I fear that many of us – throughout the world, not just in the U.S. – are on the verge of financial ruin.

While it’s tough to place the blame on just one country or group of countries, especially considering how interconnected the world has become, I think it’s safe to say that one person (yes, a single individual) should be held accountable for a large portion of the problems we’re facing right now.

That person’s name is Alan Greenspan.

You see, Mr. Greenspan was the champion of cheap money. Under his watch, we saw the Federal Reserve, the group entrusted with controlling our country’s money supply, drop federal funds rate 1% – an absurdly low amount.

While this helped to stimulate growth in what had become a stagnant economy (especially after the September 11 attacks) it brought a lot of cheap money into the economy. What I mean by cheap money is due to the historically low interest rates there wasn’t much cost associated with borrowing money.

This of course ended up being the major cause behind this country’s real estate boom and subsequent bust.

We have always been brought up to believe in the “American dream,” part of which includes owning your very own home. Since most of us don’t have between $200,000 and $500,000 spare cash lying around, the most common way for people to realize this dream is to borrow money from a lending institution. However, because these institutions aren’t charities, they expect to be paid extra (the interest that you pay) in order to compensate for the large amount of money they give to you so that you may buy your home.

When the Fed continued to lower interest rates, it became easier for people to afford to own a home because essentially their payments would be lower due to the decreased interest expense. However, because more people could afford houses, the demand for houses began to increase, and as we all know from basic economics, as demand increases, prices tend to increase as well.

Additionally, for those of us who already owned a home and had realized a gain in equity (due to the increased values) we were able to borrow against our homes (usually with a home equity credit line) at a cheap rate and with the possibility of that money being tax deductible. Essentially, our homes became ATM machines.

So far we’ve covered regular first time home buyers as well as people who already owned homes and borrowed money against their house’s escalating value. Two down, two to go.

Now, we’ve got home builders. Because they see that there is now a huge demand for houses because of absurdly cheap money, they jump in and just start building left and right. Condos, townhouses, regular sized homes, McMansions, you name it, they built it. And people were buying left and right.

Finally, we come back to Mr. Greenspan and his desire for alternative mortgages.

Not too long ago, pretty much the only way that you could buy a house would be to qualify for a fixed rate mortgage, typically a 30 year loan, and at closing put down 20% of the value of the house you were buying. Example – you’re buying a $100,000 house; at closing you would hand over $20,000 and you would assume a 30 year, fixed rate mortgage for $80,000.

Because it’s asking a lot for someone to be able to pony up tens of thousands of dollars when buying a home, many people previously had to sit on the sidelines, rent, and hope to be able to save up enough money over time. Unfortunately, this wasn’t good enough for Mr. Greenspan, who encouraged lenders to become more creative in their lending products.

This, in turn, led to items like the ARM mortgage, the interest only mortgage, and mortgages that offered teaser rates only to balloon after a short period of time or actually tack the “unpaid” interest onto the back of the balance of the loan.

Essentially, this allowed people who had no business buying a home to not only buy a home, but probably a much bigger home than they could ever realistically expect to afford.

Aside from people who actually wanted to live in the house that they purchased, these low rates and wacky mortgages brought out many people who were looking to make a quick buck in the market. I’m sure you’ve seen the commercials for real estate flipping programs, where someone buys a property using an alternative mortgage, waits for the property to appreciate and then quickly flips it for a profit.

It was these investors that artificially drove up the prices of homes throughout the country. They had no intent on living in the property, but because they were buying something that other people wanted, they were essentially driving up the prices of every house around theirs (including their own property).

Anyway, so Mr. Greenspan set all of this up by dropping interest rates to 1%. Then, he flipped the tables by raising interest rates 17 consecutive times to the current rate of 5.25%. Essentially, he got most people in the country to buy into the 1% teaser rate, knowing that it couldn’t stay that long forever, and then raised the price on everyone and everything.

Granted, he HAD to raise the rates, otherwise inflation would have crippled the country; but he pretty much set up a no win situation. Either he had to keep the rates low and let lots of cheap money slosh around in the economy or he had to raise the rates and watch as people who bought using these creative mortgages suffer to make their higher payments.

This uncertainty in the housing sector (as well as the credit sector in general) has caused both the U.S. and world stock markets to fall sharply during the last three weeks, and, unfortunately, there doesn’t appear to be a rosy resolution in sight.

I believe that Ben Bernanke is doing the right thing by keeping interest rates where they are and not caving in to pressure to lower interest rates to soothe the credit market. I don’t believe that it is his (or the Fed’s) job to bail out these mortgage companies by lowering rates to revive a dying housing market. And, even though it’s sad to say, it’s not his job to bail out people who bought homes that they couldn’t reasonably afford.

It looks like the only way this problem is going to be solved is by tough love from the Fed. Keep interest rates the same (or even raise them slightly), stabilize the dollar, and let the housing market correct itself.

By doing this, we may end up in a mild recession throughout the country as the housing ATM dries up and people spend less money, but, like always, we will recover and ultimately resume our upward trend.

No thanks to Mr. Greenspan though.



J at Not One Cent August 11, 2007 at 7:50 pm

Well said, except that Bernanke’s Fed reversed itself yesterday in humiliating fashion (click my name link if interested).

Brian Carr August 12, 2007 at 5:32 am

That’s a very good point, but they are in a very tough spot. They can’t soothe the markets by keeping rates where they are, but they can’t drop rates either. While they say they’re going to worry about inflation over credit, aren’t they creating inflation by pumping cash into the economy? Ugh, I think we’re in a very bad spot and unfortunately, not too many people realize it.

I think we’re going to look back in 50 years and say that Alan Greenspan is one of the worst things to happen to this country.

Dk March 10, 2008 at 9:19 pm

It’s interesting as I worked in real estate during the very period your discussing, and remember everyone talking about how you should just get the lowest variable rate you can get and just refinance later.
That is of course, assuming that you CAN refinance later or even if that really makes any economic sense. Refinancing costs money – and people just assumed they would have a job at the time you need to refinance to be able to afford it – which apparently did not happen causing this crisis.

Furthermore, some much of the investment advice I have read suggests you should not pay down your mortgage first before investing in high return investments like the stock market, because by paying off your debt is a lower return.
This of course is true, but that advice is good ONLY if you assume you will always have a sound and stable economy.
Because obviously if you lose your job, and can no longer afford to pay anything, never mind your stock investments, it’s obvious that paying down your debt was more valuable.

I guess my point is that, just like in the 1920’s, before the last great depression, people have such a rosy “bull market” type of psychology, in which they seem to truly believe nothing bad can happen and that prosperity is a given.
Our prosperity has made us so divorced from the possible financial consequences that people lost the ability to create sound financial plans.
Unfortunately a great big bear is coming, either way – and after it’s aftermath we will be very different people.

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