Greenspan says flaw in market system

[October 24, 2008]  WASHINGTON (AP) -- Former Federal Reserve Chairman Alan Greenspan, describing the current financial crisis as a "once-in-a-century credit tsunami" acknowledged Thursday that the crisis has exposed flaws in his thinking and in the workings of the free-market system.

Greenspan told the House Oversight Committee that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had been proven wrong by the current crisis. He called this a "mistake" in his views and said he had been shocked by that.

Greenspan said he had made a "mistake" in believing that banks in operating in their self-interest would be sufficient to protect their shareholders and the equity in their institutions.

Greenspan called this "a flaw in the model that I perceived is the critical functioning structure that defines how the world works."

The head of the nation's central bank for 18 1/2 years, Greenspan said in his testimony to the committee that he and others who believed lending institutions would do a good job of protecting their shareholders are in a "state of shocked disbelief."

During questioning, Greenspan was challenged about various statements he had made during the five-year housing boom including forecasts that it was unlikely that there would be a nationwide collapse of home prices.

Greenspan said he had failed to predict a significant decline in home prices because the country had never experienced such a decline before.

Greenspan said that the current crisis had "turned out to be much broader than anything that I could have imagined."

The committee called Greenspan to testify along with former Treasury Secretary John Snow and Securities and Exchange Commission Chairman Christopher Cox as lawmakers sought to discover if regulatory failings had contributed to the crisis.

House Oversight Committee Chairman Henry Waxman said that he believed that the Federal Reserve, which regulates banks, the SEC and the Treasury had all played a role in contributing to the mistakes.

"The list of mistakes is long and the cost to taxpayers is staggering," Waxman, D-Calif., told the three men. "Our regulators became enablers rather than enforcers. Their trust in the wisdom of the markets was infinite. The mantra became that government regulation is wrong. The market is infallible."

In his testimony, Greenspan blamed the problems on heavy demand for securities backed by subprime mortgages by investors who did not worry that the boom in home prices might come to a crashing halt.

"Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment," Greenspan said. "Fearful American households are attempting to adjust, as best they can, to a rapid contraction in credit availability, threats to retirement funds and increased job insecurity."

Greenspan said that a necessary condition for the crisis to end will be a stabilization in home prices but he said that was not likely to occur for "many months in the future."

When home prices finally stabilize, Greenspan said, then "the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards re-engagement with risk."

Greenspan said until that occurs, the government is correct to move forward aggressively with efforts to support the financial sector. He called the $700 billion rescue package passed by Congress on Oct. 10 "adequate to serve the need" and said that its impact was already being felt in markets.

Greenspan did not specifically address the criticism he is receiving now as being partly to blame for the current crisis.

Greenspan's critics charge that he left interest rates too low in the early part of this decade, spurring an unsustainable housing boom, while also refusing to exercise the Fed's powers to impose greater regulations on the issuance of new types of mortgages, including subprime loans. It was the collapse of these mortgages and rising defaults a year ago that triggered the current crisis.

In his testimony, Greenspan put the blame for the subprime collapse on over-eager investors who did not properly take into account the threats that would be posed once home prices stopped surging upward.

"It was the failure to properly price such risky assets that precipitated the crisis," Greenspan said.

[Associated Press; By MARTIN CRUTSINGER]

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