By Steven K. Beckner

CHICAGO (MNI) – The key to minimizing damage from future financial
crises is ensuring that financial institutions have adequate capital,
not restricting their activities, former Federal Reserve Chairman Alan
Greenspan said Friday.

Greenspan, speaking at the Federal Reserve of Chicago’s annual Bank
Structure Conference, said that in the years prior to the recent
financial 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.”

He blamed the crisis primarily on securitization of subprime
mortgages and said the government sponsored enterprises (GSEs) played a
key role. He acknowledged that regulation by the Fed and other agencies
failed, but said nothing about the role of easy monetary policy earlier
in the decade.

Securitization by Fannie Mae, Freddie Mac and others of subprime
mortgages — loans made to people who could not meet a 20% down payment
requirement — set the stage for the crisis, he argued.

“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,” Greenspan said.
“An even heavier demand was driven by the need of Fannie Mae and Freddie
Mac to fund their exceptionally large “affordable housing” mandates.”

Greenspan said that during 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.”

And he said “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,”
he said. “Compounding the problem, Fannie Mae and Freddie Mac subprime
securities portfolios were 99% adjustable rate by the end of 2004.”

The long period of relative stability, which Fed officials and
others came to dub “the Great Moderation,” played a key role in lulling
financial firms and their regulators into complacency, he said.

As a result, “large bank capital buffers appeared increasingly less
pressing,” he said. “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.

Greenspan said the big banks’ “risk management” systems, on which
the Fed was then relying heavily, failed.

The next “bulwark against crisis” to fail, he said, was credit
rating agencies, which frequently stamped mortgage backed securities and
their derivative products as AAA.

Finally, the regulatory system “failed,” he said. “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.”

Financial regulators cannot forecast either financial innovations
or crisis triggers, said Greenspan. But “with adequate capital and
collateral, such forecasts are unnecessary.”

“Losses, by definition, will be fully absorbed by equity
shareholders,” he said. “If capital is adequate, no debt will default
and serial contagion will be thwarted.”

So Greenspan said “determining the proper level of risk-adjusted
capital should be the central focus of reform going forward.”

Greenspan made clear he thinks that the eponymous Volcker Rule,
named after his predecessor as Fed Chairman Paul Volcker, is not the way
to go with its limitations on the size and scope of bank activities.

“We can legislate prohibitions on the kinds of securitized assets
that aggravated the current crisis,” he said. “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.”

Greenspan was also skeptical of systemic risk management by the
authorities, as would be mandated in legislation working its way through
Congress.

He predicted “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,” he said. “Adequate
risk-adjusted capital assures that taxpayers would not be at risk.”

** Market News International Chicago Bureau **

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