Former Federal Reserve Chairman Alan Greenspan is set to testify today before the House Committee of Government Oversight and Reform. These are his prepared remarks:

Mr. Chairman, Ranking Member Davis, and Members of the Committee:

Thank you for this opportunity to testify before you this morning.

Greenspan

We are in the midst of a once-in-a century credit tsunami. Central banks and governments are being required to take unprecedented measures. You, importantly, represent those on whose behalf economic policy is made, those who are feeling the brunt of the crisis in their workplaces and homes. I hope to address their concerns today.

This morning, I would like to provide my views on the sources of the crisis, what policies can best address the financial crisis going forward, and how I expect the economy to perform in the near and longer term. I also want discuss how my thinking has evolved and what I have learned in this past year.

In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences. This crisis, however, has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment. 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. All of this implies a marked retrenchment of consumer spending as households try to divert an increasing part of their incomes to replenish depleted assets, not only in 401Ks, but in the value of their homes as well. Indeed, a necessary condition for this crisis to end is a stabilization of home prices in the U.S. They will stabilize and clarify the level of equity in U.S. homes, the ultimate collateral support for the value of much of the world’s mortgage-backed securities. At a minimum, stabilization of home prices is still many months in the future. But when it arrives, the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards reengagement with risk. Broken market ties among banks, pension, and hedge funds and all types of nonfinancial businesses will become reestablished and our complex global economy will move forward. Between then and now, however, to avoid severe retrenchment, banks and other financial intermediaries will need the support that only the substitution of sovereign credit for private credit can bestow. The $700 billion Troubled Assets Relief Program is adequate to serve that need. Indeed the impact is already being felt. Yield spreads are narrowing.

As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.

What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer. But subprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world. These mortgage backed securities being “subprime” were originally offered at what appeared to be exceptionally high risk-adjusted market interest rates. But with U.S. home prices still rising, delinquency and foreclosure rates were deceptively modest. Losses were minimal. To the most sophisticated investors in the world, they were wrongly viewed as a “steal.”

The consequent surge in global demand for U.S. subprime securities by banks, hedge, and pension funds supported by unrealistically positive rating designations by credit agencies was, in my judgment, the core of the problem. Demand became so aggressive that too many securitizers and lenders believed they were able to create and sell mortgage backed securities so quickly that they never put their shareholders’ capital at risk and hence did not have the incentive to evaluate the credit quality of what they were selling. Pressures on lenders to supply more “paper” collapsed subprime underwriting standards from 2005 forward. Uncritical acceptance of credit ratings by purchasers of these toxic assets has led to huge losses.

It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

When in August 2007 markets eventually trashed the credit agencies’ rosy ratings, a blanket of uncertainty descended on the investment community. Doubt was indiscriminately cast on the pricing of securities that had any taint of subprime backing. As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty surveillance.

There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitization. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.

The financial landscape that will greet the end of the crisis will be far different from the one that entered it little more than a year ago. Investors, chastened, will be exceptionally cautious. Structured investment vehicles, Alt-A mortgages, and a myriad of other exotic financial instruments are not now, and are unlikely to ever find willing investors. Regrettably, also on that list are subprime mortgages, the market for which has virtually disappeared. Home and small business ownership are vital commitments to a community. We should seek ways to reestablish a more sustainable subprime mortgage market.

This crisis will pass, and America will reemerge with a far sounder financial system.

Greenspan Admits Errors to Hostile House Panel

By KARA SCANNELL and SUDEEP REDDY

Alan Greenspan, lauded in Congress while the economy boomed, conceded under harsh questioning from lawmakers that he had made mistakes during his long tenure as Federal Reserve chairman that may have worsened the current slump.

In a four-hour appearance before the House Oversight Committee Thursday, Mr. Greenspan encountered legislators who interrupted his answers, caustically read back his own words from years ago, and forced him to admit that, at least in some ways, his predictions and policies had been wrong.

 

Greenspan 'Shocked' by Breakdown

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Former Fed Chairman Alan Greenspan said he was "shocked" by the breakdown in the credit system and told Congress the crisis was once in a century. Video courtesy of Reuters. (Oct. 23)

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Former Federal Reserve Chairman Alan Greenspan testifies during a House Oversight and Government Reform Committee hearing on Capitol Hill Thursday.

Returning to Capitol Hill amid a financial crisis rooted in mortgage lending, Mr. Greenspan said he had been wrong to think banks' ability to assess risk and their self-interest would protect them from excesses. But the former Fed chairman, who kept short-term interest rates at 1% for a year earlier this decade, said no one could have predicted the collapse of the housing boom and the financial disaster that followed.

Lawmakers weren't buying his explanations. "You had the authority to prevent irresponsible lending practices that led to the subprime-mortgage crisis. You were advised to do so by many others. And now our whole economy is paying its price," said Rep. Henry Waxman (D., Calif.), chairman of the House committee.

Lawmakers read back quotations from recent years in which Mr. Greenspan said there's "no evidence" home prices would collapse and "the worst may well be over."

The 82-year-old Mr. Greenspan said he made "a mistake" in his hands-off regulatory philosophy, which many now blame in part for sparking the global economic troubles. He quoted something he had written in March: "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief."

He conceded that he has "found a flaw" in his ideology and said he was "distressed by that." Yet Mr. Greenspan maintained that no regulator was smart enough to foresee the "once-in-a-century credit tsunami."

The hearing made clear how far the 18-year central banker's reputation had fallen from the days when he was hailed for his stewardship in keeping inflation low, holding growth up and helping pull the world through financial crises, including the Asian crisis and other turmoil a decade ago.

Two and a half years after Mr. Greenspan left office, Congress is drawing plans to remake global financial regulation with the kind of tight government hand that he long opposed. At the same House hearing, Securities and Exchange Commission Chairman Christopher Cox, himself a longtime free-market Republican, said he supported merging his agency with the Commodity Futures Trading Commission, creating a beefed-up supercop to police certain previously unregulated financial products.

Amid the barrage of questions, Mr. Greenspan dodged and weaved. He would begin meandering responses in the elaborate phraseology that once served him so well, only to be cut off as lawmakers sought to use their brief question time for sharper attacks.

In an echo of the Watergate hearings 35 years ago, Mr. Greenspan was asked when he knew there was a housing bubble and when he told the public about it. He answered that he never anticipated home prices could fall so much. "I did not forecast a significant decline because we had never had a significant decline in prices," he said.

Mr. Greenspan's confidence in the resilience of home prices — shared by most in the industry at the time — became a critical forecasting error. The belief spurred more mortgage underwriting because lenders assumed that borrowers living on the edge could always refinance or sell their homes for a profit if they ran into trouble. Instead, with home prices now falling, hundreds of thousands of homeowners are facing foreclosure. Prices nationwide have fallen nearly 20% since their 2006 peak, and many economists foresee a further decline of 10% or more in the next year.

The difficulties of forecasting served as a key defense for Mr. Greenspan. The Federal Reserve, with its legions of Ph.D. economists, has a better forecasting record than the private sector, he said, but that's still not enough to prevent every problem. "We were wrong quite a good deal of the time," he said. Forecasting "never gets to the point where it's 100% accurate."

Subprime mortgages led to a global economic crisis in considerable part because of securitization, in which the home loans were sliced up, packaged into securities and sold off to investors all around the world. Anticipating such a crisis is "more than anybody is capable of judging," Mr. Greenspan said.

If the best experts were not able to foresee the development, "I think we have to ask ourselves, 'Why is that?'" Mr. Greenspan said. "And the answer is that we're not smart enough as people. We just cannot see events that far in advance."

He continued, "There are always a lot of people raising issues, and half the time they're wrong. The question is what do you do?"

Lawmakers, stung by having to put $700 billion of taxpayer money on the line to rescue the financial system, were unmoved throughout the hearing, and eager to make their own points about the situation.

Rep. John Yarmuth, Democrat of Kentucky, hit Greenspan close to home, calling the avid baseball fan one of "three Bill Buckners." That was a reference to the Boston Red Sox first baseman whose flubbed handling of a routine grounder cost his team the 1986 World Series. Former Treasury Secretary John Snow and Mr. Cox, who sat alongside Mr. Greenspan, also got tagged with that comparison.

Lawmakers homed in on a warning the late Fed governor Edward Gramlich gave Mr. Greenspan in 2000 about potential problems in lending practices. Mr. Greenspan said he agreed but added that if the matter was of such high concern, a Federal Reserve subcommittee would have presented it to the full board. He said that never occurred.

The former Fed chief also said he was often following the "will of Congress" during his long tenure and did "what I am supposed to do, not what I'd like to do."

Mr. Greenspan has spent much of this year defending his record at the Fed, trying to take apart arguments to show how his decisions were far less significant than outside forces in causing the crisis.

The central bank is blamed for too vigorously spurring home buying through its low short-term interest-rate targets, which were initially set to fight the economic slump after the dot-com bubble burst in 2000-01. Mr. Greenspan maintains that the development of China and other factors fostered low rates — around the globe and not just in the U.S. — contributing to a housing boom that was world-wide.

Lawmakers took Mr. Greenspan to task for his advocacy of credit-default swaps, an unregulated kind of insurance contract that can help investors protect themselves against another party's bankruptcy. Credit-default swaps were also used as a way of taking risks and are widely blamed for adding to financial-market instability. Rep. Waxman asked pointedly, "Were you wrong?"

Mr. Greenspan said, "Partially." While he cautioned the lawmakers against excessive regulation, he said credit-default swaps "have serious problems" and, after some pointed questions, agreed they should be subject to oversight.

The treatment was a striking contrast with one of Mr. Greenspan's last appearances before Congress as Fed chairman, on Nov. 3, 2005. "You have guided monetary policy through stock-market crashes, wars, terrorist attacks and natural disasters," Rep. Jim Saxton (R., N.J.) told him then. "You have made a great contribution to the prosperity of the U.S. and the nation is in your debt."

—Brian Blackstone contributed to this article.