- The Washington Times - Saturday, January 28, 2006

Federal Reserve Chairman Alan Greenspan leaves office this week with a glowing legacy, having presided for 18 years over an extraordinary period of economic progress and stability in the United States.

But his sterling reputation — he often is hailed as the best Fed chief in history — may be tarnished by growing concerns about a bubble in housing markets on the East and West coasts that many economists believe was nurtured by the extremely low interest rates engineered by the Fed from 2000 to 2004.

Under Mr. Greenspan’s stewardship, the Fed cut rates below the rate of inflation through a series of moves in response to the stock market crash of 2000, the September 11, 2001, terrorist attacks, the corporate scandals of 2002 and an emerging threat of deflation in 2003.

While the moves bolstered the economy and prevented the 2001 recession from being deep and painful, they unexpectedly spawned a unprecedented binge of buying and speculation in housing.

Home sales and prices hit records every year at an accelerating pace. By the middle of last year, when the market finally started settling down, prices had doubled or tripled in coastal cities and resort areas.

One result is that American households are saddled with record levels of debt and have driven up U.S. debt to the outside world to levels that pose dangers for the economy.John Makin, a visiting scholar at the American Enterprise Institute, said he knew Mr. Greenspan was dealing with a bubble of his own making when he saw condo prices double in Key West in one year. Units under construction in the Florida resort last year sold four times over before they were even occupied, he said.

It was the second bubble under Mr. Greenspan’s tenure after the tech-stock bubble of the late 1990s.

“The current U.S. housing bubble is the result of two aspects of Fed policy,” Mr. Makin said.

Fed to the rescue

One is the series of rate cuts the Fed carried out in response to various economic shocks. Between 2001 and 2003, the Fed lowered its main lending rate from 6 percent to 1 percent, before beginning to raise rates in June 2004.

The other is the widespread impression the Fed’s actions left on investors that the central bank will do whatever is necessary to prevent a meltdown in asset markets out of concern that it would damage the economy.

The Fed-engineered rescue of the Long Term Capital Management hedge fund during the financial crisis of 1998 added to the conviction that Mr. Greenspan would “spike the punchbowl” to cushion market falls, even if they are fueled by reckless speculation gone awry, Mr. Makin said.

The idea that investors could count on the Fed for a bailout was encouraged by Mr. Greenspan’s own statements that the Fed cannot stop or prevent a bubble, and the Fed’s only role is to intervene in the aftermath of a bubble to prevent the collapse from hurting the economy.

Hopes that the Fed will come to the rescue of hapless housing investors if the overheated market collapses “rightly or wrongly made the housing bubble intensify,” Mr. Makin said.

Another economist, John R. Talbott, author of “Sell Now: The End of the Housing Bubble,” said Mr. Greenspan intentionally fed the housing boom by offering “possibly the worst financial advice ever given to the American people” in February 2004.

In a speech at the Credit Union National Association, Mr. Greenspan questioned why so many people take out conservative, 30-year fixed-rate mortgages instead of adustable-rate mortgages, which have lower initial monthly payments but are riskier because the rates can climb sharply.

“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,” he said.

Cause and effect

After his comments, use of adjustable-rate mortgages and unconventional loans surged. By the middle of last year, 70 percent of all new mortgage loans were adjustable-rate, interest-only or subprime with unconventional terms.

Economists say these more liberal lending instruments are responsible for extending the life of the housing boom even when home prices rose so high in some areas that they were unaffordable for average households.

“It is Greenspan who started this whole real estate bubble mess when he cut interest rates to 1 percent to try to prevent the dot.com bubble from dragging the entire economy down,” Mr. Talbott said.

Mr. Makin gives Mr. Greenspan credit for trying to gently let the air out of the housing market since mid-2004 through a series of interest-rate increases that is expected to culminate with a 14th quarter-point rate increase Tuesday.

The sharp rise in short-term rates has hit homeowners with adjustable-rate mortgages particularly hard, helping to cool the housing market.

But the remarkable run-up in housing had some unintentional side effects that remain beyond the Fed’s control and may force it to raise rates much higher, Mr. Makin said.

The flurry of innovative mortgage loans and cash-out refinancings has enabled consumers to tap into their soaring home equity and go on a spending spree — magnifying the impact of the housing boom on the economy.

The availability of billions of dollars in funds drawn from home equity enabled consumers to spend beyond their incomes for the first time in history last year, and it has become a powerful force for inflation, Mr. Makin said.

Deregulating banking

Mr. Greenspan also gets some blame for opening the door to the risky and sometimes abusive lending practices that have fed the housing bubble, because of his strong push for deregulation of banking and lending during his years at the Fed.

Growing concern about abuses of exotic instruments such as interest-only loans and optional-payment adjustable-rate mortgages forced the Fed and other bank agencies last month to move for the first time to limit the most questionable lending practices.

But because most mortgage lenders now operate outside the banking system, some analysts question whether the banking directive will have much effect.

Banks and savings & loans used to provide most mortgages, but their share of the $2.8 trillion market dwindled to less than half in recent years, according to Harvard University’s Joint Center for Housing Studies.

While Mr. Makin faults Fed policy under Mr. Greenspan for helping to create two market bubbles, he says the result was unintended — and perhaps even necessary — given the extraordinary series of economic shocks the Fed was handling.

Horacio Marquez, an investment analyst formerly with Merrill Lynch, said he is worried that Ben Bernanke, the new Fed chairman who takes the helm Wednesday, will follow in Mr. Greenspan’s footsteps.

Like Mr. Greenspan, Mr. Bernanke has testified that he does not believe there is a nationwide housing bubble. Mr. Greenspan has testified that there may be bubbles in some local markets, but not a national one.

“There’s no question there is a housing bubble and that it will burst,” Mr. Marquez said. “I’m so sure of this, I don’t even own my primary residence.

“The housing boom has been propelled by widespread availability of highly speculative mortgages,” and will end badly, he said. “Historically, when lending expands dramatically, it is always followed by a marked increase in bad loans.”

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