Credit Crisis

Alan Greenspan is trying to steer the blame away from himself. Before the House Oversight Committee, he said that outside of credit default swaps, the bulk of financial derivatives had not caused major problems. He said the boom in subprime lending occurred because of the huge demand for investment opportunities in a global economy, and he blamed the crash on a failure by investors to properly assess the risks from such mortgages, which went to borrowers with weak credit.

This totally misses the point. The free market ideology says that smarter investors would recognize the risks of this model and punish those who did not mitigate the risks. The very existence of speculative bubbles should refute that ideology, but people can be pretty obtuse. Free markets are useful, but they must be recognized as unstable.

Here's the real culprit. For decades, financial institutions have been required to maintain as liquid assets a fraction of the mortgage balances they hold. This policy was designed to prevent the kind of fiscal meltdown we're seeing today. But to the bankers, this dead money is billions in wasted income. So JP Morgan invented Credit Default Swaps, which are basically insurance policies against forclosure losses. With those risks off the balance sheet, the bankers were free to invest the extra money and make billions without breaking the law. The insurers were not banks, and were not bound by the protective regulation.

This would not be a problem except for one thing. Insurance companies survive hurricane payouts using premiums paid by policyholders in earthquake zones. Just an example, but you get the idea. No catastrophe affects all policyholders at once. But that is not true of housing prices. They are cyclical. The insurance model does not work for mortgage risk.

If you think the insurers should be required to maintain the liquid assets, you get it.