Greenspan: 'Credit tsunami' to have severe impact

WASHINGTON - October 23, 2008 - Greenspan was to be the leadoff witness at a House hearing lawmakers called to question past key financial players about what they felt caused the most grave financial crisis since the 1930s. The witnesses were also expected to be asked how they thought the government would deliver the nation from the economic turmoil.

Greenspan was the chairman of the Federal Reserve for 18½ years. In testimony prepared for the House Government Oversight and Reform Committee, he voiced shock over the present turn of events and called conditions deplorable.

He said that he and others who believed lending institutions would do a good job of protecting their shareholders are in a "state of shocked disbelief." And Greenspan also 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."

He 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 added, then "the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards reengagement 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.

In his written testimony, 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 overeager 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," he asserted.

Meanwhile, Neel Kashkari, the interim head of the government's $700 billion rescue effort, and other government officials were going before the Senate Banking Committee to lay out their plans for implementing the massive program.

Both hearings were expected to be contentious as lawmakers, already upset about having to vote for the biggest bailout in U.S. history, sought answers to what went wrong and try to determine why the government's rescue effort, which just cleared Congress on Oct. 3, already has undergone a radical overhaul.

All the action in Washington was taking place against a backdrop of continued turbulence on financial markets around the world. The Dow Jones industrial average plunged by 514 points Wednesday amid fears that the government intervention will not be enough to prevent a serious global recession. Ahead of Thursday's market opening, the Dow was down 122 points at the 8,435 level.

Asian stocks fell for a second consecutive day Thursday, with South Korea's market sinking 7.5 percent. Japan's Nikkei 225 stock average closed down 2.5 percent, and Hong Kong's Hang Seng Index was down 4.7 percent. European stock markets were modestly lower.

Storm clouds were forming on the labor front, too. The government reported that new applications for unemployment benefits increased by more than expected last week as companies cut jobs due to the slow economy. New claims for jobless payments rose 15,000 to a seasonally adjusted 478,000, slightly above analysts' estimates of 470,000.

While conducting major hearings so close to an election is unusual, House Oversight Committee Chairman Henry Waxman, D-Calif., said the current crisis was so serious that Congress could not wait until a new administration arrives in January to find out "what went wrong and who should be held accountable."

Democrats see the prime culprits as greedy Wall Street executives and lax government regulations under a Republican administration, a view that the administration and Republicans in Congress dispute strongly.

Once praised as the "maestro" of the U.S. financial system during the 1990s economic boom, Greenspan, who was succeeded in 2006 by Ben Bernanke, was likely to find himself defending actions he took that are being blamed for contributing to the current crisis.

Greenspan, true to his Republican free-market principles, successfully opposed attempts to impose tighter controls on complex financial contracts known as derivatives, which are largely unregulated and which some see as a contributing factor in the current problems.

Greenspan recently described the current episode as the type of wrenching financial crisis that comes along only once in a century. He has defended the use of derivatives, so-named because their value is derived from the value of an underlying asset. He said they were useful in helping to spread risks.

Lawmakers in particular want government officials to explain why the emphasis in the rescue package has switched from a program that initially was aimed at buying billions of dollars of troubled mortgage-related assets from banks as a way to spur them to resume more normal lending.

A week ago, Treasury Secretary Henry Paulson announced that the program now would have as a major component the purchase by the government of $250 billion in stock in hundreds of U.S. banks, including $125 billion that would go to nine of the largest institutions. Paulson has said that the fast-moving nature of the crisis convinced him that money needed to get out more quickly as a way to encourage banks to start lending again.

But questions have been raised about whether the huge infusion of government money will actually spur more lending, especially after several banks have said they planned to employ the new capital to help finance purchases of weaker rivals.

Sens. Charles Schumer, D-N.Y., Jack Reed, D-R.I., and Robert Menendez, D-N.J., sent a letter to Paulson on Wednesday complaining that Treasury had failed to establish adequate standards "to assure that banks put this capital to good use in the lending markets."

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