NEW YORK (Reuters) - The U.S. housing downturn may be the first true test of Ben Bernanke’s leadership at the Federal Reserve, but many on Wall Street say the dilemma has its roots in the legacy of his predecessor, Alan Greenspan.
During his 18 years at the central bank, Greenspan unleashed the greatest credit boom in recent memory, bringing interest rates to their lowest levels in a generation.
The result was an unprecedented lending bonanza that saw risk spreads narrow to all-time lows and sent investors far and wide in search for the highest possible returns.
“Years and years of easy monetary policy under Greenspan created a tremendous amount of excess liquidity, which caused a total mispricing of risk,” said Frank Hsu, director of global fixed-income at Fimat. “Now we’re getting payback.”
Indeed, rising default rates in the U.S. subprime mortgage industry, which targets borrowers with sketchy credit, have begun to jeopardize asset prices worldwide.
Analysts trace this debacle back to Greenspan, who not only cheered on the Internet boom but also battled its bust with yet another dollop of cheap credit.
“He got carried away, caught in the ‘new economy’ hoopla,” said Alan Ruskin, chief international strategist at RBS Greenwich. “That’s ultimately proved quite problematic.”
The strategy helped the U.S. economy recover from the recessions of 1991 and 2001. But as credit concerns worsen and liquidity dries up in some markets, asset managers are increasingly favoring safer securities over riskier ones, with many fearing a disorderly run for the exits.
Consumers have also begun to retrench, as economic growth has slowed this year.
This leaves Bernanke and his central bank colleagues in a bind as they meet on Tuesday to discuss interest rate policy.
They could cut interest rates to provide short-term stimulus to the economy and ensure that liquidity remains plentiful, but this might have the unintended effect of simply prolonging Greenspan’s legacy of financial bubbles.
Alternatively, the Fed may choose to do nothing and hope credit conditions will not tighten rapidly enough to threaten the financial system.
Yet some analysts say such inertia could leave growth vulnerable to the whims of markets, where panic can be the quickest path to economic stagnation.
“Either way, he’s facing a very difficult choice,” said Fimat’s Hsu.
Wall Street’s growing concerns over credit are not unfounded. Despite widespread predictions that the housing boom’s unraveling would not have repercussions outside the sector, the evidence is mounting that it has indeed spread.
For one thing, the days when capital was raised at the snap of a finger appear long gone. Scores of bond offerings have been postponed because would-be financiers are afraid to part with their cash.
This has severely curtailed the appetite for the very leveraged buyouts that propelled the stock market to record highs this year.
“Investors are wondering when the next financial corpse will float to the surface,” the Wall Street Journal wrote in an editorial on Monday.
Cleary, the full extent of the damage is not yet known. It is by no means certain that the problems in the housing sector will mushroom into a full-blown crisis like the collapse of Long Term Capital Management in 1998 or the September 11, 2001, attacks.
Still, things have gotten bad enough to fuel speculation that the Fed will have to cut interest rates before the end of the year despite lingering concerns over inflation. Such a prospect was enhanced following the release of Friday’s employment report, which pointed to a weaker U.S. labor market and rising unemployment.
Throughout all of this, central bank officials have remained sanguine, insisting the housing downturn was contained and would not have a broader impact.
Many believe officials will have to acknowledge the seriousness of the situation in this week’s policy statement, although they must carefully balance any such remarks with positive comments on the economy, if only to prevent the markets from whirling into a tailspin.
But even this trap of perennial optimism can be traced to Greenspan’s legacy. By embracing ephemeral fads like the “new economy” and “innovations in home lending,” the former Chairman made it harder for Fed officials to face reality without unsettling markets.
“The U.S. housing slump was totally predictable, but the Fed remained in denial about it for a very long time,” said Bernard Connolly, global strategist at Banque AIG in London. “A lot of the problems we see today stem from Greenspan’s term in office.”