Alan Greenspan, former Federal Reserve chairman, with John Snow, former Secretary of the Treasury, at a hearing on Capitol Hill on Thursday.
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WASHINGTON (AP) — Alan Greenspan, the former Federal Reserve chairman, said Thursday that the current financial crisis had uncovered a flaw in how the free market system works that had shocked him.
CNBC Video: Greenspan TestimonyMr. Greenspan told the House Oversight Committee on Thursday that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had proved to be wrong.
Mr. Greenspan said he had made a “mistake” in believing that banks operating in their self-interest would be enough to protect their shareholders and the equity in their institutions.
Mr. Greenspan said that he had found “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”
Mr. Greenspan, who headed the nation’s central bank for 18.5 years, 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.”
He said that the current crisis had “turned out to be much broader than anything that I could have imagined.”
The committee called Mr. Greenspan to testify along with former Treasury Secretary John W. Snow and the Securities and Exchange Commission chairman, Christopher Cox, as lawmakers sought to discover if regulatory failings had contributed to the crisis.
The committee chairman, Henry A. Waxman, said he believed that the Federal Reserve, which regulates banks, the S.E.C. and the Treasury had all played a role in contributing to the mistakes.
“The list of mistakes is long and the cost to taxpayers is staggering,” Mr. Waxman, a California Democrat, told the three men. “Our regulators became enablers rather than enforcers. Their trust in the wisdom of the markets was infinite. The mantra became that government regulation is wrong. The market is infallible.”
In his testimony, Mr. Greenspan 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,” Mr. 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.”
Mr. Greenspan said that a necessary condition for the crisis to end would 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, Mr. Greenspan said, then “the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards re-engagement with risk.”
Mr. Greenspan said until that occurred, the government was 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.
Mr. Greenspan did not specifically address the criticism he is receiving now as being partly to blame for the current crisis.
Mr. 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 led to the current crisis.
In his testimony, Mr. 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,” Mr. Greenspan said.
