Often these days, I hear people saying that the real estate bubble was created by Greenspan. I wonder where they got this idea from, because it sounds like finding the perfect scapegoat for excesses that not only bankers created, consumers were speculating on real estate, hence fuelling price increases. When consumers buy properties by taking mortgages they cannot afford while expecting to sell the property after one year for nice profit are simply trying to make money out of thin air. This sounds very much like a bubble to me, and we all know bubble do not last.

So, what happened?

Obviously, low interest rates in 2002 – 2004 made borrowing cheap, and real estate prices go up. This happened before, and it will most probably continue to be like that in the future. So is this Greenspan’s mistake of having set the interest rates at such a low level that real estate prices exploded? Was it a mistake to keep the interest rates so low for so long?

Before answering this question, let’s first analyze the way the Fed operates and how the Fed sets the interest rates. First of all, the Fed’s objective is dual, it has to keep inflation under control while ensuring a healthy growth. This is more vague than in Europe, where the European Central Bank’s (ECB) primary objective is to control inflation, hence a more stringent approach on interest rates, generating conflicts between politicians and the ECB’s chief because higher interest rates increase the cost of borrowing therefore decreasing the incentives to invest which in turn contains growth.

The Fed wants therefore to maximize growth under the constraint of inflation. When inflation is ramping up, the Fed increases the interest rate, and when an economic downturn is looming, inflation decreases as corporate slash prices to get rid of inventories. In the latter case, the Fed decreases interest rates to increase investments which in turn generates employment to make the economy grow.

Now that we know how the interest rates are set, why did the Fed decrease the interest rates so much and why did the Fed keep the interest rates so low for so long? Pretty simple, inflation levels were falling rapidly and there was a risk of deflation. Between January 2002 and January 2004, inflation fell from 2.7% to 1.3%! The Fed therefore decreased the interest rates, and real estate prices started to increase very rapidly.

If it is so simple, how could such a bubble be created? First of all, interest rates were low, so a natural increase in real estate prices started. The problem however, was that bankers and mortgage brokers saw a huge opportunity to sell mortgages, and sell they did. They sold mortgages without doing a proper due diligence on the mortgage buyer. Money was available, so they sold not only one mortgage, but many mortgages to the same person. And everything was going all right as long as property prices kept on increasing, but when the owner can’t find a buyer anymore to make the profit out of thin air, everything collapses like a house of cards.

Why did Greenspan tell the congress that he acknowledges having made a mistake?

Actually, he did not acknowledge having made a mistake on the interest rate levels, he acknowledged the fact that he did not want the financial innovations like CDOs to be regulated. Obviously, CDOs were playing a large role in the mortgage bubble, CDOs were made to provide homeowners and investors all the money they needed for mortgages, and this money needed to come from somewhere. CDO structurers and banks were happy to package mortgages in opaque and complex financial products offering a so-called higher return (for a so-called low risk level) to CDO investors.

Now that the house of cards collapsed, it is too late, and financial regulation will be enforced, but let’s first get out of the recession!