Greenspan offers a mixed mea culpa

NEW YORK (CNNMoney.com) -- Alan Greenspan acknowledged Thursday that U.S. regulators had failed to grasp the magnitude of the financial crisis, but the former Federal Reserve chairman argued that low interest rates were not to blame for inflating the housing bubble.

In a paper he is due to deliver at the Brookings Institution on Friday, Greenspan, who was Fed chairman from 1987 to 2006, examines the factors that caused the global financial crisis and plunged the U.S. economy into one of the worst recessions on record.

Greenspan said the relatively minimal fallout from the bursting of the dot.com bubble in 2000 led regulators to believe that future asset bubbles would pose a limited risk to the economy.

He also blamed financial firms for relying too heavily on the recomendations of ratings agencies and their own risk management offices during the boom years, when investment banks leveraged billions of dollars worth of assets, including mortgage backed securities, that later proved to be worthless.

"In the growing state of high euphoria, risk managers, the Federal Reserve, and other regulators failed to fully comprehend the underlying size, length, and impact of the negative tail of the distribution of risk outcomes," Greenspan wrote.

"For decades, with little to no data, most analysts, in my experience, had conjectured a far more limited tail risk," he continued. "This is arguably the major source of the critical risk management system failures."

But the former Fed chief was clear that the low interest rate policy the central bank maintained during his tenure did not inflate the housing bubble that ultimately precipitated the crisis, as many critics have argued.

"To my knowledge, that lowering of the federal funds rate nearly a decade ago was not considered a key factor in the housing bubble," he said. "The global house price bubble was a consequence of lower interest rates, but it was long term interest rates that galvanized home asset prices, not the overnight rates of central banks."

To explain the decline in long-term interest rates, Greenspan argues that the explosive growth of developing economies, particularly in Asia, in the aftermath of the Cold War led to global imbalances and a surplus of liquidity.

Despite his admission that regulators failed to adequately comprehend the crisis, Greenspan offered a word of caution when it comes to imposing new regulations aimed at preventing future crises.

"Inhibiting irrational behavior when it can be identified, through regulation, as recent history has demonstrated, could be stabilizing," he said. "But, there is an inevitable cost of regulation in terms of economic growth and standards of living when it imposes restraints beyond containing unproductive behavior."

The most important reforms that regulators could make, according to Greenspan, would be to limit the amount of risk financial institutions are allowed to take and increase banks' capital requirements.

Greenspan also pointed to the risks posed by large, interconnected financial institutions to the overall economy. AIG, the giant insurance company, is perhaps the most famous of these "too-big-to-fail" institutions to have been bailed out by regulators because the company's collapse could have caused major damage to an already fragile economy.

However, the Maestro, as Greenspan is known, had this to say about the too big to fail problem: "Systemically threatening institutions is among the major regulatory problems for which there are no good solutions."

"The notion that risks can be identified in a sufficiently timely manner to enable the liquidation of a large failing bank with minimum loss, has proved untenable during this crisis and I suspect in future crises as well," he said.

Still, Greenspan said banks with the potential to become too big to fail should be required to issue bonds that could be converted into equity stakes if capital levels fall below a certain threshold.

But if that fails to reign in excessive growth, "we should allow large institutions to fail," he said. If regulators determine that an institution is to big to liquidate quickly, it should be taken in to "a special bankruptcy facility" where it will be broken into smaller entities, Greenspan said.