Market down 146 as of 10:30 AM EST

Greenspan Raises Concern Over Stocks Risks
7.42 a.m. ET (1142 GMT) October 15, 1999
By Caren Bohan

WASHINGTON - Federal Reserve Chairman Alan Greenspan on Thursday advised banks to set aside more money as insurance against a big financial-market downturn, a sign he is worried about a potential bubble in equity prices.

Pablo Martinez Monsivais/AP

Greenspan: 'Risk managers need to stress-test the assumptions underlying their models'

While emphasizing he was not predicting a stocks crash, Greenspan told a banking conference that sudden losses in investors' confidence "inevitably" occur from time to time and said financial institutions should boost their reserves to account of that possibility.

"History tells us that sharp reversals in confidence occur abruptly, most often with little advance notice," he said. "These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short period."

Greenspan, who sent markets reeling in December 1996 when he raised a question about "irrational exuberance" in stock prices, used more subtle words in Thursday's speech to remind investors that the bull stock market of the 1990s was not typical and there was no guarantee it would continue.

His comments prompted a drop in U.S. stock futures prices and sent the dollar down against the yen in Tokyo trading.

Greenspan said diversification among different types of assets a common strategy used by portfolio managers to guard against market risks may not be sufficient to account for all types of scenarios in which the value of investments might decline sharply in value.

"At a minimum, risk managers need to stress-test the assumptions underlying their models and set aside somewhat higher contingency resources reserves or capital to cover the losses," he said.

Greenspan likened the building up of such reserves to paying for fire insurance, noting that many people might be inclined to consider it a waste of money until the day a fire breaks out.

The Fed chairman pointed out that equity premiums, the return investors demand to cover the risks associated with investing in stocks, had declined in recent years but he said it was unclear why.

"The key question is whether the recent decline in equity premiums is permanent or temporary," he said.

If the decline was only temporary, then portfolio managers may find they were underestimating the credit risks of loans collateralized by stocks and could be too optimistic about how protected they were by spreading their risk, Greenspan said.

Greenspan said investment professionals who specialize in risk management should take this factor into account and weigh carefully whether investors were paying enough heed to the risk associated with holding stocks.

"The decline in recent years in the equity premium ... should prompt careful consideration of the robustness of our portfolio risk-management models in the event this judgment proves wrong," he said.

Greenspan was criticized in the aftermath of his irrational exuberance comment for appearing to second-guess financial markets.

As he has done on many other occasions since then, Greenspan on Thursday went to lengths to stress that he was not making a prediction about the market.

"To date, economists have been unable to anticipate sharp reversals in confidence," he said. "To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for specific investments."

At a top-notch symposium of central bankers in Jackson Hole, Wyo., in August, Greenspan said that fluctuations in the prices of assets such as stocks can influence monetary policy because they play a role in macroeconomic trends such as consumer spending.

But he and other Fed officials have also made clear that they do not specifically target the prices of stocks in the setting of interest rates. That suggests that even if Greenspan is worried about stock prices, his concerns may not necessarily make him more willing to boost interest rates to prick a potential stocks bubble.

Full story at www.foxmarketwire.com