Congress Tries to Fix What They Broke

"I scream, you scream, we all scream for - REGULATION!"

In contrast to the major media narrative on the current financial turmoil there are two articles that everyone must read.

The first is Congress Tries to Fix What it Broke, an editorial by Investor's Business Daily.

Regulation: As the financial crisis spreads, denials on Capitol Hill grow more shrill. Blame an aloof President Bush, greedy Wall Street, risky capitalism — anybody but those in Congress who wrote the banking rules.

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In other words, nobody up and down the line — from the branch office on main street to the high-rise on Wall Street — analyzed the risk of such ill-advised loans. But why should they? Everybody was just doing what the regulators in Washington wanted them to do.

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The original culprits in all this were the social engineers who compelled banks to make the bad loans. The private sector has no business conducting social experiments on behalf of government. Its business is making profit. Period. So it did what it naturally does and turned the subprime social mandate into a lucrative industry.

Of course, it was a Ponzi scheme, because they weren't allowed to play by their rules. The government changed the rules for risk.

In order to put low-income minorities into home loans, they were ordered to suspend lending standards that had served the banking industry well for centuries. No one wants to talk about it, so they just scapegoat Wall Street.

The other is Zachary Karabell's Bad Accounting Rules Helped Sink AIG, a WSJ editorial.

The current meltdown isn't the result of too much regulation or too little. The root cause is bad regulation.

Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards force companies to value or "mark" their assets according to a different set of standards and levels.

The rules are complicated and arcane; the result isn't. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses.

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Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack.

The value of the underlying assets -- homes and mortgages -- declined, sometimes 10%, sometimes 20%, rarely more. That is a hit to the system, but on its own should never have led to the implosion of Wall Street. What has leveled Wall Street is that the value of the derivatives has declined to zero in some cases, at least according to what these companies are reporting.

There's something wrong with that picture: Down 20% doesn't equal down 100%. In a paralyzed environment, where few are buying and everyone is selling, a market price could well be near zero. But that is hardly the "real" price. If someone had to sell a home in Galveston, Texas, last week before Hurricane Ike, it might have sold for pennies on the dollar. Who would buy a home in the path of a hurricane? But only for those few days was that value "real."

No matter what else you hear or read on this subject, keep these two articles in mind.

2008 Race Economics and Markets Posted by JohnGalt at September 18, 2008 3:57 PM