How to End the Subprime Crisis

Reforms often

do more harm than good
.  This is currently the case
with the

rule, which is imploding the
US financial system by requiring financial institutions
to value

subprime mortgages
at their current market values.  

This makes a big
problem for balance sheets.  These financial instruments
became troubled prior to a market being established for
them, as they were marketed direct from issuers to
investors.  Now that they are troubled and with their
true values unknown, no one wants them. Their lack of
liquidity assigns them a low value.  

The result is
tremendous pressure on balance sheets. The plummeting
value of subprime derivatives is pushing institutions
that own them into insolvency, destroying their own
stock values and forcing the financial institutions to
sell untroubled liquid assets, thus resulting in an
overall decline in the stock market.

The solution is to
suspend the mark-to-market rule. Instead, allow
financial institutions to keep the troubled instruments
at book value, or 85-90% of book value, until a market
forms that can sort out values, and allow financial
institutions to write down the subprime mortgages and
other troubled instruments over time.  

Suspending the
mark-to-market rule would take pressure off the stock
market and make it unnecessary for the Fed to lower
interest rates in an effort to force liquidity into the
economy through an impaired banking system.  The problem
is not a general lack of liquidity, but liquidity for
poorly conceived new financial instruments.  Low US
interest rates could worsen the crisis by accelerating
the dollar`s decline.  Now that inflation has raised its
head, more liquidity from the Fed adds to the economic

It is mindless to
allow a "reform" to cause a financial crisis, but
that is what is happening.  Unfortunately, there are
people who argue that anything less than financial
Armageddon would create a "moral hazard." 

It is certainly true
that securitized subprime mortgage instruments were a
bad idea, that a lot of people who should have known
better opened floodgates to greed and fraud, and that
"somebody should pay."
  But it shouldn`t be the
general public and the economy that pays.

It is also true that
without the Federal Reserve`s irresponsible low interest
rate monetary policy, which produced a housing boom, the
subprime instruments would not have been created, or at
least not in such amounts.  Rapidly rising real estate
prices were expected to make the risky loans good.  What
were issuers and the Federal Reserve thinking?

No doubt but that
greed, fraud, and bad policy all played their roles. 
But at the heart of the problem is a 1999 "reform"
that repealed an earlier reform known as the

Glass-Steagall Act.

In 1933 the Glass-Steagall
Act separated commercial banking from the securities
business.  It prevented securities speculation from
destroying bank capital and shrinking bank deposits from
bank failures and runs on banks by depositors.  Congress
and President Bill Clinton foolishly repealed the Glass-Steagall
Act in 1999.

The repeal of the
1933 law was driven by profit lust in the banking
industry and by "free market" ideology, which
claims the unfettered marketplace is always superior to
regulation. In pushing the repeal forward, Congress and
Clinton ignored warnings from the General Accounting
Office that the banks needed to build up their capital
levels before being permitted to enter a broad range of
securities businesses.  The GAO also noted that there
were no regulatory structures in place to monitor the
new financial networks that would result from removing
the wall between commercial and investment banking.

However, greed and
ideology won over sound advice. The result is a crisis
that, if mishandled, will be calamitous.

Paul Craig Roberts [email
] was Assistant
Secretary of the Treasury during President Reagan`s
first term.  He was Associate Editor of the
Street Journal.  He has held numerous academic
appointments, including the William E. Simon Chair,
Center for Strategic and International Studies,
Georgetown University, and Senior Research Fellow,
Hoover Institution, Stanford University. He was awarded
the Legion of Honor by French President Francois
Mitterrand. He is the author of

Supply-Side Revolution : An Insider`s Account of
Policymaking in Washington
and the Soviet Economy

Meltdown: Inside the Soviet Economy
and is the co-author
with Lawrence M. Stratton of

The Tyranny of Good Intentions : How Prosecutors and
Bureaucrats Are Trampling the Constitution in the Name
of Justice
. Click

for Peter
Forbes Magazine interview with Roberts
about the recent epidemic of prosecutorial misconduct.