Treasury Secretary Hank Paulson put forth a number of “new” ideas for changes in the regulatory structures. Nothing I saw will help all that much in the current crisis. It’s more like re-arranging the deck chairs as the ship is going down. It seems like most of it is being proposed to prevent another crisis like the one we are in from occurring in the future. That simply insures that Wall Street will have to invent whole new ways to create a crisis in the future. I am sure they will be up to the task. ~ John Mauldin (April 4, 2008)

We have seen this before. In 1980, Congress abolished the law that prohibited banks from paying market rates of interest on deposits under $100,000 — a law that had been designed to hurt small investors and also make low-cost funds available to banks. It was a price control. It blew up after 1976. Price controls restrict the supply of whatever is controlled.

The new law was the Monetary Control Act of 1980. Why did Congress pass it? Because the banks were hemorrhaging money. Why? Because Federal Reserve policy had changed. Under Arthur Burns and his short-termed successor, G. William Miller, the FED had pumped in fiat money with abandon. This began in the 1970—71 recession, which was caused by tight-money policies imposed after Johnson left office in 1969. In fiscal 1971 and 1972, Nixon’s administration ran back-to-back deficits of $23 billion, which were considered gigantic at the time — and were.

The FED’s policy of monetary expansion accelerated the outflow of gold, which had begun under Eisenhower’s second term and became a major problem under Johnson in 1968. So, Nixon unilaterally took the country of the gold exchange standard, under which foreign governments and central banks had been able to buy gold from the U.S. Treasury at $35/oz. That marked the beginning of the stagflation of the 1970’s.

The FED accelerated this inflationary process in the recession of 1975. Interest rates rose in response to rising prices.

Paul Volcker replaced Miller in the fall of 1979. Under him, the FED changed policy: from targeting interest rates to tight money. Short-term rates soared as the new conditions — high demand for loans, tight money — pushed rates higher than they had ever been in the 20th century.

In 1974, an entrepreneur created the Capital Preservation Fund. It invested only in short-term Treasury debt. It was not a bank. It was called a money-market fund. It could legally offer investors a rate of return close to what the U.S. Treasury was offering big investors. Banks couldn’t. You could write checks off of it. Savings accounts in banks offered no such option.

I worked for Howard Ruff as a telephone consultant from 1977—1979. We recommended Capital Preservation Fund. It was a time of rising interest rates.

The fund had imitators. Soon, money was flowing out of banks into a new investment medium, money market funds. The banks could not compete. They were trapped: rising interest rates, falling deposits, and a price control on what they were allowed to offer to small depositors.

Meanwhile, the loans that they had made to Latin America as agents of the oil-exporting nations’ gigantic inflow of funds began to go bad in 1980. The market value of these loans began to fall, threatening the biggest banks’ balance sheets. So, Congress changed the rules that year. It allowed the banks to keep these bad loans on the books at book value: the price originally paid.

That decision led to today’s subprime crisis, where bad debt that was rated AAA turned out to be worthless. New accounting rules, adopted last year, require banks to mark their value to market. This has threatened the banks’ balance sheets.

In 1980, Congress intervened in another area. It abolished Regulation Q, the interest rate ceiling on small deposits (under $100,000). This raised the cost of funds for the banks, but it kept them from bankruptcy.

As part of the payoff to the banks, Congress allowed banks to make mortgages, putting them in competition with the savings & loan industry.

Soon, the S&L industry responded by raising its rates to “depositors” (legally, investors) and making more long-term mortgage loans. This was the ancient carry trade: borrow short, lend long.

With Carter’s recession of 1980, which ended but then was replaced by a worse one under Reagan in 1981, the S&L industry went into a crisis. They began going bankrupt in the mid-1980’s because of a slowdown in home sales due to the recession and its aftermath. It took Congress hundreds of billions of dollars to bail out the S&L industry.

Step by step, Congress solves one crisis by sowing the seeds for the next one.

THE HORSES ARE OUT OF THE BARN

The subprime real estate loans have been made. The slightly safer Alt-A loans have been made. The unqualified borrowers bought their homes at the top of the housing bubble: 2005, 2006. In 2007, the market visibly reversed. Now the delinquency rate has risen. As the subprime crisis has spread around the world ever since last August, over-leveraged hedge funds and investment pools have been hit with hundreds of billions of dollars of losses. The Carlyle Capital fund, created in 2006 to buy Fannie Mae mortgages with borrowed money (32 to one leverage) is the poster child of stupid money invested by supposedly very smart people. It got a $400 million margin call on $16.6 billion in debt and went bust in just one week — the week of the Bear Stearns disaster.

The investment banks that loaned smart people all that stupid money are now hemorrhaging. They are lining up to get paid by busted hedge funds. When the courts and the lawyers get through with them, whatever is left over will have to be put on the books at market value, not book value.

Mayday! Mayday!

The horses are out of the barn. What is crucial to the solvency of the American financial sector today is a legal way for accountants to count missing horses as if they were still safely locked inside the barn. This, the government has recently provided.

The Division of Corporate Finance of the United States Government has therefore modified the new rule by allowing a specific interpretation of the rule. As of March, it will allow institutions to cook the books temporarily.

In March 2008, the Division of Corporation Finance sent the following illustrative letter to certain public companies identifying a number of disclosure issues they may wish to consider in preparing Management’s Discussion and Analysis for their upcoming quarterly reports on Form 10-Q.

What, exactly, does the modification allow? Postponement. The key phrase is “unobservable inputs.”

We note that you reported a significant amount of asset-backed securities, loans carried at fair value or the lower of cost or market, and derivative assets and liabilities in your financial statements in your recent Form 10-K. Statement of Financial Accounting Standards No. 157, Fair Value Measurements, defines fair value, provides a framework for you to measure the fair value of your assets and liabilities, and requires you to provide certain disclosures about those measurements. Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities.

So, the corporate accounting team looks at the current market price of the asset and then searches for mitigating factors. This is pick-and-choose accounting.

For example, consider providing a range of values around the fair value amount you arrived at to provide a sense of how the fair value estimate could potentially change as the significant inputs vary. To the extent you provide a range, discuss why you believe the range is appropriate, identifying the key drivers of variability, and discussing how you developed the inputs you used in determining the range.

This reminds of me of the new, improved way of teaching arithmetic. The student can get extra credit for explaining why he got the wrong answer.

Investors will still be kept, if not in the dark, then at least the shadows. But existing investors prefer this. They do not want the truth. They prefer the illusion of solvency. Like Japanese bankers from 1990 to 2006, they do not want the capital losses to be written down where the investment world can see them.

The game must be kept going for the economy not to fall into a major recession. Investors were lured into leveraged investments that have gone bad. These investments are not going to get better. They will get written off as losses. The question is: When? The government and the big banks want this answer: later.

GETTING FROM NOW UNTIL THEN

If the price of housing continues to fall, the number of bad loans will increase. Borrowers will find themselves under water: owing more than their homes are worth. They will either walk away or just stop paying their monthly bills, and wait for a court to kick them out. This will take years if they just sit there, paying only their property taxes on time. They may not know this yet, but hundreds of thousands of them will find out. The ability of the mortgage-holding financial institutions to conceal these bad loans from the capital markets is limited.

The longer the price decline continues, the more of the loans will be called into question. The standard figure is $200 billion in bad loans. This is standard because most of this is behind us. The problem is, the figure is acknowledged to be overly optimistic. According to a report issued by the International Monetary Fund, losses could reach $800 billion. This was reported by Germany’s major news magazine, Der Spiegel (March 26), but it has received little attention in the American media.

Understand, this is not $800 billion of losses in a broad market, such as all U.S. stocks. This is concentrated in the financial sector, which supplies capital to the economy. This is the center of the economy — exactly where Ludwig von Mises wrote in 1912 that the forecasting errors are concentrated during a period of monetary inflation fostered by the central bank. But, in this case, the errors were not confined to one nation. They have spread into the international financial markets that bought America’s AAA-rated debt.

The bad news keeps dribbling out. It has not created a panic in the capital markets because investors do not understand the Austrian theory of the business cycle. They do not understand the extent to which capital has been misallocated. They do not see the severity of the losses under recessionary conditions.

These losses can be concealed by cooking the books temporarily. They cannot be concealed if the decline in housing prices continues.

There is nothing on the horizon that I see that will reverse this decline. The chief economist for the National Association of Realtors thinks the housing market may turn up in the second half of 2008. This is similar to the happy-face prediction that led to the departure of his predecessor, David Lereah. For a time chart that tracks their statements and the housing decline, click here.

Yun’s March, 2008 forecast is this:

Rising sales will also bring down inventory and help strengthen home prices. The national median price of an existing home will fall in the first half of the year and then rise in the second half. For the year as a whole, the median price will have fallen by 1 percent — after having fallen 1.4 percent last year.

His figures are immediately suspect. From January, 2007 to January, 2008, according to the Case-Shiller index, which is widely accepted, the median house price fell in 10 cities declined by 11.4%. This is the steepest decline in the index’s 21-year history. In 20 cities, it was down 10.7%, the steepest decline in the index’s 8-year history.

We are in the early stages of a recession. Why should we expect American housing prices to bottom in June? The interest rate re-sets are contractually scheduled to continue through 2009. Who expects the foreclosure rate to slow? If they increase, why should prices increase in the second half of 2008? Or 2009?

CONCLUSION

The media will promote the changes that will centralize control under the Federal Reserve System. This is a foregone conclusion. But the changes will not fix the financial system’s losses from the previous mistakes. These mistakes have not begun to spread through the economy.

The public is not in panic mode. It has not been in panic mode since 1991. Today’s investors do not remember what a serious recession can do.

The public’s faith shown in the FED is remarkable. That faith will be abandoned by a growing minority of Americans when the economy moves into full-scale recession. The press will do what it can to blame anyone and anything except the FED, but this strategy has limits.

The government and the FED have worked together to create this crisis. They will work together to cover up the effects of prior policies. This will lead to even greater crises.

We have a tiger by the tail.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2008 LewRockwell.com