3/11/2008: Paul Craig Roberts on mark-to-market

Excerpts from How to End the Subprime Crisis
By Paul Craig Roberts, Assistant Secretary of the Treasury in the Reagan administration

Reforms often do more harm than good. This is currently the case with the “mark-to-market” 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 distress.

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.”