Bad Medicine

(By Richard Drew -- Associated Press)
  Enlarge Photo    
By James Grant
Sunday, October 5, 2008

Low interest rates, easy money and malleable accounting rules are what plunged Wall Street into crisis. Yet it is low interest rates, easy money and malleable accounting rules that top the list of federal fixes. The unifying theme of the new bailout bill, all 451 pages of it, is the hair of the dog that bit you.

The unblinkable fact is that Americans own too much house. We overpaid and overborrowed, and many of us are "upside down," as the car dealers say. What to do? Recognize the losses and write them off. What not to do? Inflate the currency and debase accounting standards.

But inflation and debasement are the very policies being put in place. The Federal Reserve, not waiting for Congress, embarked last month on a radical program of money-printing. Reserve Bank credit -- the raw material of bank lending -- is growing at the year-over-year rate of 61 percent.

Credit creation is the Fed's signature crisis-management policy: Let a bubble inflate, then watch it burst; clean up with lots of dollar bills. After the stock market broke in 2000, then-Fed Chairman Alan Greenspan set about easing policy. In company with Fed Governor Ben S. Bernanke, the man who wound up succeeding him, Greenspan warned against "deflation." He vowed that this country would not sleepwalk through a decade of falling prices, as Japan had done. Rather, the Fed would push interest rates low enough to jolt the U.S. economy back into prosperity.

So it pushed the "federal funds rate" -- the interest rate that the Fed directly controls -- to 1 percent in mid-2003 and kept it there for a full 12 months. Here was a curious chapter in modern monetary history: Too little inflation was the problem, not too much, Greenspan and Bernanke insisted. Easy money and low interest rates were the answer. American consumers pinched themselves. Could they really borrow more than 100 percent of the price of a house at an unimaginably low teaser rate without so much as presenting proof of employment? Indeed, they could. House prices went up and up.

When, in 2006, the roof began to fall in, Wall Street was in a quandary. It held outsize volumes of triple-A-rated mortgage-backed securities (MBSs). That they were not, in fact, triple-A, had become painfully obvious. Curious analysts consulted the financial statements of the top mortgage dealers, including Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley, for clarification.

Readers, however, found no clarification and no foreshadowing of the troubles to come. Neither in Bear's year-end 2006 report (10K, in Securities and Exchange Commission jargon) nor in its March 31, 2007, quarterly filing was there a meaningful word of warning about the sagging prices of the MBSs that did so much to pull Bear down. Those seeking to learn Merrill's exposure to the mortgage contraptions called collateralized debt obligations, or CDOs, were similarly stymied. Although Merrill was to write off $23 billion worth of CDOs in 2007, the phrase "collateralized debt obligation" did not appear once in its 2006 10K.

Because there was often no market for these idiosyncratic securities, Wall Street did not have to value them at market prices. Rather, it marked them "to model." That is, it assigned them prices at which they would trade, according to one mathematical construct or another, if they could trade. Of course, these mathematical constructs tended to cast things in a cheerful, management-approved way. Only later did a telltale plunge in the value of traded mortgage indices open the eyes of the market to the full extent of the troubles.

Prices can be unwelcome pieces of information. When an especially unwelcome batch wells up after a financial collapse, governments try to quash it. So it is today. The SEC has suppressed short selling. The bailout bill will open the door to the suspension of market-value accounting. The Fed is moving heaven and earth to cheapen the value of the dollar.

Long after the crisis burst into the open, the Fed and Treasury downplayed it. It was, they insisted, "contained." Last week they asserted that, unless the House voted "yea," the wheels would come off this $14 trillion economy. President Bush himself has broadly hinted that the nation is on the cusp of disaster.

How can they be so sure? And how can they know that the unintended consequences of the radical policies they are pushing through won't be worse than the panic that they themselves are helping to foment? When the Fed insists it has no choice but to print up hundreds of billions of new dollars and when the keepers of accounting standards bend in the face of criticism that market prices hurt, what they are really saying is the that financial truth is too awful to bear. Heaven help us all if they're right.

James Grant is the editor of Grant's Interest Rate Observer and author of the forthcoming book "Mr. Market Miscalculates: The Bubble Years and Beyond."

© 2008 The Washington Post Company