How to End the Subprime Crisis

By PAUL CRAIG ROBERTS

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.”

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 was Assistant Secretary of the Treasury in the Reagan administration. He was Associate Editor of the Wall Street Journal editorial page and Contributing Editor of National Review. He is coauthor of The Tyranny of Good Intentions.He can be reached at: PaulCraigRoberts@yahoo.com

Will Japan Intervene if the Yen Falls Below 100?

Many doubted "Mr. Yen," Eisuke Sakakibara, when he said earlier this year that the Japanese currency unit would appreciate more quickly in lockstep with the Chinese yuan. The logic is simple: if the Chinese allow the yuan to revalue at a slightly faster clip, then Japan can allow its own currency to become stronger as well since competitive parity of exchange rates would more or less be maintained. This from Bloomberg:

The Chinese yuan may rise more than 10 percent this year against the dollar, allowing Japanese policy makers to accept further gains in the yen, said Eisuke Sakakibara, Japan's former top currency official.

China's currency has strengthened 1.4 percent this year, on course for the biggest monthly advance since the end of a dollar peg in July 2005, as the government seeks to curb inflation. The Group of Seven industrialized nations have called on China, Japan's biggest trading partner, to stop keeping the yuan artificially weak to support exports...
A rising yuan would make Chinese goods more expensive in global markets, bolstering the competitiveness of Japanese exporters. The yen may advance as much as 12 percent to 95 per dollar by summer as the U.S. economy slows and the Bank of Japan refrains from intervention to slow the rally, he said.

Sakakibara was dubbed "Mr. Yen'' because of his ability to influence the foreign-exchange market during his 1997-1999 tenure at the finance ministry. He correctly forecast in an interview in October that the dollar would plunge against the yen because of the risk of a U.S. slump.

Sakakibara-san also said there was pressure from the US against Bank of Japan intervention. Ah, good old-fashioned political economy:

Sakakibara said today that Japan's central bank is unlikely to intervene to slow the yen's advance because the U.S. government is opposed to interfering with currency markets.

Using a technical analysis, though, Daily FX says Bank of Japan intervention is possible if the yen breaks the JPY100 level. The chart above indicates the levels at which the Japanese came in to prop up the US dollar--at about JPY100. Of the major industrial economies, Japan is alleged to be the most likely to intervene. As always, FX traders will place their bets and see what happens:

Of the G-10 countries, Japanese policymakers are the most likely to get their hands dirty and intervene in the currency markets when the Japanese yen’s price movements are too volatile and extreme for their liking. However, the Bank of Japan and Ministry of Finance have been a bit more lenient in recent years, as the last official intervention was conducted in March 2004. Nevertheless, policymakers have plenty of reason to be concerned about the Japanese yen’s most recent surge, as the USDJPY pair has recently tumbled to am 8-year low of 101.40. The strength of the currency is hurting the profit margins of major Japanese corporations, as the most recent Tankan survey showed that most Japanese corporations forecast the value of USDJPY in 2008 to be around 113.00. With the pair now rapidly approaching the 100 level, those hedges are deep in the red. Furthermore, Japanese Economy Minister Hiroko Ota noted that the approximate break-even point for companies is at the 106.60 level, and firms like Toyota, Yamaha Motor Co., and Nippon Steel have all reported disappointing earnings as a result. Unsurprisingly, the shares of exporters have taken a hit and are a major reason why the Nikkei Stock Average has plummeted declined 6 percent over the past five days, the biggest loss since the week ended August 17.

Given the virtual standstill in economic activity, the growing squeeze on Japan’s export sector, and the sharp drop in the Nikkei, it is not unreasonable to wonder if the Bank of Japan may consider intervening in the currency market to help prop up USD/JPY above the 100 level – a point not seen since December 1995 – in order to assure that the country’s exporters are not crippled by uncompetitive exchange rates.

While the effectiveness of currency intervention as a policy tool has been an ongoing debate within the financial markets and academia for years, there is little argument that at least in the short term, it can be brutally effective. Amongst the G-3 central banks, the Bank of Japan is by far the most active practitioner of this policy. Furthermore, the Bank of Japan prefers to optimize the effectiveness of its intervention by fading speculative extremes, meaning that the currency pair can rise by hundreds of points within minutes. However, the most recent COT data shows that yen positioning is not extreme quite yet, suggesting the currency may have more room to gain. Either way, FX traders who are short USD/JPY need to be increasingly careful and stringent with their stops as the currency approaches 100.

THE LIBERTARIAN

Tuesday, March 11, 2008

How to End the Subprime Crisis

Will Japan Intervene if the Yen Falls Below 100?

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