Free Market Destoyed by Loss of Faith

We are witnessing yet another "forest for the trees" moment. So often in life the most obvious answer to a problem is the wrong answer. In fact, the most often asked question is usually the wrong question to ask. That is the case right now with the financial crisis we are going through in the United States. The financial crisis is actually a crisis of confidence, and that crisis of confidence has been caused by a loss of faith in the free market system by those who regulate it. The federal government created the problem because they lost faith, or never had it, in the free market system's ability to create wealth and benefit our society.

How did the government create this problem? We only have to go back to the end of the technology bubble in 2000 and the failure of Enron. Many people, including myself, lost money in the subsequent market sell-off. I had faith that the excesses of the system would be wrung out, that capital would be redeployed to those industries and markets most worthy. Shareholders would begin to assert control and implement needed corporate governance actions. Inefficient companies or those with poor management unworthy of investment would be forced to change or face extinction. Sure there would be layoffs and lost jobs and people get hurt, but recovery in a dynamic economy is swift. After a relatively short period of dislocation, the United States would again be on the path toward healthy, sustainable, economic growth, increased wealth, and employment growth.

But our politicians had no faith. Many of their noisiest constituents (and ignorant news media talking heads) were clamoring for action. Feeling a need to be seen doing something, they instituted a number of regulatory "reforms" culminating in the ill-conceived Sarbanes-Oxley bill. One of these ill-conceived reforms was the fore mentioned mark-to-market accounting standard (see Mark-T0-Market Disaster, December 9 2008, post below). There were other stupid moves made by our federal government, particularly the enforcement of the Community Reinvestment Act which forced banks to make mortgage loans to less credit-worthy borrowers in under served communities. Those borrowers made up a large percentage of sub-prime loans that were subsequently guaranteed by Fannie Mae and Freddie Mac under pressure from congress. Those sub-prime loans began to fail in 2007 in increasing numbers which led to the rapid decline in the overheated housing market. Buyers for those sub-prime collateralized mortgage obligations disappeared quickly. Exacerbated by mark-to-market accounting of illiquid securities, financial institutions were forced to post mounting losses driving many into failure and destroying the market capitalization of the survivors. The result: a massive loss of stock market value, a massive contraction of credit, and a rapid decline into recession. The long and short of it all: THE GOVERNMENT CAUSED THE FINANCIAL CRISIS!

Contrary to conventional wisdom and the pronouncements of offending politicians, unfettered capitalism did not cause this financial crisis. It was the regulators that caused the problem. And now we are expected to believe that regulation will save us? Not a chance. How do I know? Because instead of fixing the "reforms" that got us into this mess, the federal government keeps coming up with giant new programs and regulations that do nothing to reverse their previous actions, deal only with resulting credit seizure, and require yet more government control and eventually higher taxes. The use of government intervention to save the free market? Socialism can not save capitalism. Government caused the problems with the "free market." Socialism can't save the free market.

"Okay, smartypants. What should we do then," you say? The first answer is simple: Undo the actions that got us into the problem in the first place. Immediately repeal the mark-to-market accounting standard for assets not held for sale and replace it with mark-to-model accounting. That would immediately make the vast majority of financial institutions liquid and solvent. In fact, they would have too much capital on their balance sheets so lending to credit worthy borrowers would increase very rapidly. The regulator's job would then be to validate the models of financial institutions for asset write downs based upon actual and historical loss rates and cash flow expectations.

The second is more difficult but can be answered by asking the right question: Absent the credit crisis, what are the most immediate problems with the financial markets? The answer: market liquidity, market volatility, and housing values.

1. Market liquidity. How can we help market liquidity? We have to encourage participation in the market. How do we do that? Lower taxes. Immediately reduce capital gains taxes to zero for at least the next two years. Lower capital gains taxes encourage investors to take risk. Money will pour out of money-market funds into stocks, bonds, and mutual funds re-liquefying the market. And a rising market will encourage investment and recovery. How else? Double IRA and 401k contribution limits for at least the next two years. As it is, contribution limits are not high enough for individuals to save enough for a secure retirement. Raising the contribution limits would help. And it would allow individuals who have been so hurt in the last year's decline to participate in the market's recovery.

2. Market volatility. Reinstate the uptick rule for short sellers. As it stands now, short sellers using massive leverage can destroy the market value of virtually any company in a spiralling down market in a "bear raid," limiting a company's ability to raise capital, and endangering its entire existence as a going concern regardless of a company's intrinsic value or true economic prospects. The uptick rule prohibits a stock from being sold short when the last sale was priced down. It has worked well in the past at ensuring market stability and reducing volatility while enabling the practise of short selling to provide efficiency in market pricing.

3. Housing values. Rich Karlgaard of Forbes Magazine had a great idea (http://www.forbes.com/business/forbes/2008/1208/029a.html). In Hong Kong, when a mortgage borrower's financial situation changes in the historically volatile Hong Kong housing market, lending institutions simply rework the mortgage terms extending mortgage loan lengths to match the payment to the cash flow generated on the property. When cash flow increases, the mortgage term contracts. As a result, mortgage foreclosure is relatively infrequent in a market that is much more volatile than ours even considering the large declines over the last two years. Rather than renegotiating principle reductions or payments on mortgages that have a high propensity to fail yet again, financial institutions should negotiate increased loan lengths to keep people in their homes so long as they have the ability to pay. I spend a lot of time in Hong Kong. I've see it. It works.

What is the common thread here? No massive government intervention in the credit markets and equity ownership. We do not need socialism to save capitalism. We need government to get out of the way and have faith that the free market will continue to provide the most freedom, highest incomes, and greatest sustainable growth possible to this great country.