How To Save The Financial System

by William M. Isaac - September 19th, 2008 - Wall Street Journal

At the outset of the current crisis in the credit markets, we had no serious economic problems. Inflation was under control, GDP growth was good, unemployment was low, and there were no major credit problems in the banking system.

The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.

The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.

How did we let this serious but manageable situation get so far out of hand -- to the point where several of our most respected American financial companies are being put out of business, sometimes involving massive government bailouts?

Really good question. The reality is that we have allowed government to destroy many of the financial barriers to good decision making in a free market. I concur with the three recommendations here, suspend the Fair Value Accounting rules, clamp down on abuses by short sellers, and withdraw the Basel II capital rules, which hamstring banks in finding liquidity when it is most needed.

These are complicated issues. However the consequences (during hard times) of each of these rules were identified when they were proposed. Our current problem is simply a refusal to acknowledge that government rules that work well in good times can have serious consequences when times go bad. Some of our earlier structural protections (such as Glass-Steagall to limit speculation and corruption) were also done away with because of the good times during the nineties, when huge productivity surges due to the Internet and the World Wide Web convinced many people that the world had changed.

It is time we accept, the world has not changed that much. Just because we are starting at a higher level of productivity does not mean that the basic rules of banking can be altered. Requiring banks to liquidate and mark down assets creating paper losses that are not rational over the long term is a sure way to bankrupt otherwise solvent entities.

If you doubt that, read today's headlines!