The new law was the Monetary Control Act of 1980. Why did Congress pass it? Because the banks were hemorrhaging money. Why? Because Federal Reserve policy had changed.

Treasury Secretary Hank Paulson put forth a
number of “new” ideas for changes in the
regulatory structures. Nothing I saw will help
all that much in the current crisis. It’s more
like re-arranging the deck chairs as the ship is
going down. It seems like most of it is being
proposed to prevent another crisis like the one
we are in from occurring in the future. That
simply insures that Wall Street will have to
invent whole new ways to create a crisis in the
future. I am sure they will be up to the task.

John Mauldin (April 4, 2008)

We have seen this before. In 1980, Congress abolished
the law that prohibited banks from paying market rates of
interest on deposits under $100,000 — a law that had been
designed to hurt small investors and also make low-cost
funds available to banks. It was a price control. It blew
up after 1976. Price controls restrict the supply of
whatever is controlled.

The new law was the Monetary Control Act of 1980. Why
did Congress pass it? Because the banks were hemorrhaging
money. Why? Because Federal Reserve policy had changed.

Under Arthur Burns and his short-termed successor, G.
William Miller, the FED has pumped in fiat money with
abandon. This began in the 1970-71 recession, which was
caused by tight-money policies imposed after Johnson left
office in 1969. In fiscal 1971 and 1972, Nixon’s
administration ran back-to-back deficits of $23 billion,
which were considered gigantic at the time — and were.

The FED’s policy of monetary expansion accelerated the
outflow of gold, which had begun under Eisenhower’s second
term and became a major problem under Johnson in 1968. So,
Nixon unilaterally took the country of the gold exchange
standard, under which foreign governments and central banks
had been able to buy gold from the U.S. Treasury at $35/oz.
That marked the beginning of the stagflation of the 1970’s.

The FED accelerated this inflationary process in the
recession of 1975. Interest rates rose in response to
rising prices.

Paul Volcker replaced Miller in the fall of 1979.
Under him, the FED changed policy: from targeting interest
rates to tight money. Short-term rates soared as the new
conditions — high demand for loans, tight money — pushed
rates higher than they had ever been in the 20th century.

In 1974, an entrepreneur created the Capital
Preservation Fund. It invested only in short-term Treasury
debt. It was not a bank. It was called a money-market
fund. It could legally offer investors a rate of return
close to what the U.S. Treasury was offering big investors.
Banks couldn’t. You could write checks off of it. Savings
accounts in banks offered no such option.

I worked for Howard Ruff as a telephone consultant
from 1977-1979. We recommended Capital Preservation Fund.
It was a time of rising interest rates.

The fund had imitators. Soon, money was flowing out
of banks into a new investment medium, money market funds.
The banks could not compete. They were trapped: rising
interest rates, falling deposits, and a price control on
what they were allowed to offer to small depositors.

Meanwhile, the loans that they had made to Latin
America as agents of the oil-exporting nations’ gigantic
inflow of funds began to go bad in 1980. The market value
of these loans began to fall, threatening the biggest
banks’ balance sheets. So, Congress changed the rules that
year. It allowed the banks to keep these bad loans on the
books at book value: the price originally paid.

That decision led to today’s subprime crisis, where
bad debt that was rated AAA turned out to be worthless.
New accounting rules, adopted last year, require banks to
mark their value to market. This has threatened the banks’
balance sheets.

In 1980, Congress intervened in another area. It
abolished Regulation Q, the interest rate ceiling on small
deposits (under $100,000). This raised the cost of funds
for the banks, but it kept them from bankruptcy.

As part of the payoff to the banks, Congress allowed
banks to make mortgages, putting them in competition with
the savings & loan industry.

Soon, the S&L industry responded by raising its rates
to “depositors” (legally, investors) and making more long-
term mortgage loans. This was the ancient carry trade:
borrow short, lend long.

With Carter’s recession of 1980, which ended but then
was replaced by a worse one under Reagan in 1981, the S&L
industry went into a crisis. They began going bankrupt in
the mid-1980’s because of a slowdown in home sales due to
the recession and its aftermath. It took Congress hundreds
of billions of dollars to bail out the S&L industry.

Step by step, Congress solves one crisis by sowing the
seeds for the next one.

THE HORSES ARE OUT OF THE BARN

The subprime real estate loans have been made. The
slightly safer Alt-A loans have been made. The unqualified
borrowers bought their homes at the top of the housing
bubble: 2005, 2006. In 2007, the market visibly reversed.
Now the delinquency rate has risen.

As the subprime crisis has spread around the world
ever since last August, over-leveraged hedge funds and
investment pools have been hit with hundreds of billions of
dollars of losses. The Carlyle Capital fund, created in
2006 to buy Fannie Mae mortgages with borrowed money (32 to
one leverage) is the poster child of stupid money invested
by supposedly very smart people. It got a $400 million
margin call on $16.6 billion in debt and went bust in just
one week — the week of the Bear Stearns disaster.

The investment banks that loaned smart people all that
stupid money are now hemorrhaging. They are lining up to
get paid by busted hedge funds. When the courts and the
lawyers get through with them, whatever is left over will
have to be put on the books at market value, not book
value.

Mayday! Mayday!

The horses are out of the barn. What is crucial to
the solvency of the American financial sector today is a
legal way for accountants to count missing horses as if
they were still safely locked inside the barn. This, the
government has recently provided.

The Division of Corporate Finance of the United States
Government has therefore modified the new rule by allowing
a specific interpretation of the rule. As of March, it
will allow institutions to cook the books temporarily.

In March 2008, the Division of Corporation
Finance sent the following illustrative letter to
certain public companies identifying a number of
disclosure issues they may wish to consider in
preparing Management’s Discussion and Analysis
for their upcoming quarterly reports on Form
10-Q.

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