When it comes to financial stocks, the government engineered one of the largest, if briefest, short squeezes of all time last Friday by making it illegal to short their shares. It was too late for Bear Stearns, Lehman Brothers, and AIG as well as the quasi-governmental Fannie Mae and Freddie Mac. The government had no compunction about making a rule change which many proponents of free markets said was unjustifiable and pointless. As I noted in a prior posting, financial stocks fell more than 8% on Monday, with short-selling not permitted. Who do they blame for that, with the evil speculating short-sellers out of the picture? So they impeded the free market with no proof of justification.

On the other hand, the price of mortgage securities has been plummeting for months primarily because of a recently imposed rule change called "mark-to-market", which basically forces banks to say that their mortgage security portfolios are worth much less than an objective analysis absent those rules would show them to be. That reduction in "capital" forced banks to try to sell these things and get cash on their balance sheets. But there's no progress in getting the destructive rule changed, even temporarily for a very narrow range of assets.

The hypocrisy is not just stunning, it's financially deadly.

The government made a rule change which affects the markets that the public sees, the stock market. But the real risk to our economy is not problems in the stock market. It's problems in the credit market. It's exceptionally difficult to get a loan for anything right now, and loans are the lifeblood of the economy in every industry. Whether bank loans or commercial paper (the basis of much of the money market fund business), credit is somewhere between non-existent and very expensive.

One small example is the Hard Rock Park in Myrtle Beach, South Carolina. It had a very difficult first year because of the relatively weak economy, but it filed for bankruptcy on Wednesday with this statement being made by a Park spokesman: "In addition, the frozen credit markets severely limited our ability to line up loans or the other planned financial resources we needed to execute our summer marketing plan and adequately promote the park."

As for "mark-to-market", it's something like this: Imagine you have a combination of bonds something worth 90 dollars. Something bad happens to one of the debts and the total portfolio value drops to 80 dollars in a standard model for valuing such things. But there's a rule in place that says you have to "mark" the value of every bond in the portfolio at the price of the one bad bond for purposes of reported capital. So you have to say that your portfolio is worth $20 when you think it's worth $80. Because of bank capital requirements, you absolutely have to have $50 to meet your regulatory requirements. Therefore, you go out to try to sell this thing for $50 or more even though you think it's worth $80. Unfortunately every bank which would normally buy these things is in exactly the same situation. All the banks are running for the door at the same time and the only buyers are occasional hedge funds who buy these assets from the most desperate sellers at pennies on the dollar.

You can read more about the issue from my favorite economist, Brian Wesbury, at these links:
http://www.ftportfolios.com/Commentary/EconomicResearch/2008/9/25/mark-to-market_mayhem
http://www.ftportfolios.com/Commentary/EconomicResearch/2008/9/22/heres_a_plan_to_avoid_a_new_rtc

This whole problem may not go away if the mark-to-market rules change...but the vast majority if it could, with no taxpayer money being spent and no permanent intrusion of the federal government into the deepest reaches of our financial companies. But the government won't do it. It seems like it's barely even being discussed with the exception of the Republican Study Committee trying to get it into the mix with little apparent success.

What's the difference between the short-selling rule change and the mark-to-market lack of rule change? Even if the government gets "control" of some failed financial companies, the plan is simply to sell them off in pieces and that will be the end of it. So failing financial companies don't give government a permanent entry into the deepest reaches of running our nation's financial system. Also, it effects stocks so it makes the government look good to make that superficial rule change. On the other hand, the mark-to-market rule, basically invisible to the man on the street (until he loses his job or can't buy a car or home), is the path toward the largest increase in government involvement in the economy since the New Deal.

I'm not one who believes in conspiracies, but look at who's in control here. Democrats in Congress, a Democrat former king-of-the-investment-banking-world as Treasury Secretary, and a president (along with two presidential candidates) who have regularly supported increasing the power and reach of government.

The short-selling rule change combined with the lack of change in the mark-to-market rule demonstrates that what Congress wants even more than to "save the economy" is to increase their own power and to attack the most fundamental aspects of capitalism and free markets. I only hope the House Republicans can move the debate away from the Paulson/Barney Frank plan.