How Spitzer made the markets tumble

When Gov Eliot Spitzer's humiliation was revealed 10 days ago, Wall Street cheered. Their scourge had been undone in the most demeaning way. Scarcely had the party balloons popped than Bear Stearns followed Spitzer into oblivion. With both the arch-regulator and the arch-free-marketeers now whirling down the drain of history, no one knows where to turn for answers.

It is customary in the wake of a financial blow-up to see a whip-saw effect. It happened after the tech bubble imploded in 2000, exposing corporate fraud at Enron, Tyco and Worldcom, and the willing deception of investors by Wall Street analysts. Washington reacted with Sarbanes Oxley, a burdensome new set of accounting laws intended to create more corporate transparency.

Spitzer used his job as Attorney General of New York to do the work he felt was being neglected by the Bush administration. He went after Wall Street's bosses with ferocious prosecutions, vowing to bring down the individuals and institutions which crossed him. He championed investors who felt misled during the late 1990s into buying worthless stocks.

But one thing Spitzer and other politicians did not do was look forward. They were so intent on mopping up the mess leading up to 2000 that they failed to stop the mortgage business spinning out of control. The problems we see in the American economy today were seeded as Spitzer, Sarbanes and Oxley chastised yesterday's villains instead of foreseeing tomorrow's crises.

If you go back further, you find that the dreaded 'mark-to-market' accounting rule, which is now wreaking such havoc in America, was introduced in the early 1990s after another market collapse. The rule was intended to force companies to value their financial assets more rigorously. At the end of each trading day, those assets now had to be valued at their market value.

In stable markets, this works fine. In the hurricane of recent months, it is insanity. Imagine if you had to value your house, in a volatile housing market. As the owner you have a long horizon. You don't care what it's worth on any particular day because you're not selling it for a long time. But say you did have to mark your house to market every day and your mortgage lender demanded that your mortgage never exceeded 80 per cent of the home's value. On bad days, you might have to find thousands of pounds to maintain the debt-to-equity ratio or risk losing the property. This is essentially what has happened in the financial markets.

Banks hold assets - notably mortgage loans and their derivatives - which in the long-term may hold their value. But in the short-term the assets are being pounded and, because of the mark to market rule, the owners must come up with cash to satisfy their creditors. It is exacerbated by the fact that many of the assets in question are more complicated to value than houses. Sam Zell, one of America's smartest investors, has called the current crisis a "mark crisis" not a "cash crisis" and that once the panic subsides, so will the financial problems.

Part of Spitzer's tragedy is that shortly before he was brought down he wrote a piece in the Washington Post describing how the Bush administration had facilitated the mortgage bust. The article appeared on Valentine's Day, the morning after Spitzer spent the night in Washington with a hooker.

Spitzer wrote that, in 2003, the Bush administration used an obscure federal law to pre-empt all state predatory lending laws and prevent states from enforcing consumer protection laws against national banks. What ensued was the untrammeled growth in subprime mortgages.

Spitzer wrote: "The federal government's actions were so egregious and so unprecedented that all 50 state attorney generals, and all 50 state banking superintendents, actively fought the new rules." The Bush administration had been a "willing accomplice to the lenders who went to any lengths in their quest for profits." But then, despite Spitzer's protestations, public officials were complicit too - and failed to stop what came next. ·