MELTDOWN MADNESS

After the worst week on Wall Street since 1929, it's high time adhocracy is abandoned in favor of a concerted effort at reform of the regulatory regime that by lack of sophistication or sheer inaction failed to address the gathering storm. Expect the usual blame game to dominate popular media. Success has a thousand fathers, while no one wants to admit responsibility for a disaster. Still, some lessons can be drawn without allowing the discussion to degenerate into an attack on Obama or the Bush administration.

At the heart of the current crisis is the inability of investors, businesses and other creditworthy individuals to access credit. Money has fled from the credit market into T-bills or highly sought after tangible assets such as gold and other metals. People and institutions with money to shelter have even been willing to accept a 3 month Treasury bond rate of 0.05% interest (in effect, no interest at all) or the pointlessness of tangible assets that don't pay interest (gold) or accrete appreciably in value over time.

Alas, that's not what caused the crisis, however. The credit crunch is the financial industry's response to fear. It is a fear that mortgage backed securities may not be worth the paper they are printed on. Since no one knows the real value of any of these securities no one is willing to buy these "assets" when they are put up for sale in order to raise capital to meet declining asset values in order to maintain market capitalization.

Companies that could not do this have failed. Bears, Stearns was sold on the cheap to J.P. Morgan/Chase. Lehman Brothers filed for bankruptcy and will be scooped up on the cheap by Barclay's bank. Merrill Lynch avoid ignomy, but was swallowed up by Bank of America. Morgan Stanley might be acquired by Wachovia. And Wells Fargo may come to the rescue of WaMu.

AIG apparently was so large that only the government could come to the rescue by taking over its assets. Though nationalization was not used to describe what transpired, the U.S. government essentially nationalized the largest American insurance group. The ostensible aim was to avoid a further unraveling of shaky Wall Street institutions.

Now, the Treasury Department under the leadership of Henry Paulson is mulling over what to do with the toxic waste that pollutes too many Wall Street balance sheets. These are principally the mortgage backed securities whose value no one seems able to establish since there now is no market for them. Credit default swaps are also in the news, and these seem even more difficult to price since their ostensible purpose seemed to be the creation of an asset that guaranteed "Heads I Win, Tails You Lose".

An oft-cited precedent is the Resolution Trust Corporation, a short-lived institution that disposed of assets acquired through the defaults of various savings and loans institutions commencing in the late 1980s. RTC has been held up as a model as an entity that executed its assigned task at a cost far lower than originally estimated and even managed to dispose of some assets at a profit.

The analogy is misleading in so far as RTC acquired tangible assets. It held the mortgages to commercial and private real estate that had tangible value, even if many of the final values were less than the prices at which they were held on S&L balance sheets. Tangible assets can be disposed of. Unfortunately, there is hardly anything tangible in the toxic waste held currently by too many firms on Wall Street.

Unwittingly, the RTC - in order to auction off some of its more worthless "assets" - resorted to innovation, innovation that gave rise to the current mortgage-backed securities that are at the center of today's problems. To find buyers for non-performing loans, RTC initiated the securitization of these loans. What worked then won't now since it's the very existence of mortgage-backed securities and derivatives that are secured on a very shaky foundation, the subprime, Alt-A and even ostensibly sound mortgages that have gone into foreclosure. Worse: these mortgage-backed securities are not tied to specific properties. Rather, the mortgages were sliced and diced as the originating institutions spun them off to secure more capital to make even more loans of dubious quality. Untangling this mess of who owns what is difficult at best and impossible if one desires to separate the wheat from the chaff.

The current proposal foresees a huge government effort to suck up all of the worthless junk cluttering up Wall Street balance sheets. That's a catch-all phrase for whatever financial institutions cannot unload on the market. In this respect, whether it's Fannie Mae, Freddie Mac or some other agency, the government will acquire whatever junk Wall Street wants to jettison.

One of two models could emerge. The federal government could create an entity - let's call it Goodwill Securities - that would simply accept - without cost - whatever Wall Street wants to unload. Even though the government would expend money to dispose of this junk, it wouldn't have to spend money to acquire it. On the other hand, the federal goverment could create a different entity - let's call it Salvation Securities - that would offer some value for the junk they took in. Ultimately, the government might hope that it could dispose of the junk for more than it paid to acquire the "toxic securities".

Wall Street would benefit under either model, but not to the same extent. True, Goodwill Securities would allow Wall Street to purge its balance sheets, but no money would flow back to the companies unloading these securities. With Salvation Securities, Wall Street would get some remuneration. How much will depend on what the government is willing to lay out and that may reflect not a guess as to what these "assets" might be worth, but rather what it might take to keep these companies afloat.

If that's the case, then there is a real risk of moral hazard. Rewarding the reckless executives who ran their companies into the ground and paid themselves handsome bonuses along the way is a policy that will only serve to encourage others to undertake equally risky ventures, as they know that if they screw up hugely, the government will bail them out since the collateral damage would be horrendous. Indeed, one of the lessons from the government's refusal to bail out Lehman Brothers is that its executive officers failed to screw up badly enough. Had they really messed up, the government would have come to their rescue.

As a result, something needs to be done in order to rein in Wall Street excesses without damaging the valuable functions that Wall Street does manage to perform. Alas, demagoguery will compete with sound proposals to create a more regulated, yet flexible environment. Indeed, fulmination against short sellers has led to the banning of short selling of the stock of certain financial companies. But, short sellers do perform a valuable function. Betting that a company is not as sound as it appears or wishes to present itself forces the market to take note. If the short sellers are correct, a company's problems will be aired.

So what can be done? Two thoughts come to mind. Given the constant reference to "toxic waste", it is easy to imagine the need for a National Institute of Financial Research that would be tasked with examining the ever more exotic instruments dreamed up in Wall Street's derivative, securities and credit default swap markets in order to make the assumptions and processes understandable to leading financial analysts in the industry and at universities. Armed with the authority to subpoena whatever information required in order to conduct their analyses, the NIFR could provide the American public with valuable, advance information regarding possible future risks to the financial industry.

Think of the NIH (National Institute of Health). The NIH conducts fundamental research into diseases and endeavors to develop medicines that can cope with ever mutating viruses, bacteria and other germs. In some respects, the development of ever more exotic financial instruments is but a variation of the mutating aspects of germs.

An institution such as the NIFR could and should be financed by levees on the industry itself. Surtaxes on bonuses and executive compensation, as well as licensing fees, could be assessed of corporations that wish to partake of trading in the financial sector. Such fees should be regarded as legitimate costs of doing business and might go a long way towards reigning in the excesses of Wall Street.

The remaining investment banks could and should come under much closer regulatory scrutiny and be subject to the same regulations that the commercial banking industry is now subject to. Equalization of the regulatory regime is all the more urgent given the increasing merger of commercial and investment banks as Bank of America and Wachovia acquire investment banks.

Of course, much of this remains in the abstract for Main Street. Many of us do not hold assets of more than $100,000 in banks. We are not heavily invested in stocks, bonds and securities. We are just everyday joes living paycheck to paycheck. However, what Wall Street does or does not do can have a very direct impact on Main Street. If credit dries up - as it has recently - even the most creditworthy of businesses might find it difficult to secure loans. That impacts business activity and ultimately places in jeopardy the very jobs that we rely upon to pay for the basics of living, to pay back debt and perhaps to save for retirement. Thus, we all have a vested interest that Wall Street be rescued in a responsible way.