Why Wall Street is Melting Down, and What to Do About It

Hank Paulson didn’t blink, so Lehman Brothers went down the tubes. The end of socialized capitalism? Don’t bet on it. The Treasury and the Fed are scrambling to enlarge the government’s authority to exchange securities of unknown value for guaranteed securities in an effort to stave off the biggest financial meltdown since the 1930s.

Ironically, a free-market-loving Republican administration is presiding over the most ambitious intrusion of government into the market in almost anyone’s memory. But to what end? Bailouts, subsidies, and government insurance won’t help Wall Street because the Street’s fundamental problem isn’t lack of capital. It’s lack of trust.

The sub-prime mortgage mess triggered it, but the problem lies much deeper. Financial markets trade in promises — that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting the promises, Wall Street can’t function.

But it’s turned out that many promises like these weren’t worth the paper they were written on.

That’s because, when the market was roaring a few years back, many financial players had no idea what they were buying or selling. Worse, they didn’t care. Derivatives on derivatives, SIVs, credit default swaps (watch this one!), and of course securities backed by home loans. There seemed no limit to the leverage, the off-balance sheet liabilities, and what credit rating agencies would approve by issuers who paid them to.

Two years ago I asked a hedge fund manager to describe the assets in his fund. He laughed and said he had no idea.

This meant almost no limit to what was promised. Regulators — Alan Greenspan in particular — looked the other way.

It worked great as long as everyone kept trusting and the market kept roaring. But all it took was a few broken promises for the whole system to break down.

What to do? Not to socialize capitalism with bailouts and subsidies that put taxpayers at risk. If what’s lacking is trust rather than capital, the most important steps policymakers can take are to rebuild trust. And the best way to rebuild trust is through regulations that require financial players to stand behind their promises and tell the truth, along with strict oversight to make sure they do.

We tell poor nations they have to make their financial markets transparent before capital will flow to them. Now it’s our turn. Lacking adequate regulation or oversight, our financial markets have become a snare and a delusion. Government only has two choices now: Either continue to bail them out, or regulate them in order to keep them honest. I vote for the latter.

Originally published at Robert Reich’s Blog and reproduced here with the author’s permission.

4 Responses to "Why Wall Street is Melting Down, and What to Do About It"

  1. Guest   September 16, 2008 at 9:36 pm

    I wish Barck Obama would be as articulate as RR and get out the messaage of what must be done to treat our ailing finacial markets.Izzy

  2. Alex   September 17, 2008 at 1:40 am

    Despite the fact I disagree with much of the stuff you write between you McCain and Obama its clear that you would have by far and away been the best choice for President with your insight and knowledge.Regarding regulations the Bush administration has been fighting a war to rein in fanny and freddie (or as Bill Fleckenstein eloquently put it Fanron)for years, but Fanron has used its immense clout to lobby Congress,especially the Democrats. You can read about the “war” in back issues gsereport.com.I think the problem is really one of moral hazard. These corporations sell garbage yet whats happens to them? Are they punished or allowed to go bankrupt, we bail them out.If the financial regulators were parents its as if we lecture the kids for driving fast but bail them out for their DUI so they can speed again.In a sense its the problem that Frank Partnoy wrote about in his book Infectious Greed : http://www.amazon.com/Infectious-Greed-Corrupted-Financial-Markets/dp/0805075100Securitization was suppose to allow banks to pass on risks to those best able to handle them. Instead we have created a situation where financial institutions can offload the garbage onto third parties and collect fees.This system has allowed us to transfer risks from one party to another but we have moved the risk into the system as a whole. Its like saying instead of dumping your trash in a landfill you’re going to dump it into the ocean. The Ocean seems massive and limitless at first but given enough trash its going to start showing up somehere.Our financial system is trashed and keeping it alive is akin to trying to fix a computer filled with virus,spam and malware. We need to reformat the system, start over tabla rasa.The real flaw here isn’t thinking that tommorrow can be better than today its believing that the current system can continue. Everyone should simply take their losses, if they do we can start over.This bailout has not resolved the fundamental problems with valuations that are at the heart of the current crisis its simply moved those problems from AIG to the US taxpayer.I’m not saying that starting over is going to be easy, it will be tough and could even mean the end of the United States but we will NEVER resolve this crisis until we face the truth, that alot of these assets are totally overvalued and alot of companies and countries that aren’t bankrupt should be.As the Americal Division used to say during the Vietnam War :”We had to destroy the village to save it”.Perhaps the same thing is in order for our financial system.

  3. Oppose the international Jewish plutocracy   September 17, 2008 at 4:55 am

    It’s the machinations of greedy Jews like Reich who got us in to this mess…and now he and his ilk want to lecture us on how to get America and the international financial system out this mess? Laughable.

  4. Peggy Finston MD   September 20, 2008 at 10:27 am

    Unfortunately, this lack of trust, or more accurately lack of trustworthiness, has permeated many insitutions in our society, including education, healthcare, etc. Some where along the way (the past 20 years) we have confused appearance for substance. And technology has been perverted to legitamize this appearance. Anything that be measured must bear more truth than one representative “live” event.If an insitution can present a good “show” and roll out enough paperwork to “document” what it claims, we have come to take the PR-speak as reality. For example, all the Veterans Hospitals in our country do not translate to veterans getting quality health care. Or, the IPPA regulations, hyped as needed to protect patients’ confidentiality, actually forces them to relinguish control over medical records. Worse yet, patients cannot purchase medical help without first signing away their “confidentiality” with this law.This dishonesty and people’s unspoken and understandable lack of trust is not just about financial markets.