The AIG bailout was a massive relief, of course, but it does just buy time not only to fix the problem, but to install a new set of regulatory structures and rules. That hasn't yet begun. Wall Street worthies like Quadrangle's Steve Rattner in Wednesday's Journal continue to write columns describing the problem and suggesting that leverage will be -- should be -- reduced on a future Wall Street and that size will matter, so watch out Goldman, Sachs & Co. and Morgan Stanley. You can't argue with that, really, but it doesn't take us very far. Leverage is already down, enforced by regulators and the market. Can a deleveraged financial sector do all the thing everyone wants? And if deleveraging is going to be such a prudent and effective idea, why have we spent the last four decades figuring out how to maximize leverage and amplify liquidity? Was that just a dead end, or one massive project driven by corruption and greed, or both? The same folks that are now preaching from the pulpit of deleveraging are the ones that were great proponents of liquidity, convergence, and efficiency just a few moments ago, including Congress.
That's a little unfair, but the gap between the challenges of developing a new regulatory system and the limitations of our politics is a little scary. Consider an issue like shorting, which continues to erupt around every meltdown; on Tuesday, former American International Group Inc. chief Maurice Greenberg decried it -- and demanded action against it -- on CNBC. We're still awaiting the Securities and Exchange Commission investigation, but events are moving so fast, that that project, like so much at the SEC, seems anachronistic. Shorting is interesting because it is so difficult, and thinking about it takes us into the tangle of issues and ambiguities that reside at the heart of the big regulatory questions.
Here's the problem. Anyone with a brain knows shorting provides a necessary contrarianism to a market that is all-too-often thundering in one direction. Yale's Robert Shiller in his new book on the subprime problem argues that there has been too little shorting, and that bubbles are a result. But like everything else, there is "good" shorting and "bad" shorting -- the bad being organized attempts to perpetuate widespread "falsehoods" and "rumors" through the market. Even with naked shorting, which seems on the face of it to be a clear abuse, there's a good side: Some naked shorting is used for hedging purposes. What's the balance between good naked and bad naked shorting? And where's the bright line that separates lies from rumors from unsubstantiated facts, in a market that's profoundly speculative and short term?
There is no bright line. Wrestling with shorting thus carries us into the question of speculation and risk management. Let's face it: Over the last few decades the entire culture has cozily embraced speculation. McCain can decry greed on Wall Street, but he's not talking about shutting Las Vegas down, or preaching against state lotteries or Indian reservations. In the financial markets, speculation, empowered by technology and by advances in financial economics, is a major consumer of leverage and a major factor in the creation of liquidity. As in shorting, there is no bright line that separates speculation from investment any more. How do you separate mortgages bought for speculative ends and those to pay for a house? Highly speculative (and highly complex) instruments like AIG's credit default swaps can have dual purposes: Both to speculate and to hedge, that is to manage risk. Risk management may have failed us, but there's no real outcry to banish all risk management tools to Siberia, or for that matter to dampen ordinary folks from playing the market.
What we do know is that firms that finance themselves in the overnight markets -- that means Wall Street -- seem to be cooked. But that may be just the current panic, which at this point is well beyond the efforts of a bunch of shorts.
Could we alter the speculative component of the markets? Certainly. Years before he was Treasury secretary, Larry Summers, then at Harvard, began making arguments about how to encourage longer-term holdings in stocks. It was an idea, writ large, overwhelmed by the zeitgeist. Corporate folks would clearly love such an idea, because the greatest threats to their power come from activist hedge funds, who operate at the speculative end of the market. Thus another deep ambiguity: the marriage of speculation and the corporate governance orthodoxy.
All this is not to say that a new regulatory framework can't be built, just that it won't be easy. The political world has a big problem with ambiguity and complexity, to say the least, and the financial world is -- shockingly -- prone to argue its parochial self-interest. That's not a great combination. On the other hand, maybe a few more weeks of major firms folding and blowing away will serve to concentrate the mind. - Robert Teitelman
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Another amazing set of events, and with no end in sight. This time, as the storm blows ever harder (and today there's no let up), the political crowd actually seemed to stir. Suddenly Democrats in Congress think a new Resolution Trust Corp. "bad banks" just has to be done (the idea continues to be pushed by a trio of former regulators, including Paul Volcker, in a Wall Street Journal op-ed). So it's a year and four very large financial bailouts (and a bankruptcy) later for it to become a feasible idea? Better late than never. Meanwhile the presidential campaigns actually sparred over the issue. But that dialogue proved so embarrassingly silly that even the Journal felt compelled in its lead editorial to offer talking points to John McCain to get him past the notion that this whole mess was created by "greed" and "corruption" on Wall Street. Echoes of President Bush's notion a while back that Wall Street was drunk. 
There are the people - retired, orphans, widows - who bought preferred bank stock along with Fannie Mae and Freddie Mac because the ratings were high, and it was supposed to be a good, safe place for income investors. The Feds have let these people down - by not regulating the people who do the ratings and also by doing such a thing as creating a higher lever of stock over the preferred level. Everybody in this deal is not a rich gambler - many people's life savings are being wiped out.