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Make It Work

We are now on our second multibillion-dollar plan to bail out Wall Street. The Bush administration has abandoned the free-market ideology that laid the groundwork for the crisis, acknowledging that nothing less than wholesale intervention can prevent a complete collapse of the global financial system. Yet the question remains: Have we finally regained control of the economy? Nobody knows for sure, but, with its move to restore trust in the banking system, the United States will certainly ease the credit crunch. Now it is up to the banks in which Uncle Sam is becoming a shareholder to do their part. Wall Street must go back to its roots, and, instead of financing the kind of speculative trading activities and excessively leveraged transactions that led to this crisis, it must finance a revitalization of the U.S. economy. It must set the table for a new world economic order that rewards productive investment instead of speculation.

By now, an endless stream of pundits have explained that markets are built on confidence, by which they mean confidence in the promises that market participants make to each other. In his insightful new book, Fixing Global Finance, Martin Wolf of the Financial Times describes the financial system as "a pyramid of promises." The credit markets seized up because investors and institutions lost confidence in the ability of their counterparties to keep such promises--that is, confidence in the ability of borrowers to repay loans. The only way to guarantee such promises and get the financial sector back on its feet was for the government to stand behind them, which is precisely what the Bush administration has now done--and what it should have done in the first place.

From the beginning, the $700 billion plan to buy impaired mortgage loans was poorly conceived. Its biggest flaw was that financial institutions carry most of these securities on their books at far above their current market value. Accordingly, if the government paid a fair price for them, the institutions would incur huge losses--and perhaps be rendered insolvent. Alternatively, if the government paid a higher price, it would effectively be giving American taxpayers' money away to these institutions. Moreover, there are trillions of dollars of bad mortgage paper in the market; $700 billion wouldn't even make a dent in the problem.

Injecting $250 billion into financial institutions in return for an equity stake is a far more efficient use of American taxpayers' capital because each of these dollars will be loaned and re-loaned multiple times. We can expect each dollar to create approximately ten dollars of economic activity, making approximately $2.5 trillion of capital available for the economy if the firms that receive government investments do what they are supposed to and begin making loans again. Rather than spend the other $450 billion buying toxic mortgage paper at prices that are going to either inflict huge losses on banks or cheat the taxpayer, the government should keep that ammunition in reserve to prompt future lending if the first $250 billion does not do the trick.

In addition to building trust and injecting capital, the government needs to give financial institutions time to rebuild their balance sheets. This will require two steps. First, central banks must further cut interest rates so that banks can increase the profit they make from lending money. Second, the government must temporarily suspend mark-to-market accounting in which the balance-sheet value of an asset is reduced to reflect its current market value. In today's market, there is no way to accurately value the trillions of dollars of mortgage and mortgage-related paper and derivatives that are cluttering balance sheets, so why drive the world into insolvency trying?

As banks begin to regain their stability, we need broad regulatory reforms to insure that the past weeks are not the prelude to an even greater catastrophe. These reforms should start with the huge market for credit default swaps. A credit default swap, or CDS, is an insurance policy in which one party agrees to protect another party against the default of a bond, loan, or mortgage. This market, which is completely unregulated, has grown to an unimaginable $55 trillion, and includes many insuring parties that are incapable of making good on their obligations. (In one case now before the New York state courts, UBS Securities is suing a hedge fund that promised to insure $1.3 billion of debt. There was only one problem--the hedge fund had only $200 million!) Even more frightening, no central organization knows who owes what to whom in the CDS market. Thankfully, a clearinghouse that will require full disclosure of all CDS positions is currently being formed. Once that is done, the government must institute capital requirements to insure that all parties writing credit insurance contracts are capable of making good on their promises.

Finally, we must limit the freedom of financial firms to leverage themselves to the point where their failure can cause systemic damage. Bear Stearns was 30 times leveraged when it ran into trouble, and Lehman Brothers was well over 20 times leveraged when it finally collapsed. Over the past year, several hedge fund failures roiled the markets: Sowood Capital Management, LP; Carlyle Capital Corp.; and Peloton Partners LLP were three of the largest casualties. Each was leveraged at least four times over, and, in Carlyle's case, more than 30 times. Ten times is probably the upper limit of leverage that any bank should bear, and the limit should be lower for hedge funds. It is now abundantly clear that the free market will not regulate leverage on its own. An illusion had developed on Wall Street that this generation of investment managers possessed a new kind of genius, but, in truth, the only thing these managers did differently was to apply more leverage to the same old investment strategies in a bull market. When the laws of investment gravity brought the markets back to Earth, their spaceships crashed on the rest of us.

Wall Street as we knew it is gone, and that is not a bad thing. The government should use its new power not simply to restore the status quo ante, but to craft a new economy. Over the past three decades, an increasing amount of America's financial and intellectual capital has been devoted to speculative rather than productive activities--betting on much but producing little. This is no accident--it was the result of tax and fiscal policies that rewarded certain types of investments over others (i.e., debt over equity). Those policies should be redesigned to create the proper incentives to direct America's economic, intellectual, and creative energies toward rebuilding our physical infrastructure, cleaning our environment, rebuilding schools and neighborhoods, solving medical and scientific problems, and, most importantly, reducing our dependence on fossil fuels. There is more than enough productive work to keep our economy growing for decades to come. This crisis has given us the best opportunity in a generation to redirect America's energies. It will only become a tragedy if we squander it.

Michael E. Lewitt, a money manager, is editor of The HCM Market Letter.

This article originally ran in the November 5, 2008, issue of the magazine.