Wall Street's Day of Reckoning

Fear, panic, and uncertainty pervade the world of finance.

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The investment bankers took ungodly and unnecessary risks and then really did not speak openly about them or address them soon enough in order to avoid the collapse of some of the firms. This was the case of Lehman Brothers and its real estate holdings. As Woody Brock of Strategic Economic Decisions points out, mismanagement, along with "greed, perverse incentives, poor risk assessment . . . are deeply rooted in human nature and thus cannot be changed." But too much leverage, which amplifies those human failings like ignorance and bad judgment, can certainly be reformed and regulated.

What is to be done?

Both presidential candidates recognize that in the post-securitization world that has emerged in the past decade, a new system of regulation is inescapable. First, it will have to limit mortgages to viable buyers, and it will require imposing maximum loan-to-value mortgage ratios. Secondly, we will have to change our monetary policy framework to take explicit account of asset prices whose escalation was what blew up the bubble and finally burst it. Thirdly, a whole system of regulation (including limits on leverage) will have to apply to the investment banking, hedge fund, and private equity world: When firms directly or indirectly have to rely on the federal government to bail them out, they invite something similar to the Federal Reserve policy that was put into place in the 1930s toregulate banks and avoid systemic risk. In the short run some new federal agency may have to buy at a discount illiquid assets in order to enable private financing to resume.

The world of finance will never escape the existence of fear and greed. The appropriate degree of regulation will clearly be needed to prevent the kind of excesses that have now put at risk the entire economy.