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Wall Street in Crisis September 17, 2008, 5:08PM EST

Wall Street Staggers

What brought down the markets? Bad choices, greed—and never learning from past mistakes

by Paul Barrett

Chang Park

In times of high stress, many in the financial world seek solace in watery metaphors. We hear of vast irresistible forces converging in "perfect storms" and unforeseeable events contributing to "100-year floods."

How could we have expected, let alone prevented, this?

Count on Warren E. Buffett to cut to the truth. Years ago, referring to reckless corporate debt, Buffett noted (or so the story goes): "You never know who is swimming naked until the tide goes out."

The tide's moving, and we're starting to get the full, not-so-pretty view. Along with the bare swimmers emerging from the soggy murk, we're being reminded of some of the dumb ideas and reckless choices that helped deliver us to our current debacle. As stunning as the scene seems, we've actually had plenty of experience with this sort of thing. But like some stubborn residents of hurricane zones, we swiftly choose to forget the last tempest and reassure ourselves that things will be different from now on. Why don't we learn the obvious lesson to the contrary? Answers: the timeless power of hubris during periods when profits seem easy, and a set of foolish financial notions that have become prevalent over the past three decades.

One of those beliefs is the indiscriminate antiregulatory ideology one hears preached on Wall Street with tent-revival fervor. What makes this thinking so perplexing is that many of the free-market true believers also assume the federal government will save them if they flop. Consider the extraordinary taxpayer-backed rescues of insurance titan American International Group (AIG), housing financiers Fannie Mae (FNM) and Freddie Mac (FRE), and, before those, the Treasury-guided merger of Bear Stearns into JPMorgan Chase (JPM). It brings to mind the homeowner who rants about getting Washington off his back but wants federally guaranteed flood insurance no matter how close to the Gulf Coast he builds his house.

Other by-now-familiar attitudes have helped put us in the drink: In good times, there's no such thing as too much leverage. (Remember Michael Milken?) Derivatives don't require oversight, even though almost no one understands them. (How now, Long-Term Capital Management?) And, don't worry, the quantitative geniuses have devised models to eliminate extreme risk. (Enron, anyone?)

"Now, again, the banks and the Bush Administration and [Treasury Secretary Henry] Paulson and [Federal Reserve Chairman Ben] Bernanke would like you to think these crises are like floods or hurricanes," says Michael Greenberger, a senior official at the Commodity Futures Trading Commission (CFTC) during the Clinton Administration. An advocate of more aggressive regulation of investment banks, he was shot down in the late 1990s by Democratic colleagues, not just GOP foes. Most financial calamities aren't like natural forces beyond control, Greenberger says. "These are predictable events." Predictable events, of course, are more likely to be prevented with sound rules and stiff enforcement.

Different Animals

Alfred E. Kahn offers the long view—a very long view. As the Carter Administration's aviation czar, he unshackled airline routes and fares in the late 1970s, reshaping that industry (for better and worse) and helping spur a lengthy era of economic deregulation. Still sharp at 91, the retired Cornell University economist and part-time consultant recalls that almost as soon as the free-market spirits were set loose, a furious stampede ensued. Lenders, for one, demanded lots more freedom. But they "were a different kind of animal" from airlines and trucking firms, which the Carterites also deregulated, Kahn says. "They were animals that had a direct effect on the macroeconomy. That is very different from the regulation of industries that provided goods and services.…I never supported any type of deregulation of banking."

During the Reagan years, Kahn's cautious industry-by-industry analysis was replaced by the all-encompassing antiregulatory ideology of the University of Chicago. One result: the liberation of an armada of savings and loan pirates, abetted by congressional Democrats as well as Republicans, many of them drunk on S&L campaign largesse. (Wall Street lobbyists with open wallets have since perfected the practice of neutralizing Congress on a bipartisan basis.) Hundreds of thrifts ultimately collapsed in the late 1980s and 1990s amid greedy and, in some cases, fraudulent real estate deals.

As early as 2000, William J. Brennan, a prominent consumer attorney who has represented mortgage borrowers since the S&L catastrophe, warned in testimony before the House Financial Services Committee that real estate finance would return in new guises to haunt us. Few listened. Behind every burst of ill-advised lending lurk financial innovators creating new mechanisms to entice ever-more-sketchy borrowers, says Brennan, the director of Atlanta Legal Aid Society's Home Defense Program. In the 1980s, Michael Milken and his comrades at the now-defunct Drexel Burnham Lambert investment bank exacerbated the S&L fiasco by hawking their thrift clients' high-risk junk bonds. More recently the likes of soon-to-be-defunct Lehman Brothers and Bear Stearns engineered the securitization of mortgages, encouraging home lenders to spew wildly unwise loans. "Lending without regard [for] the ability to pay back started with the S&L scandal," says Brennan. In the 1980s the borrowers were reckless shopping-mall developers; in the recent boom, unsophisticated and sometimes cavalier homeowners.

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