Do Something

With the country in the middle of a contentious political campaign, the attention span of the Congress is understandably diverted to the mundane task of getting re-elected. All 435 members of the House and one-third of the Senate are working to keep their jobs. Of course, statistics prove that they should not be concerned: the single best predictor of success is incumbency. But this is an unusual year, and anything is possible.

Meanwhile, there is plenty going on that deserves the attention of these people, and chief among them is the economy's ill health and the catastrophe that used to be Wall Street. The Congress is expected to consider stabilization measures this week, and with the public's attention fixed on the problem, legislators recognize that they can't go home to campaign if they have not at least gone through the motions of acting to repair the mess.

The roots of the meltdown are many, but there are a few obvious things that are glaring.

One of these is the naked short. An investor can buy stock, and an investor can sell stock. But an investor can also sell stock he doesn't own ("going short"), betting that the price will go down. Then he can buy the stock back more cheaply ("covering the short") and pocket the difference, although if the price of the stock goes up instead of down, he loses money when he covers the short at a higher price.

But selling stock you don't own is the equivalent of issuing unregistered stock, which is contrary to good regulatory sense. If you buy more than 5% of any listed company, you have to tell the Securities and Exchange Commission because the government and the public, quite properly, want to know who controls companies. But if you sell more than 5% of any company you don't have to tell the SEC anything. Indeed, if a counterparty were willing to do the trade, you could sell 100% of a company and say nothing to anybody. Unfettered selling of equity produces enormous market volatility, and that erodes confidence, perhaps the most important determinant of economic health.

Another result of having regulators asleep at the wheel is the lack of supervision over credit default swaps. The transaction has been very popular among financial institutions, and it is essentially the equivalent of buying an insurance policy on non-existent financial risk. it has the practical effect of pure gambling. The face value of transactions in this market is large enough to defy understanding, and some observers place the total at $70 TRILLION. That's a great deal of unregulated gambling indeed.

Furthermore, when financial institutions engage in these kinds of transactions, like all investors including you and me, they borrow money to execute them. But when we borrow money, say to buy a house, we normally can borrow no more than 80 or 90 percent of what we need, and that amount is limited by the value of the house we want to buy. But financial institutions borrow all the money they need for their transactions, and the face value of these bets can exceed the total assets of the firm. When investments go their way, they make piles of money, but when they don't they go bankrupt.

In theory, there are several things that are supposed to keep institutions from doing stupid things like this. These institutions are purportedly run by people who know what they are doing, but clearly they often don't. Boards of directors are supposed to supervise the activities of these officers but obviously they are also remiss. And regulators, including the Securities and Exchange Commission, have the responsibility to exercise yet another layer of adult supervision. Failed again.

And over all this are the Executive Branch and the Congress, and neither has thought that the financial health of the market has been sufficiently important to warrant their meaningful attention or action. While excessive regulation kills prosperity, a lack of control has the same nasty effect. Finding the proper balance requires a commodity rare in Washington: wisdom.