An Unfamiliar (Economic) Game

When a young Jack Nicklaus won the 1965 Master's Tournament, golf legend Bobby Jones said Nicklaus was "playing a game with which I am not familiar." I have the same feeling about today's financial markets.

This is not capitalism as I learned it. Rather, for the past three decades financial engineers have been playing a game with unlimited upside reward and, thanks to the Federal Reserve and the White House, limited downside risk.

The new rules: A $45 trillion market in immensely complex derivative securities, with no regulation, no capital requirements, no transparency, and a Federal Reserve that is so terrified of the consequences of this market blowing up that it seems prepared to bail out the losers at almost any cost.

The perfectly predictable result is a Wall Street willing to peddle increasingly dicey paper in return for the promise of ever-higher returns. Who wouldn't, especially with the Fed prepared to cover your bad bets? The phenomenon has been around long enough to have a name: moral hazard.

Just since the 1970s, we have gone through Michael Milken's junk bonds, the savings and loan crash, leveraged buyouts, Long-Term Capital Management and the hedge funds, venture firms and the dot-com bubble, the private equity craze, and the sub-prime mortgage mess. It's all a variation on the same theme -- smart guys take other people's money, leverage it by as much as they can get away with, buy stuff, securitize it, and then flip the paper for a huge profit.

Unfortunately, the deals get riskier and riskier and finally crater. Eventually, someone gets caught holding the bag. If that someone is big enough -- a bank or even an investment house -- the Fed steps in to bail them out. Even more troubling, the central bank continues to pump liquidity through the whole financial system to keep things afloat. So, to ease the consequences of the bursting dot-com bubble, the Fed made plenty of money available for the mortgage market. That not only kept home prices up, it set off a housing boom, sub-prime and no down-payment mortgages, and finally, kersplat, here we all are.

A handful of observers, such as the late Fed Governor Ned Gramlich, warned of the dangers of sub-prime lending. Sadly, they were largely drowned out by a curious combination of the Bush administration, which believed that a new "ownership society" would create fresh cadres of happy Republican voters, Fed Chairman Alan Greenspan, and some Democrats, who encouraged the expansion of sub-prime loans in a misguided attempt to aid low-income homebuyers.

More broadly, Greenspan believed that derivatives and the massive casino they created were good for the economy. Unregulated hedge funds and private equity firms would, he believed, be a more efficient mechanism for clearing market prices than traditional regulated securities firms. They were, until they weren't.

As a result, we seem to be reverting to an era where recessions are caused by financial busts rather than downturns in the real economy. The 2001 slump began with the bursting of the dot-com bubble in March of 2000. Similarly, the current slowdown is being driven by Wall Street's crisis of confidence far more than economic fundamentals such as employment or consumer demand, which, all things considered, have held up pretty well.

These Wall Street-driven busts used to happen all the time, until post-Depression regulation of commercial and investment banks leashed the speculators. In recent decades many of those rules were repealed, the Securities & Exchange Commission and other regulators were defenestrated, and financial rocket scientists invented securities that were beyond the law. Somewhere Jay Gould is looking down on derivatives traders and smiling.

The consequences of this bursting bubble were enough to get the attention of even Bush administration Treasury Secretary Hank Paulson who reacted by proposing a broad overhaul of financial regulation. You may not agree with Paulson's proposed solutions, but he is at least asking the right question: Do we need to restructure securities and banking regulation to keep up with warp-speed changes in these markets?

Most likely the Fed's decision to rescue Bear Stearns and make $200 billion available to keep other firms afloat focused Paulson's mind. The Fed's support went not to commercial banks, mind you, but investment banks and, in the end, their unregulated, off-the-books subsidiaries that are gagging on junk-laden portfolios. As Fed Chairman Ben Bernanke candidly admitted to the Joint Economic Committee, "The damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain." He didn't add, but could have, that the Fed believes this is true of other high-rollers as well.

Bernanke and other defenders of the Fed's move say Bear Stearns' stockholders have paid a huge price, with their shares plunging from $172 a year ago to $10 today. I prefer to say that Bear's shareholders are getting 10 bucks for stock that would be worthless without the Fed's help. The bigger issue, however, is not with Bear but with those other firms (whose names the Fed will not disclose) who are also being bailed out, thanks to that $200 billion credit line.

In the words of Fortune Senior Editor Allan Sloan, "Private profits, socialized losses."

Howard Gleckman is editor of TaxVox, the blog of the Tax Policy center. He is also a senior research associate at the Urban Institute. This article is adopted from a TaxVox posting.