Why Wall Street is Melting Down, and What to Do About It

Hank Paulson didn't blink, so Lehman Brothers went down the tubes. The end of socialized capitalism? Don't bet on it. The Treasury and the Fed are scrambling to enlarge the government's authority to exchange securities of unknown value for guaranteed securities in an effort to stave off the biggest financial meltdown since the 1930s.

Ironically, a free-market-loving Republican administration is presiding over the most ambitious intrusion of government into the market in almost anyone's memory. But to what end? Bailouts, subsidies, and government insurance won't help Wall Street because the Street's fundamental problem isn't lack of capital. It's lack of trust.

The sub-prime mortgage mess triggered it, but the problem lies much deeper. Financial markets trade in promises -- that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting the promises, Wall Street can't function.

But it's turned out that many promises like these weren't worth the paper they were written on.

That's because, when the market was roaring a few years back, many financial players had no idea what they were buying or selling. Worse, they didn't care. Derivatives on derivatives, SIVs, credit default swaps (watch this one!), and of course securities backed by home loans. There seemed no limit to the leverage, the off-balance sheet liabilities, and what credit rating agencies would approve by issuers who paid them to.

Two years ago I asked a hedge fund manager to describe the assets in his fund. He laughed and said he had no idea.

This meant almost no limit to what was promised. Regulators -- Alan Greenspan in particular -- looked the other way.

It worked great as long as everyone kept trusting and the market kept roaring. But all it took was a few broken promises for the whole system to break down.

What to do? Not to socialize capitalism with bailouts and subsidies that put taxpayers at risk. If what's lacking is trust rather than capital, the most important steps policymakers can take are to rebuild trust. And the best way to rebuild trust is through regulations that require financial players to stand behind their promises and tell the truth, along with strict oversight to make sure they do.

We tell poor nations they have to make their financial markets transparent before capital will flow to them. Now it's our turn. Lacking adequate regulation or oversight, our financial markets have become a snare and a delusion. Government only has two choices now: Either continue to bail them out, or regulate them in order to keep them honest. I vote for the latter.