It's the Debt Stupid

So here we are, we hope, at the selling climax of this bear market, with the big Wall Street investment firms going cap in hand to the Feds and to the banks for a handout. Last night there was talk that Morgan Stanley and Goldman Sachs might be the next to go.

As Robert Samuelson says, this is the end of Wall Street as we know it. It is the end of the Masters of the Universe and their leverage fueled “principal transactions.” In the old days, investment firms worked for their clients. But now they work for themselves.:

Now, most financial firms also invest for themselves. They use partners’ or shareholders’ money to place bets on stocks, bonds and other securities — so-called "principal transactions."

And most of this investing has been financed with a high level of borrowed money. Nothing wrong with that, of course, until things go south and the asset that is collateralizing the loan can no longer liquidate the loan.

The trouble with high-leverage investing is that it is taking money that is not really supposed to be risk capital—i.e., fixed-income debt—and then using it in high-risk transactions. The banks or individuals supplying the money for this activity are not hands-off investors. They are risk partners in the venture. Because if asset values go south, then they are out of the chips.

For too long, for far too long, government has allowed this high-octane, highly flammable business model to operate, when everyone should know the risks. People investing money in these high-risk ventures and people lending money to these high-risk ventures are, whether they like it or not, risk partners in the venture. They should be treated as such and rewarded as such.

When you are a partner in the risk, then you should be getting an equity stake in the venture, not you should not be lending money backed by collateral.

How hard is this? Well, I’ll tell you. If we enforced this rule, that risk=equity and should be capitalized as such, then the Masters of the Universe wouldn’t be making so much money in the good times. They would have to share the wealth with their equity partners.

But on the downside they wouldn’t be forcing fixed-income investors and taxpayers to pay for their stupid mistakes.