Analyzing Bear Stearns Bailout

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Then there is the central and controversial issue of how to pay people who work for financial firms. In blowup after blowup, compensation schemes based on short-term performance have encouraged traders, division heads, and C.E.O.’s to act recklessly. In the typical case, a trader or executive places a bet that pays off immediately—or soon enough to increase the individual’s bonus or stock-options value—but exposes the firm to long-term dangers. Examples include Merrill’s decision to step up its production of mortgage securities just as the outlook for the real estate market darkened and Bear’s refusal to keep an adequate reserve of cash on hand. Earlier this year, Raghuram Rajan, a former chief economist at the International Monetary Fund, referred to such behavior as “creating fake alpha—appearing to create excess returns but in fact taking on hidden risks.” When many people at different firms are doing the same thing, a ruinous boom-and-bust cycle results. One way to force traders and senior executives to take a more long-term view would be to pay them largely in stock or stock options that don’t vest for five or 10 years.

First and foremost, the executive and legislative branches need to repudiate the hands-off philosophy that free-market evangelists like Alan Greenspan and Wall Street lobbyists have been pushing for decades. The financial industry isn’t like the sporting-goods or music business. When lenders extend mortgages to home buyers who haven’t shown proof of income, or when commercial banks invest in risky securities, or when investment banks gear up their leverage ratios to 20 or 30 to 1, their decisions affect the entire economy. Common sense dictates vigilant oversight.

Until recently, few politicians and none of the presidential candidates were adequately addressing this issue. From Republicans, cozying up to Wall Street is to be expected, but Hillary Clinton and Obama had also been going easy on the traders. (Recall Clinton’s wobbling over whether earnings from private equity deals should be taxed at the regular rate.)

Doubtless, hefty campaign contributions from the financial industry had something to do with the candidates’ reticence. But now the economic circumstances have changed, and so has the political calculus. The country is in a recession (or near recession) that’s stamped made on wall street, and voters are furious about Stan O’Neal, Chuck Prince, and other bigwigs walking away from financial disasters with their pockets stuffed. In this febrile environment, the populist appeal of attacking Wall Street outweighs the financial benefit of acting as its protector. Hence Obama’s proposals for a thorough regulatory overhaul and Clinton’s call for troubled mortgage holders to receive a Bear Stearns-stye bailout. (Even Treasury Secretary Hank Paulson, the former head of Goldman Sachs, has advocated beefing up the oversight of investment banks.) The financial industry’s lobbying power should never be underestimated. But the great Wall Street free-for-all might finally be at an end.

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