Washington Tries to Clean Up Mess It Created

Did I get it really right or really wrong in my column last week? And by the way, last week seems like about a million years ago; so much has changed in this crazy market.

I said the government rescue of Fannie Mae (FNM) and Freddie Mac (FRE) would mark the turning point in the credit crisis. Wrong. The crisis got worse.

But I also said that the short-term reaction might be very negative. Correct. And has it ever been negative.

And I said, "If Fannie and Freddie are worth zero, then why not Lehman Brothers, too?" Exactly! But I should have mentioned that American International Group (AIG) was heading to zero as well, shouldn't I?

The reason for this week's insanity -- despite even more government rescues like the explicit bailout of AIG and the shotgun marriage between Merrill Lynch (MER) and Bank of America (BAC) -- is that the manner in which Washington is carrying out these rescues is making things worse, not better.

The Federal Reserve was set up almost a century ago specifically to do rescues: to loan money to banks that were temporarily in trouble, and to keep panic from setting in and spreading. That involves "moral hazard." That's because those loans insulate banks from having to take their lumps from poor business decisions that get them into trouble in the first place. But that's OK, because it's better to have a banking system that takes some risk -- knowing it will get bailed out by the Fed if things get too bad -- as opposed to a system so risk-averse that it's paralyzed, and will never loan any money to anyone.

The new model is that if you get in trouble, the price of a bailout is you lose your company. Fannie and Freddie, and now AIG, saw the government seize 80% stakes as the price for federal assistance.

Now many people say -- I'm sure Fed Chief Ben Bernanke and Treasury Secretary Henry Paulson feel this way, too -- that these companies were so profligate that they deserved to be wiped out. Why should taxpayers take any risk to protect companies so stupid and so greedy that they blew up as badly as those three?

Fair enough. But that has consequences. Once the market knows that certain firms deemed "too big to fail" will be both rescued by the government and wiped out by the government at the same time, there's every incentive to mount a "speculative attack" on those companies. That means artificially pushing them into distress, so that the government will have to nationalize them.

Who would want to mount such an attack? Short-sellers, for one. Competitors, for another. For that matter, even shareholders in the companies themselves participate in the attack. At the least sign of trouble, shareholders dump their shares in order to get out with at least something before the inevitable government takeover. The result: The company being attacked sees its stock collapse, its business weaken and confidence evaporate. Next thing you know, it's being nationalized -- and the shorts take their huge profits. Their blood money.

So as soon as the government nationalized AIG, I put out a memo to my institutional investor clients saying that investment bank giants Morgan Stanley (MS) and Goldman Sachs (GS) were next. And that's just what happened. Their stocks have been hammered, and it looks like Morgan will have to arrange a hasty and very expensive merger with some other company in order to survive. I'm not sure what strategy Goldman has in mind.

Rescues that wipe out shareholders -- and target other companies to have short-sellers and other attackers drive them into the government's jaws -- aren't rescues at all. They are an invitation to more disaster, and that's just what we got this week.

What rallied stocks on Thursday wasn't just the hints of some kind of mega-bailout that would have the government buy up every bad subprime mortgage in the world, and anything else that people are sorry they bought. (Hey, Mr. President, I have some shares of Petfood.com that I bought for $250 in March 2000 -- how about it?) The catalyst was the rumor that the Securities and Exchange Commission was going to do something serious to stop short-sellers from attacking stocks like Morgan Stanley and Goldman Sachs, just as its equivalent regulatory agency in the United Kingdom has done.

Now it's official. The SEC has temporarily banned short-selling of financial stocks. I'm all for it. It will be a very effective solution to the market's current death spiral.

I should kick myself for saying that because I'm a die-hard advocate of free markets left to operate on their own without government interference. But it's too late for that. The government has already interfered, with a set of poorly designed bailouts that have caused healthy companies to become crippled in attacks by short-sellers, and ultimately wiped out by nationalization.

So now the government has to interfere again, to make up for its first interference. If banning short-selling for a while does that, then so be it. (Also on Friday, details are emerging on Congress's desire to really do that mega-bailout.)

This could be the bottom. This could be what it takes to really stanch the bleeding, and put the financial sector in a position to take a deep breath, pick itself up and start to heal. When confidence in the financial sector returns, it will spread across the entire economy and the entire market.

And then you know what will happen? Of course. It always does. The idiot politicians and regulators and central bankers who created the problem in the first place will take credit for solving the problem.

Well, at least it will be solved.