The U.S. stock market boomed throughout the mid-1980s. One contributing factor was a major technical innovation of that time called “portfolio insurance.” This was basically a trading technique by which an investment bank would buy a basket of stocks and simultaneously “short” another, closely related basket of stocks. (“Shorting,” or “selling short,” amounts to betting that the price of a given security will decline. One technique involves borrowing shares for a specified time and immediately selling them, with the intention of buying them back at a lower price when the loan comes due.) If you did this just right, you could make money whether the stocks you bought went up or down. It was like a bookie’s taking action on both sides of a bet.

Some foresaw that this technique could radically increase the speed and severity of a market decline. That’s because a key hidden assumption of portfolio insurance was that you could short stocks at will without your trade’s affecting the price. If a very small fraction of the trading volume for these securities is driven by portfolio insurance, the assumption works very well. But, in the extreme, if all trading volume were following this strategy, then once a general market decline began (for whatever external reason), the complicated financial logic of portfolio insurance would require everyone to start shorting more and more. There would be an avalanche of would-be short sellers with no buyers; you can’t bet on a price decline if there’s no one to bet against you. This would create an ever-growing herd of investors desperate to sell shares at any price, and the market would go into free fall with no bottom. At some unpredictable point between “a very small fraction” of trading and “all,” the whole market is vulnerable to collapse in the face of a price decline.

By October of 1987, the market had been declining on and off for more than a month, but by historical measures it remained quite overvalued. The night before trading opened on October 19, the Hong Kong market declined significantly. This was the spark that set off exactly the conflagration that had been predicted. Price declines led to automated shorting of stocks, which led to further declines, which led to further shorting, and so on. Markets all but collapsed in the face of unprecedented volume, about half of which was automated trading by ten large investment houses executing portfolio-insurance strategies. The aggregate value of U.S. publicly traded corporations declined by more than 20 percent in seven hours.

Now, this is not a simple morality tale of hubris meeting nemesis. In the face of many calls for sweeping changes, regulators did not overreact. New regulations were limited and technical. But the crash permanently changed the way the market prices risks. Market prices changed after October of 1987 to reflect much higher estimates of the probability of a crash, and they have never changed back. The market recovered its losses within a couple of years and went on to have one of its greatest run-ups in history over the next decade. Since the 1987 crash, “quantitative” finance (the exploitation of arcane relations between various financial instruments, derived through intense number crunching) has become ever more dominant, and it is now an important driver of wealth creation. These techniques have turned out to be very useful; it just took the market some time, and the experience gained from the 1987 crash, to figure out how to use them effectively.

Fortunately, the effects of that crash were contained. America today faces something much more serious— a financial crisis linked to subprime mortgages that threatens to become a general economic crisis, because the kind of crash it might create would be much harder to contain. The problem we face is often described as mind-bendingly complex, but in its essentials, it is simple.

MORTGAGE MANIA

It is clear, in retrospect, that America had a classic speculative bubble in home prices. As is typical in a bubble, its later stages were characterized by reckless investment, excess debt, and shady-tending-to-illegal business practices. As cheap credit pushed up the market price of houses, many homeowners began to incur lots of debt. They were comfortable doing so because they believed that they had sufficient equity value in their homes to make good on the debt if required. Many people who previously would not have qualified for mortgages now got them, some because of the government’s market-rigging via Fannie Mae and Freddie Mac. Simultaneously, many homeowners were offered and accepted mortgages that approached all-debt (“zero down”) at floating interest rates, rather than traditional fixed-rate mortgages. In the worst instances, these mortgages had payments that were all but certain to increase in the future. These homeowners were betting that they would get raises, inherit money, or, more likely, be bailed out by an increasing home price that would allow them to roll over the debt.

Here’s the problem with having lots of debt and very little savings or equity: Sooner or later you’ll have a bad month, and when it’s time to mail in your mortgage payment, you won’t have the money. In the present case, once home prices began to decline (or, for the most over-leveraged homeowners, simply stopped rising fast enough), that’s what started happening to more and more borrowers.

Normally this would be bad for the homeowner and the lender, but not a big deal for anyone else. But the impact was magnified because the original lenders had sold rights to third parties to receive payments under some of the mortgages. These third parties bought up lots of mortgages, broke them into little pieces, combined them with pieces of other mortgages, repackaged them all in “creative” ways, and resold them to commercial and investment banks as mortgage-backed securities. Because of all the cross-sales, most banks ended up making direct and indirect loans to many other banks, and therefore they were at risk in case of a default by any large institution.

The banks were aware of this risk. Luckily for them, various investment banks, hedge funds, and other major financial institutions offered the following deal: Pay an up-front fee, and we will guarantee to make you whole for any mortgage-backed securities that default. These contracts are the infamous “credit-default swaps.” The total amount of such swaps currently outstanding is unknown because they are not regulated, but it is estimated to be about $60 trillion. As this is more than four times total U.S. GDP, the providers can’t possibly have that much cash on hand. So how can they pay off if required? Well, they have a large number of very smart Ph.D.s who have developed clever trading strategies. These strategies involve things like shorting securities that are highly correlated with mortgage defaults, to generate trading profits in the event that the mortgages default — again, like a bookie taking action on both sides of a bet. They then market these swaps to the banks as “credit insurance.” Is this starting to sound familiar?

Things went along swimmingly until there was a general decline in home prices. Defaults started to rise. At first, banks weren’t worried: They had credit insurance! Then a major provider of swaps, AIG, realized that its hedging strategies were insufficient to pay off the swaps it had issued. Suddenly all the bankers confronted a horrible realization: Their credit insurance was an illusion. If more than a tiny fraction of market participants relied on it, then as soon as it was needed, it wouldn’t be there. And if even one large provider of swaps went bankrupt, it could create a chain reaction. Banks that depended on that provider’s swaps would not have enough money to pay their depositors, and would go bankrupt. Other banks that had lent money to these banks would suddenly be short on money themselves. Since nobody knows for sure how deeply exposed various banks are to swaps or similar instruments, even depositors at highly conservative banks would begin to withdraw money. A series of bank runs would start. Banks would stop making normal business-operating loans in order to conserve capital and protect themselves against runs. Many people would then lose their jobs and default on their mortgages. This would lead to more defaults by providers of swaps, which in turn would lead to more bank runs and more constriction of lending, and so on. In short, financial contagion would spread, leading to an enormous economic contraction.

As I write this, we appear to be teetering on the precipice of such a situation throughout the developed world. What should we do about it?

In the short run, the Federal Reserve and Treasury Department, along with similar institutions in other countries, are trying to intervene to prevent such a contagion. The evolving Fed/Treasury approach is some combination of: forced merger or nationalization of failing institutions that threaten to create contagion; public purchase of enough mortgage-backed assets to allow proper valuation of risks, and therefore hopefully unfreezing of credit markets (by removing bad assets from the banks’ balance sheets and providing some idea of what these securities are worth); and direct investment into weak but salvageable banks to allow them to continue operations, and ideally return to health.

The disadvantages of this approach are numerous and severe. It will almost certainly lead to higher taxes. It may encourage some financial institutions in the future to take wild risks because they think that as long as they are big, the government will save them (economists call this tendency “moral hazard”). It re-legitimizes the kind of direct government intervention in the economy that we have spent at least 30 years trying to escape. It is also obviously unfair to prudent savers, who missed out on the easy money of the go-go years and now have to foot the bill for their less careful fellow citizens. That fact won’t be lost on voters, who will likely demand similar bailouts for people who don’t make a million dollars per year. Finally, it might not even work.

These all sit on one side of the scale. Against them we have one huge consideration: The catastrophe of full-scale contagion would make somewhat higher taxes, moral hazard, and so forth seem like child’s play. The current plan is the worst conceivable course of action — except for every other alternative. What is essential is that these government investments be unwound (i.e., sold on the open market) as rapidly as possible, and that the ultimate resolution require management and investors in these institutions to bear very large financial penalties. Irresponsible homeowners should be made to pay as well. (Expect big political battles over the definition of “irresponsible.”)

TWO PRINCIPLES

In the long run, we must have a market-oriented economy in order to grow and remain globally competitive. Markets, by theory and empirical observation, have a tendency to boom and bust. In the real world, a completely unfettered boom-and-bust cycle would lead to so much instability that the political process must either moderate it to some degree or face the possibility of near-socialist restrictions after some especially spectacular bust. There is no perfect, or even very good, regulatory solution to this dilemma, but there are two general principles that should provide reasonable guidance.

Do no harm.The closest thing to original sin in this crisis was the pseudo-privatization of Fannie Mae in the 1960s. Fannie Mae began as a New Deal program to facilitate mortgages to people (i.e., voters) with marginal credit. It was a bad idea, but it was contained in scope. Lyndon Johnson, faced with budget problems during the Vietnam War, spun it out of the government in 1968. This was an accounting gimmick that made its costs disappear from the federal budget, though it still operated with the “implicit” backing of the government, because (wink, wink) we all know that when push comes to shove, as it recently did, the taxpayers are on the hook. The expansion of Fannie Mae and the creation of Fannie’s sibling, Freddie Mac, led to the development of a market for mortgage-backed securities. This went on for many years without creating a national crisis, so it was probably not, by itself, a sufficient cause of the subprime meltdown, but it surely contributed, and was an easily avoidable error. We should get something positive out of this crisis by fully privatizing Fannie Mae and Freddie Mac. Without the government’s implicit guarantee, their securities would sell at lower prices, which would reduce their incentive and their ability to purchase questionable mortgages.

Asset bubbles are almost always followed by stricter regulation of markets. These regulations are often excessively focused on winning the last war by preventing whatever particular flavors of malfeasance were most recently prevalent. Targeting wrongdoing like this is easy to understand, plays to our need to believe that somebody must be to blame, and allows politicians to be seen doing something. Such regulations are usually produced very quickly, and they often have impacts that the authors never anticipated. The drafting and implementation of the Sarbanes-Oxley laws after the Enron scandals a few years ago, and the punitive prosecutions after the 1929 stock-market crash, are excellent examples of what should be avoided. Probably the last thing that will be needed for at least a generation will be regulations preventing banks from taking on risky mortgage debt.

Walls, not brakes. Financial regulations designed to moderate the business cycle all pretty much boil down to either brakes (regulations that make certain kinds of transactions illegal in the hope of reducing the amplitude of booms and busts) or walls (regulations that restrict certain kinds of transactions to certain kinds of financial entities in the hope of compartmentalizing the effects of booms and busts). In general, we should emphasize walls.

The crash of 1987 was, in the end, healthy. Its immediate effects were contained, and it produced knowledge that was put to good use to deploy new technology that has created enormous wealth. Real markets will always have busts because they are making bets about the future, and can’t always be right. What’s dangerous about the current credit crisis isn’t that some executives at Lehman Brothers will lose their jobs or that Wachovia stockholders will lose their investments, but that it threatens to bring down the whole economy.

As a practical matter, many people lack the time, inclination, or mental acuity to evaluate complex potential sources of risk versus profit, and just want a safe place to put their money. Federally insured deposits at plain-vanilla banks that accept risk-reducing regulations and pay depositors lower interest rates than uninsured investment alternatives are a great example of this. They are a New Deal–era innovation that has proven remarkably robust in the stress test of the past few months.

Our vision should be one of, roughly speaking, tiers of financial alternatives of increasing risk, volatility, and complexity that are open to any appropriate investor. Almost any non-coercive transaction should be legally permitted in some context. The tiers should be compartmentalized so that a bust in a higher-risk tier doesn’t propagate to lower-risk tiers, and the government should unsparingly permit failure in the higher-risk tiers. Something like this should provide the benefits of better capital allocation, continued market innovation, and stability. Of course, such a vision will never be fully realized. Markets constantly undermine such regulatory schemes. There is no substitute for ongoing, democratic evolution of regulations; unfortunately, this usually occurs only in response to failure.