08/13/2009 05:12 am ET Updated May 25, 2011

Returning to the Scene of the Crime

Investment bankers and career criminals have something in common: When they get caught, they spend their time figuring out what they did wrong, so they can do it better next time.

Harsh words, you say; if nothing else, high finance is legal, so by definition, its practitioners can't be criminals.

True, but that doesn't mean they've committed no crimes. Just have a gander at the business headlines. CDOs, CDSs, SIVs, and a cluster of other acronyms for what turned out to be imaginary investments triggered a sickening plunge in stock market values. That freefall cost the afflicted trillions of dollars in retirement funds--and many jobs--while most of the afflicters sit in their corner offices, investing their bonuses. If that's not a crime, what is?

In this pass, regulators might have been expected to at least afflict the comfortable, even if comforting the afflicted is beyond their writ. But the damage wrought by the comfortable has been so profound that regulators have been forced to turn to them for help returning the economy to productive channels.

And the consequences have been predictable; sacrifice of a few egregious offenders, followed by a defense of the status quo ante bellum, and, finally, a selective return to the old ways. A thorough housecleaning and restructuring was apparently never on the table.

So it came as little surprise last week to read that Morgan Stanley plans to repackage a downgraded CDO into new securities with a AAA rating, or that Morgan is only joining a recent, fast-growing trend.

The story, running on Bloomberg, quoted a June 12 report by Bank of America Merrill Lynch that said about $27 billion of these bonds have been issued since January, up from $17 billion for all of last year.

To make the trend even less appealing, the story reported that commercial banks are packaging commercial mortgage debt into bonds as fast as they can push the product out the door. They've issued about $2 billion of such investments in the last three weeks, compared with $5.8 billion of similar offerings in all of 2008.

This last detail is the more pernicious because a glance at the financial news will tell you that commercial mortgage defaults are expected to spike, as the economy forces more companies to jettison some of the office and retail space they rent. Just a few weeks ago, Standard & Poor's warned it's considering dropping the rankings of $235.2 billion in bonds backed by commercial properties.

In other words, we can expect a new wave of mortgage-backed bond defaults to hit the headlines any day now. And considering the size of your typical commercial mortgage, that wave should be pretty impressive; S&P isn't the only one that rated this sort of paper. It doesn't take much to imagine what news like that will do to the stock markets.

Yet Wall Street's factories--sorry, investment banks--continue grinding out what amounts to re-named, iffy bonds like sausage, and even worse, institutions continue to buy the sausage, and rating agencies are apparently continuing to rate them AAA.

Just to aggravate matters, regulators aren't stopping it, since said regulators are on record as wanting to re-start the securitization markets. As though the securitization market wasn't the scene of the crime.

But it was. It was various sorts of securitized debt that tipped us into what's still being called a global recession; securitized debt that was salted with garbage, structured with the help of esoteric math, rated AAA by the rating agencies, and sold around the world like gilt-edged cluster bombs.

And now, Messers Summers, Bernanke, and Geither want to try it all over again.

Have they gone mad? Well, it's probably just the triumph of hope over experience. Probably, they're telling themselves that it wasn't the idea of securitization that went wrong--just the execution. And since the world operates on credit, and the securitization markets are part of how modern credit is created, they want said securitization markets to revive and prosper, so the world can do the same.

They don't want to lay the foundation for another crash; they're just out of ideas, like the rest of us. What they've forgotten is how, in August 2007, the CDO market suddenly crashed, and credit froze system-wide, after the math that created sub-prime mortgage bonds stopped working, and began telling traders one thing should be happening, when it was something else.

Since every trading room in the world used a computer program built on some variation of a model called value-at-risk--VaR--all the computers flashed sell signals at the same time; next came a rush for the exits, and a pile of bodies at the doors. That in turn reminded traders that their every investment was measured with VaR; in other words, nobody, anywhere, knew what anything was worth. Acting rationally, they did nothing. We know the rest.

In other words, what sent us over the cliff wasn't the execution of the idea; it was the idea. Doing it better next time won't change that: The securitization markets shouldn't be revived, because they're built on the false premise that risk can be accurately measured and provided for. Experience proves that at the scale they reached, they're much too dangerous.

Messers Summers, Bernanke, and Geithner should instead listen to their wiser elders, in this case, Paul Volker, who testified before Congress last year that banking should go back to being a boring business in which relatively smaller banks lent money to credit-worthy customers, and held the loans to maturity.

Soon enough after he said this, Mr. Volker was banished to the Bank of International Settlements, where he chaired a committee on how to avoid another financial crisis, and issued a very sound report that was promptly ignored.

Said leaders forgot the wisdom of Mickey Rourke in BODY HEAT: "Anytime you try a decent crime, there's a hundred way you can (mess) up. If you think of fifty of 'em, you're a genius--and you're no genius." Not to mention Proverbs 26:11.