THE BLOG
04/15/2010 05:12 am ET Updated May 25, 2011

Too Big To Lose

A lot has been written on the "too big to fail" problem: the perception that some firms are so large that their failures would lead to systemic failure for the entire economy and the related conclusion that companies in that category should be bailed out to prevent a massive breakdown of the financial system. The resulting moral hazard problem; these big firms then can take all the risks in the world knowing there is no downside to them. A direct result of this problem has been that many Wall Street insiders profited at the expense of American taxpayers when they were bailed out by the US government.

But a no less serious problem is that some of these firms are "too big to lose." They wield so much influence over the economy that they can manipulate the outcome of their trades. It's as if the President of the United States could short a particular market and then use his bully pulpit to scare the market to move in his direction.

A case in point is what Goldman did with mortgage securities. Gretchen Morgenson of the New York Times wrote an incisive article about the Goldman conflict with AIG. In it, she details how Goldman bet against the mortgage market by buying insurance from AIG on certain products that would pay if the underlying mortgage securities went south. There is nothing wrong with that, so far. For years, many (including me) also feared that a bubble had formed in real estate. Goldman's Jonathan Egol and Ram Sundaram were smart and arguably even visionary to anticipate it and bet against mortgage securities. But the problem is what they did next. They proceeded to bully A.I.G., other business partners, and even the Federal Government, to pay them at valuations they arbitrarily set. The perception that Goldman bankers are the smartest bankers in the room helped them create the momentum that led to the devaluation from which they benefited.

Wall Street sharks will go where they smell the blood, and you cannot change that. It is a necessary feature of a market economy -- which is the worst of all economic models, except for all other options, to paraphrase Winston Churchill.

But Paul Volcker's call to structurally protect against these financial behemoths must be heeded. In this opinion piece he walks through some of the prescriptions that are necessary, including regulating which risks the different financial institutions can take, separating commercial banks from investment banks by reversing the recent decision to allow them to perform the same function and gamble with their account-holders' savings, and limiting the leverage these firms can have.