The public came to think of these firms and markets as the brains of
our economy. There's some truth in that. Wall Street allocated both
cash and credit more productively than any central planner ever could,
and the credit enabled people to invest in the future, to run
businesses, and to buy homes. The prestige—and rewards—of finance
attracted elites from our best universities and, indeed, the rest of
the world.

But the financiers were too clever by half. The "masters of the
universe" created not one bubble but two—a housing bubble and then a
credit bubble. Now that both have burst, we face a growing danger of a
global financial panic. Every day that passes without a remedy
multiplies the risk that we might see a complete freeze-up of the
financial and credit markets. This would cause a flight from the
system that finances all our activities into safe but less productive
havens like U.S. Treasury securities. Such a move could cause an
economic crash of horrible consequences.

That's why the administration and Congress have no choice but to try
to fix things. Unfortunately, they fumbled the first time round. The
idea that greed and carelessness might be condoned, much less
rewarded, rightly brought an explosion of public anger. Now they're
trying again. But the insistent question in the public mind, one to
answer before looking for an exit strategy, is how we got into this
potentially lethal maze in the first place.

First, housing. People with no credit history and insufficient income
were enabled to buy homes with no money down—often at ridiculously
high prices. How come? The immediate cause was as much political as
financial. In the early days of the housing boom, members of Congress
won votes by pressing for "affordable housing" for everyone. Community
organizers were eager to get on the bandwagon and round up likely
buyers. The money often came from Fannie Mae and Freddie Mac, which
both parties protected by allowing them to run with artificially loose
rules. Of course, everyone assumed houses would go on appreciating way
beyond the value of any collateral, so that somehow it would all work
out. These mortgages, and others like them, became the straw out of
which the Wall Street money wizards could spin gold by bundling them
into bonds and securities to be sold to institutions like banks around
the world. The banks bought them because they were highly rated by
credit agencies that didn't actually know what they were rating.

Money everywhere. The result was the greatest housing boom in the
country's history. Home values appreciated from 2002 to 2006 at the
extraordinary rate of 16 percent a year, compared with 3 percent
annually in the prior 55 years. But at a point, it became impossible
for the typical American family to buy an average-price house using a
conventional 30-year mortgage. Those who used so-called teaser
mortgages found their payments ballooning. People defaulted, lenders
foreclosed, and house prices started falling. Prices are still 60
percent above their value in the year 2000, when they began to go
crazy. If they continue to fall, there will be more defaults on
mortgages and mortgage securities—and increased personal bankruptcies
and credit card defaults.

No one knows what the mortgage securities and the fancy derivatives
that emerged out of them are worth, and which firms might fail, since
so much was based on the assumption that housing prices would not go
down. Nobody knows who owes what to whom and whether borrowers at any
level have the ability to pay. Investors have lost the confidence to
trade with one another. And confidence is the essential ingredient in
the world of finance. Without confidence, the markets stop
functioning. We saw that when stock prices of financial firms,
especially those that were massively leveraged with excessive debt,
plummeted.

Even worse was the run on money market funds after one announced it
would give investors less than 100 cents on each dollar invested. By
"breaking the buck," this provoked a stampede out of these funds.
That, in turn, shrank the commercial paper market, which corporations
use to fund their operations, and provoked a sharp rise in the London
Interbank Offered Rate, or Libor, the benchmark rate that banks charge
to lend to each other.

So there's been a rush to liquidity and a freeze of the various
sources of credit that threatens the continuation of the economic life
we know and the specter of a crisis even greater than the 1930s. The
double bubbles bursting simultaneously in both housing and in the
financial world is what broke more than 300 mortgage lenders,
bankrupted Lehman Brothers, forced other banks into marriages, and
compelled the government to take over Fannie Mae and Freddie Mac. And
we are not through yet.

The Treasury Department's solution to this crisis had many, many
problems. The idea was to buy depressed mortgage securities and other
illiquid, even toxic assets. But how to figure out what to pay for
assets that are so complex and so uncertain in value, particularly
when many of them remain overvalued on the books of financial
institutions? The likelihood is that the government will buy them at a
price above market and thus provide a huge, unjustified bailout of
Wall Street. On the other hand, if the government buys them at market
prices, financial firms might have to take enormous write-offs that
would damage their balance sheets and force them to seek billions more
in private equity capital, which might not be available. Then they'd
have to freeze their lending—the exact opposite of what the program
was intended to induce. The above-market price would rescue the
financial industry from the consequences of its own misjudgments,
profligacy, and greed. Meanwhile, the average American who is forced
to sell his home must do so at market prices, not above them.

Public outrage. The reaction in the public was overwhelmingly hostile
to this possibility. The average American saw the government as
purchasing the bad loans taken on by a reckless and greedy financial
sector, transferring billions of taxpayer dollars to these very
shareholders and management whose excesses created the crisis and
potentially creating a great windfall for these companies and
inflicting huge losses on the taxpayers. The same executives who
created the problem would gain through the increased value of their
stockholdings. This was seen as being contrary to the American
economic premise that whoever reaps the gains also bears the losses.

The political antagonism to this perceived undeserved windfall
collapsed the bipartisanl support for the plan, and it was rejected by
the House of Representatives (with more Republicans voting against it
than for it). Abraham Lincoln had it right when he said, "With public
sentiment, nothing can fail; without it, nothing can succeed."

But stabilizing the financial markets is an imperative. A major
breakdown in the financial world and the credit system would make it
impossible to transfer money from those people who have it to those
people who can put it to productive use. The real issue is who should
bear the cost. It should not be the taxpayer. Why, then, shell out
$700 billion to the foolish financiers and deal makers who led their
companies into this swamp? Would this not be welfare to the financial
elites at taxpayer expense and undermine the moral credibility of
future government action?

There's an alternative to buying the bad loans. This would be to
invest public funds in these financial institutions through the
purchase of prior preferred stock by the government, which would put
the government senior to other shareholders. Preferred
shareholders—the taxpayers, through the government— would be the last
to realize losses and the first to receive gains. This would
recapitalize the banking system and give it time to dispose of bad
assets in an orderly fashion.

It's the same approach that Warren Buffett adopted when he invested $5
billion in Goldman Sachs. Buffett received dividend-paying preferred
stock that ultimately could be convertible into equity in one of the
best-managed investment banks in the country. This is similar to the
government takeover of Fannie Mae and Freddie Mac.

Why should the public get a worse deal when asked to use its dollars
to help lesser-quality financial institutions that have a higher risk?
The existing shareholders should be at risk, with their value
extinguished or diminished, before the taxpayers are asked to bear the
burden of the likelihood that the securities the financial companies
hold will further decline. Otherwise, the executives who did so well
on the way up will not be responsible for their losses incurred when
their business decisions turned out to be flawed. The first
description of the plan as a bailout was right: It would bail them out
of their mistakes and pay a reward for failure. If there were profits
to be made from spending money to shore up the banking system, it
should be made by the taxpayers and not just by the political and
financial elites who created this mess.

That is why Americans have been furious at these proposals, as they
had every right to be. Congress needs to modify the way any rescue
effort is executed. The outline of the new effort looks too much like
the failed one, but Congress maintains oversight and the ability to
influence the execution. Wall Street must be seen to bear
responsibility for flawed business decisions. The role of markets to
reward success and punish failure should not be undercut.

Congress should get it right the second time around—and quickly.