STEVE INSKEEP, host:
One reason the economy seems shaky right now is because of decisions made in the past by big Wall Street firms like Merrill Lynch, which reported its biggest loss in history last week.
To find out why so many smart people made such big mistakes, we turn to David Wessel, economics editor of The Wall Street Journal.
David, good morning.
Mr. DAVID WESSEL (Economics Editor, The Wall Street Journal): Good morning.
INSKEEP: What were they thinking?
(Soundbite of laughter)
Mr. WESSEL: Well, I guess they weren't thinking. It seems that at least two bad calls made by the big banks and investment banks on Wall Street. One, they thought home prices would never go down, except maybe in a few communities. And they thought by slicing and dicing mortgages and turning them into securities that were then turned in to still more securities, somehow they were spreading the risk widely if something went wrong.
INSKEEP: And why weren't they?
Mr. WESSEL: Well, for one thing, housing prices went down.
INSKEEP: Everywhere.
Mr. WESSEL: Almost everywhere. And they didn't count on that. Secondly, the securities were so complicated, structured by these geniuses who they hire on Wall Street that literally - literally - nobody understood them.
So when the market changed, they behaved in ways that were completely unanticipated by the experts and by their computer models. And the third thing is it turns out that some of these securities that the banks thought were spreading risk to somebody else were written in such a way that when things went bad, the risk came back on their books. And that's why we're seeing big write downs by Citigroup, Merrill Lynch, Bear Sterns, JP Morgan and all the others.
INSKEEP: Have banks figured out a way around this now?
Mr. WESSEL: Not yet. Right now, we're in what they call on Wall Street the kitchen sink mode, where you say anything that's bad on our books, let's write it down and take the hit now. It's particularly common when you have new chief executives, as a number of these places have.
But there is some talk about things that might be done differently in the future. One thing is either the government or the banks themselves could decide that when you securitize mortgages, you keep a piece for yourself. That means that you have an interest in making sure that the loan that was made is actually paid back.
One of the problems we have here is people made loans, sold them to someone else, and they didn't care whether they got paid back. Another thing is to change the way the rating agencies work.
Surprisingly, very smart, highly paid people on Wall Street looked at these securities, said we don't understand them. But the folks at Moody's and Standard & Poor's - the rating agencies - do, and they stamped triple A, gilt-edged ratings on these securities. And everybody said that's fine. It turns out they weren't triple A.
INSKEEP: So the ratings agencies - which are the ones that determine if these securities and if companies have the credit ratings or not - are they doing anything differently?
Mr. WESSEL: Well, I'm sure they're being much more careful today than they were a few years ago, both in how they evaluate these securities and how they explain their ratings. But it's very likely that there will be some new rules, perhaps even regulations to set standards for rating agencies in the future.
INSKEEP: Who is really harmed if a bunch of relatively wealthy investors on Wall Street get into a bunch of creative financial schemes that they can't control and end up losing a bunch of money that was all on paper to begin with?
Mr. WESSEL: That's a great question. And the problem is all of us.
If the financial system - banks and investments banks - are so concerned about their capital and about the losses they're taking that they all at the same time decide we ought to be a little less ready to lend money to people, the economy will contract. The reason the Federal Reserve and the president and the treasury secretary are so worried about this crisis is that it could spread to the whole economy, because the economy lives on credit. And if the people who give credit pull back, we'll have recession.
INSKEEP: David Wessel of Wall Street Journal, good talking with you again.
Mr. WESSEL: A pleasure.