If public must buy bad debt, it should get justice, too

Welcome back to the New Deal.

The greatest federal overhaul of the U.S. financial system since the 1930s is now in progress, sparked by one of the scariest weeks Wall Street has ever seen.

After Treasury Secretary Henry Paulson and the country’s leading bankers let Lehman Brothers fail last weekend, investors – long nervous over the mounting credit crisis – broke into full stampede from a host of other companies being sucked toward the widening subprime mortgage vortex.

Two stunning one-day plunges in the stock market were reversed – with equally stunning rallies – when investors got wind of a massive federal bailout in the works.

The bailout is an open acknowledgement – from a conservative Republican administration – that markets aren’t automatically self-correcting and that some market failures can threaten global disaster.

The fundamental insight of free market theory is that government can’t successfully stage-manage the economy; individual enterprise, choices and investments yield far more success.

But “don’t just do something, stand there” doesn’t work as a universal principle. Markets need firm ground rules, including safeguards against fraud, folly and reckless endangerment of other people’s money. The failure to enact or enforce such rules was a big reason lenders were able to bundle billions of dollars worth of high-risk mortgage loans, sell them and spread vast risks throughout the financial system.

Hard-core free marketeers are grumping, but federal officials have little choice but to pay the price for past failures to regulate. What may emerge is a federal agency empowered to buy up the bad paper at the heart of the crisis and sell it for whatever it can get.

Paulson and other financial leaders have been doing this – on an ad hoc basis – by bailing out Bear Stearns, Fannie Mae and Freddie Mac, and most recently AIG. The proposed agency or its equivalent would do it more systematically, offering more reassurance to the world’s spooked markets.

Only one problem: The bill will be sent to American taxpayers, who – aside from foolish homebuyers – have been innocent bystanders in all this. A wholesale bailout of the entire market will run hundreds of billions of dollars – a New Deal-magnitude intervention in the private sector.

Taxpayers won’t see many dividends from their “investments” in bad debt, but they do deserve to see some justice. For starters, the Justice Department can bring criminal charges or civil action against corporate officers who knowingly traded in bad debt.

Watching CEOs walk away from failed companies with millions of dollars in their pockets has been the single most grating thing about this debacle. Others may be guilty of outright thievery. The safer banks are probably rife with personal accounts filled with ill-gotten gains. That money belongs in the U.S. Treasury.