Yesterday Brought to You By the Irrational Herd

It's a lovely theory, but it doesn't square very well with recent history -- the junk bond craze of the late '80s, the commercial real estate bubble of the early '90s, the Asian financial boom and the tech and telecom bubbles of the late '90s. For it is at times like these, when markets are at their most frothy and in need of discipline, that lenders and investors and the highflying fund managers tend to get the sloppiest.

This is when mortgage bankers, having already refinanced every house in America at least twice, start making home loans to people with poor credit histories requiring little or no money down and an option to skip monthly payments whenever they are short on cash, as they did in 2005 and 2006.

It is at these times that banks, eager to continue delivering double-digit earnings growth, compete furiously to finance mergers and acquisitions, allowing borrowers to put less of their own money into deals and forgoing the usual conditions that would allow the loan to be called if business begins to sour. In many cases, they are even putting their own equity into the deal.

And now is when pension funds and college endowments that have held back from investing in hedge or private-equity funds finally decide to jump on the bandwagon -- hardly the time to expect them to make demands about greater transparency or internal controls.

In other words, this is precisely when markets need good regulators, and good regulations, to make these financial intermediaries behave in the "rational" way that the Bush administration says they are supposed to. To leave it to "voluntary" codes of conduct and "market discipline" is both naive and dangerous.

To be fair, the Bush administration is moving belatedly to significantly step up surveillance of bank lending. The comptroller of the currency has issued tougher guidelines on mortgage and commercial real estate lending, and now has in his sights the loosey-goosey "leveraged loans" that have been used to finance corporate buyouts.

And under the aggressive leadership of Tim Geithner, the president of the Federal Reserve Bank of New York, the Fed is requiring the big money-center banks to upgrade their risk-management systems and subject their portfolios to "stress tests" to see if they would withstand a financial crisis in which credit dries up and everyone tries to unwind their positions at the same time.

Unregulated and highly competitive financial markets are wonderful at lots of things -- allocating capital efficiently, coming up with innovative products, pricing and spreading risk. But, as we were reminded yesterday, one thing they are not good at is controlling their own excesses.

Steven Pearlstein can be reached atpearlsteins@washpost.com.