Why This Fire Must Be Put Out

We've got a fire going on Wall Street and we have to keep it from spreading to Main Street with whatever the government can throw at it. While we are waiting for something to happen we have to slow down the selling, even if that requires using methods we don't like, like a short-selling ban. It was inelegant, poorly executed and no one, long or short, agreed with it.

We had to slow down the selling because otherwise we would have had something occur that makes me shake to this moment: the possible collapse of both Morgan Stanley (MS) and Goldman Sachs (GS) in a 24-hour period.

I want to put these two in perspective, because when you think about what happened you will have to admit that the market had become totally dysfunctional. Neither of these companies has big mortgage exposure. The only thing they do have in common with companies that failed like Bear Stearns is they have prime brokerages that can take money in and out. That's it. Of course, Goldman has a big balance sheet, but it has nowhere near the kind of nonsense that Lehman Brothers or Bear had. And unlike Morgan Stanley, Goldman has not had losses. But, again, if there were simply no hedge fund clients to pull out, it is hard to see what they did wrong other than have leverage, but you can't run a brokerage house without leverage.

I know there are a lot of people who feel that the government didn't swing into action with a big plan until Goldman Sachs and Morgan Stanley got in trouble, as if, somehow, the old boy network worked its magic.

That's nonsense. The fact is that the fire of house price depreciation has spread from the reckless abettors like Lehman and Bear, to the firm that tried to address it with big capital raises and sales of bad mortgages, Merrill Lynch (MER) , to a company that had eliminated its mortgage exposure a while ago with losses, Morgan Stanley, to the firm that never had a mortgage problem at all, Goldman Sachs.

It's now spread from the extremely guilty to the innocent. There's plenty else that was wrong last week. For example, the breaking of the buck, courtesy of Lehman debt (How could so many accounts own so much of that junk?) scared Main Street. The incredible decision by the government to let Lehman go but not AIG (AIG) when Lehman customers couldn't get their money has me still scratching my head. That's right, the customers' money from the offshore entity is stuck in the bankruptcy queue. Plus, the $700 billion in Lehman debt is owned by a lot of players and is so big it makes you think many firms went bust last week but we just don't know about it yet.

The AIG guarantees are actually hugely positive for the market because all of the nonsense they insured is actually triple-A. This was totally lost in the tsunami of Lehman. Think of that: AIG insured about $500 billion in awful bonds, which are now money good, and nobody cared.

No, it was when the good and the great were about to go under -- and still could -- that made me feel that things are totally out of control. And, again, I think you need to sell into whatever coordinated intervention we will most likely see tomorrow because tomorrow the shorts will be back through derivatives and the Lehman problems are still very much with us.

How will the shorts operate? Quite simply, what they will do is buy puts from brokers at the same time that they buy common stock. Once they have the puts on they will blast out the common stock ferociously and get the job done. There's only one reason why the brokers might not do this trade and that's if they can't locate stock to borrow to hedge themselves when they sell the puts to the shorts. But these stocks are easily borrowed, so I think they can go to work.

Remember, if the shorts can send credit default swap prices skyrocketing on Goldman (which is easy to do because it doesn't take much money to move them up) and put downward pressure on Goldman's stock, that will cause a ratings downgrade and force Goldman to sell what it can to raise capital (something it's possible Goldman might not even need, but nobody even cares anymore).

I say if Morgan Stanley's John Mack is complaining about shorts -- and he is no cry baby -- and Goldman's swaps are bulging, there's a real fire going on, and until it is put out and we find where all the Lehman bodies are buried, don't expect me to run into the building.