Michael Lewis' books include Liar's Poker, The New New Thing, and Moneyball, and he is the editor of a new anthology, Panic: The Story of Modern Financial Insanity. Last week, I had the opportunity to talk to him about the current financial panic. In this first of three installments, Lewis talks about the causes of the crisis and offers up some solutions. For the full audio version of the interview, click here.

Mac Greer: Michael Lewis, it is ugly out there. Where did it all go wrong?

Michael Lewis: There is a short answer and a long answer. I will give you the short answer first. The very short answer was the ability of Wall Street to repackage subprime mortgages as an investment-grade security. That is the heart of the immediate problem.

Then, having done that, [Wall Street] created alongside this market, which grew to a couple of trillion dollars, a casino in side bets where smart people could bet against the subprime mortgages going bad -- which smart people did do -- this market in side bets, with many trillions more than the original market. So you have got -- because the subprime mortgages have all turned out to be, or mostly turned out to be kind of rotten -- you have got many trillions of dollars of supposedly investment-grade securities that are suddenly worthless. That is a traumatizing event for the global economy, but that is the very short answer.

Greer: And Michael, you say that the common thread in all financial panics, or at least recent financial panics, is the underpricing of risk.

Lewis: Yes, I think it is true that the models that have been used on Wall Street since the early 1980s to price financial risk -- to essentially price financial insurance, which takes different forms, but the most common form is an option -- work reasonably well in normal financial environments, when things aren't too volatile. When there are really extreme moves, they fall apart. And over and over in the past 25 years, we have seen really extreme moves in which they fall apart. This is another example of that.

There is a logic to, for example, why subprime mortgages were reclassified as investment-grade securities. It is the diversiphilia that has swept the ratings agencies in the last 20 years, and it grows out of academic research. And if you make assumptions about these different subprime mortgages that are -- and the assumption is that they are not correlated with each other -- well, then when you throw them all together in a single package, well, maybe the people who get the first payments out of that package do have an investment-grade security.

But the fact is, the financial markets have been growing increasingly correlated over the last 20 years, and subprime mortgages in particular are all correlated perfectly with one another. So it is as if Wall Street has been writing catastrophe insurance -- say, insurance against houses on Miami Beach being destroyed by hurricanes -- as if it was auto insurance. They have sort of systematically misclassified the nature of the risk that they are dealing with.

Greer: So along those lines, Michael, how could this crisis have been prevented?

Lewis: Well, that is a really great question, because a lot of things could have happened to prevent it. It took a conspiracy of many forces for it to be as bad as it is, but why don't we start from the top down? If the financial regulatory system had controlled the leverage that investment banks were able to run, that would have dramatically reduced the amount of risk in the system. But they didn't, not properly. If the ratings agencies had done their job properly and not caved to pressure from Wall Street to ... not allow themselves to essentially be gamed by Wall Street into putting investment-grade stickers on things that were essentially crap, then all of it would have been avoided.

Greer: Michael, you are telling me Moody's (NYSE:MCO) was asleep at the switch? I think of Moody's as this like sleepy old company, not taking many risks.

Lewis: Isn't it sleepy old companies that fall asleep at the switch?

Greer: I guess that works both ways.

Lewis: Moody's had an incredible run there, where their profits were incredible. In fact, the whole of the financial system was running on the profits from the American mortgage securitization industry. It was a vast industry, and Moody's was making huge sums of money rubberstamping these CDOs [collateralized debt obligations] -- Moody's that is 20% owned by Warren Buffett. And so if they had done their job, if they had behaved with real total integrity or not been stupid -- who knows exactly what they were thinking? -- then the problem would have been prevented.

However, those are just the top-tier culprits. If the Wall Street firms had been partnerships instead of corporations, if the people in them had had total long-term engagement with the risks they were taking, they never would have done what they did. If American culture had not evolved to inure people to the risks of leverage, then I don't think nearly so many people would have borrowed money they couldn't repay. So this is just the beginning, off the top of my head.

Greer: And along those lines, what is the solution to the current mess?

Lewis: I think you let more institutions fail. I think there is no solution that is not a painful solution. I think that this top-down approach of trying to sort of hand over taxpayer dollars to failed banks, hoping that they will become successful banks, is a mug's game ...  what they should do is target homeowners in their homes, and use that subsidy to subsidize those people so they stay in their homes, and re-jig the mortgages so they lower principal balances, and so and so ... you start with the level of the crisis, which is the level of the individual homeowner. And if, above that, and while you are doing that, some of these institutions fail, then they fail.

Mac Greer: And Michael, what are you going to do about the automakers [General Motors (NYSE:GM), Ford (NYSE:F), Chrysler]?

Michael Lewis: Bankruptcy is the best option, I think. I think if you give them money, you are going to make it harder for them to change what they need to change. They need to be reorganized in bankruptcy. The unintended consequences of handing huge sums of money to failed enterprise are seldom appreciated. I hope that the Treasury and the Congress has already learned something from the money they have handed out to the banks. It wasn't a smart thing to do.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.