Let's stipulate that speculation and manipulation is part of the problem here. Let's stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.
To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan's falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.
In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn't help either. Media reports suggesting that a particular "expected" default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.
What could be done? The first step would be to move CDS trading to an exchange. This would allow for more disclosure and less mystery. It would also reduce all the country-party confusion that has surrounded AIG and Lehman and eliminate the need for novation.
Second, make the CDS contracts more standardized. Currently many CDS players don't actually close out their contracts, but rather buy off setting contracts. As a result, any given contract becomes less liquid than it really should be, which makes price discovery all the more difficult.
Another step would be for market makers in CDS to increase the margin requirements on CDS trades. Margin requirements on CDS are set by individual investment banks, but there is no reason why there couldn't be a coordinated effort on this. Increasing collateral requirements would force protection buyers to be more judicious about which names they short. By the way, having an exchange would make monitoring collateral requirements much easier.
There may be other solutions to the CDS problem, some of which will take time. But the steps I've outlined could get done quickly. And they need to be.