Persaud offers some intriguing suggestions. Still, any conversation about his or anyone else’s proposals will be more productive if language is used in a meaningful instead of nonsensical fashion.

Contrary to his description, banks were not ‘lending’ during the heyday of the securitization and ‘innovation’ scam. Banks were ‘handing out money to all comers’.

Any regulatory scheme will fail if it permits banks to ‘hand out’ money instead of ‘lending’ money.

That’s pretty basic. But, then, the three card monte wizards of ‘innovation’ prefer banks that hand out money over banks that lend money.

Current Fed actions are not resolving the crisis, they are postponing it. Keep injecting reserves, keep swapping Treasuries for toxic waste, and eventually all that happens is the I-banks swap their MBS to the Fed for Treasuries and with them safely locked away, they channel their newfound liquidity into large cap equities and commodities. That is EXACTLY what is happening. Now that the Fed is willing to take the garbage off their hands (effectively for as long as they are willing to rollover the TSLF positions) Wall Street can go about blowing new bubbles in equities and commodities. None of that changes the fact that the toxic assets still exist. What happens when the Fed decides to stop rolling over the TSLF loans? What happens when (due to inflationary pressures) the Fed has to raise the Fed Funds rate? I still only see a few options – Great Depression style crash, decade long (or longer) zombie economy ala Japan, or hyperinflation to ameliorate the debts. There is no soft landing option, near as I can see.

Loan retailers, including mortgage brokers, set aside very little for losses because they weren’t going to hold the debt; instead, they pushed it up the chain, typically for securitization. Banks skirted their reserve requirements by opening conduits with pitiful liquid reserves to park debt of various kinds while shopping it or bundling it to be shopped. Similarly, banks underwrote huge volumes of inherently risky and unstable LBO debt against which they compiled no adequate reserves because, again, they expected to sell the debt at a profit not retain it.

CDOs are the freak show exhibit for tortured ill-thinking about how to reserve against losses. The principle benefit, initially, from securitization was overcollateralization against losses. Yes, really. This had at least three legs, of unequal size. In many cases, default swaps were bundled into the CDO as a shock absorber to take first losses. The CDO was sold at a discount to the face of the underlying debt, so that a further cushion against loss was bundled in. Both of these provisions were unequally distributed to tranche buyers, but in principle offered significant reserves against loss risk. Finally, some CDOs had limited recourse provisions against the originators of the original debt in case of fraud, high failure rate or the like. These mitigation options were small and hardly universal, but again they in principal reserved against risk.

All of these ‘reserves’ have failed massively in the present circumstance, and for much the same reason: they weren’t real reserves—cash or near equivalents tied to the debt—but promises of payment. Issuers of default swaps as we see never expected to pay off more than a tiny fraction of their swaps, and to the extent that they themselves had any ‘reserves’ these proved to be not cash but debt which in a pinch they have been unable to sell to raise money. The swaps on any one CDO may pay out, but on the instruments as a whole _cannot_ pay out. Then the underlying debt bundled in CDOs has tended to be overconcentrated in single asset classes, and thus totally, even ridiculously, exposed to price declines in the same asset class. The ‘excess collateral’ has been wiped out and far more by overall price declines. And many loan originators have simply gone out of business, or are accidents awaiting liquidation, eliminating pittance mitigation from retail underwriters. There were no REAL reserves in these CDOs, only promises to pay. This is the biggest fallacy of passing risk around the financial system, that promises without substance will be honored, or even can be.

Banks lent a great deal of money against which they retained no reserves. This in fact was a principle accelerator of the bubble in asset prices, because these hot, fluid, expanding vaporbucks competed for the same assets and so inflated their prices. This had the appearance of inflating asset _values_ but this was not really the case. Hopes that actual gains in asset values would cover any potential (and putatively unlikely) losses proved utterly speculative in all the worst sense of the word. Thus, at the same time that banks contributed to a balloon of asset prices they underreserved against the risk of trafficking in and owning those same assets, in effect multiplying their exposure to loss.

The public authorities also failed to reserve against risk in this, even leaving aside their regulatory dementia in allowing banks to vastly expand their exposure without increasing their reserves. The authorities did this by their implied, and now explicit, guarantee to let no major institution fail. With that hope and belief, why would big institutions lending money hold _any_ reserves, let alone large ones? And while the Fed had 800 gigabucks to play around with here, and many regulatory fudges, that sum isn’t nearly large enough to backstop the entire financial economy of the US. So the Fed didn’t really have the money to put where their mouth has been, either.

The issue isn’t simply that the financial system, in whole and in part, took excessive risks. Far more, it is that they system and all it’s players convinced themselves they didn’t need to set aside money commensurate to the amounts they were moving around—because the ‘vaporbucks’ would always stay in motion until they ended up somewhere else. We need to return to the concept or requiring solid and sizable reserves against losses for parties that lend large amounts of money.

And those reserves at the Federal ‘Reserve’ System? Well, part of them need to come from increased fees levied on regulated players. However, we also need the option of nationalizing failed or failing institutions, wiping their equity holders and shaving their bondholders to the extent necessary. We need that option in part to keep the public authorities from being greenmailed by financial institutions or cartels of same ‘too large to fail.’ The public needs to be able to give failing marks to those that so merit and run them out of the game. And money set aside for the purpose in the hundred billion dollar range needs to be there so that the threat has substance.

Pillar One: Contra cyclical dynamic provisioning requirements for financial institutions would be most welcome. The index for the ratchet is what counts, though. Economic cycles do vary in length and focus of effect, and more significantly are not easily predictable with regard to their peaks. Where the cycle turning points are designated, and especially by whom, have major cost impacts for financials, and so such decisions and their makers should be well insulated from influence. This suggests that a stiff ratchet should be used, i.e. that the number of years (or better quarters) since the last cycle turn should be a stiff multiplier for driving reserve provisioning levels.

Pillar Two: In principle, it is no bad idea to grant less support and hence increasing speculative latitude to financial players with little leverage and minimal term mismatch exposure—all three of them, as there just won’t be many players of any size that fit that profile. However, the _lack of systemic risk_ carried by such players, i.e. low leverage &etc., needs to be verified by public authorities. Just taking their word that “We’re good for it” doesn’t cut it. And their needs to be clear criminal penalties for lying to public authorities. There also seems to be an underlying assumption here, perhaps more in Persaud’s phrasing than in the concept, that such large, wholly owned speculators shouldn’t be held to short term rules because they are buying into long-term positions. The opposite seems often to be the case in recent times: their positions are often hot and fluid, or meant to be. Hot, fluid money is by no means necessarily or at all a healthy things for smart, safe economic development, often the reverse. This is the real cost of letting big private bucks speculate as they please, they burn other people’s interests in the process. But focusing on outcomes rather than regulating processes here is perhaps a cogent approach.

Pillar Three: Charging financial institutions a Systemic Insurance Fee is a fine idea. Scaling said fee up increasingly relative to their size is even better. However, let’s not leave out the concept of capping financial institution size by assets, by exposure, and likely by both. Currently, we don’t really do this, although there are weak limitations on market concentration. But really, behemoth banks or quasi-banks give few advantages to society. It may be as you say, Yves, that banker-brokers must be of a certain size to capture enough of the market to maintain a viable position. If that leaves the public exposed due to the size of their risks the situation all but cries out for public guarantees and oversight, regardless of how, exactly, such are conceived. The banking industry, like the airlines, has demonstrated that yes, it WILL kill it self if left to its own devices; the principle difference is that banking systems have _repeatedly demonstrated this capacity historically whereas the airline industry has only done so twice.

We needn’t worry about any of these proposals being passed soon, though. It was five years into the Great Depression before serious financial reforms were implemented although public intervention to prop up the markets was pursued from the outset. We can’t even agree at the present that we are in a crisis; “I mean, it’s over already, isn’t it?” The first public policies we see will be either window dressing, blanket protection proposals for existing stakeholders, or dithering. We’ll have time to shape up reasonable proposals before cycle trough political pressures build to the point of pushing through real reforms.