Steven Pearlstein has some thoughts on the economic mess in the Washington Post:

The top priority ought to be on setting up a new clearinghouse for those credit-default swaps that everyone’s heard about but few understand. The swaps are essentially insurance policies — in this case, insuring against the possibility that a particular loan or bond or tranche of an asset-backed security will default. But unlike real insurance companies, the hedge funds and investment banks that wrote these policies were largely unregulated and were not required to set aside any reserves in case they were required to pay up. The big fear now is that when those defaults start to roll in, as they almost surely will, the “insurer” will be broke.

The Federal Reserve is already working on launching a clearinghouse. It would offer the advantage of finally bringing credit-default swaps out from the shadows and into a regulated marketplace where they can be standardized, traded and priced in a way that everyone can see. More important, to gain access to this marketplace, buyers and sellers could be required to pay into a reinsurance fund that could be tapped in the event that one of the “insurers” can’t make good on its policies. And until the market has been around long enough for that re-insurance fund to build up a sufficient reserve, the Fed might have to finance it with a sizable loan.

The logic is simple: better to have the government bail out the CDS market, and finally bring it under government regulation, than be put in the position of having to bail out a dozen more AIGs out of a fear that their failure would also take down the CDS market.

It was a little disappointing yesterday that the major industrial countries stopped short of doing the one thing that is desperately needed, which is to free up interbank lending by guaranteeing the short-term loans made between the biggest money-center banks and bank-like institutions. Because these banks operate globally, some sort of collaborative action is necessary. The International Monetary Fund, which has been looking for something useful to do, could be authorized to finance and administer the guarantee program, using the IMF’s existing funding formula, with countries recouping their contributions through a fee imposed on participating institutions.

More encouraging is that the Treasury is moving quickly to tap the new $700 billion rescue fund to provide additional risk-capital to banks that want and need it, in exchange for preferred stock that will give taxpayers an ownership interest and a handsome quarterly dividend whenever there are profits to distribute. Britain has already announced such a program. That is also the policy preferred by most economists, who believe it’s just the thing to get banks lending again, to each other and to customers.

What to say? We agree.

UPDATE — Contemplate the reckless audacity involved in hedge funds and others playing at being insurance companies on such a grand scale: “The swaps are essentially insurance policies — in this case, insuring against the possibility that a particular loan or bond or tranche of an asset-backed security will default. But unlike real insurance companies, the hedge funds and investment banks that wrote these policies were largely unregulated and were not required to set aside any reserves in case they were required to pay up.”

This entry was posted on Saturday, October 11th, 2008 at 9:59 pm and is filed under Democrats, General, Republicans, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.