Uncle Sam's Big Gamble on Derivatives

Back in May, as Rep. Barney Frank (D-Massachusetts) and municipal bond dealers were considering a federal insurance policy against muni bond defaults, I marveled at Frank's courageous, damn-the-tape desire to plunge taxpayers into the murky pond of complicated debt derivatives. I even suggested they might want to take the deal to the next level of post-modernity:

Maybe if Treasury goes along with this plan, we could get some Department with a lot of free time (Homeland Security maybe?) to start writing insurance policies against the risk of default by muni bond insurers. What could possibly go wrong?

From my mouth to God's ear. At the Federal Reserve's symposium in Jackson Hole, Wyoming, following a rewarding day spent putting on coconut-bra drag performances and hunting human prey on a walled-in game preserve, attendees got to hear a presentation by M.I.T. economists Ricardo Caballero and Pablo Kurlat. The subject? Getting the government permanently into the credit-default swap business:

The two professors say the underlying idea - selling insurance against extreme financial risk - should be in the Fed's arsenal to manage financial crises.

"Insurance is an effective and cheap tool during a panic," they say in their Jackson Hole paper. The Fed did provide an ad-hoc form of insurance during the crisis -- guarantees to Citigroup Inc. and Bank of America Corp. on the value of more than $400 billion in assets they held. More broadly, the Fed provided insurance to the whole financial system when officials there vowed to do "whatever it takes" to stabilize markets last fall and extended their safety net beyond banks to AIG. The professors say the bank guarantee program should be formalized in instruments called tradable insurance credits which could be triggered by banks and even hedge funds if another crisis erupts.

Apparently, the schedule also included a rebuttal of this presentation, which I hope included the question: "What planet do you live on?" In any case it's exciting to see my ideas in action, even though the Fed isn't really the government, just an old-fashioned bank run by simple folks.