While the bailout is necessary, and what to do next

There is a fundamental problem with the whole "let Wall Street fail" meme. Here's why a bailout of some sort is unfortunately necessary - the fundamental issue is that it isn't Wall Street's money that's at risk; it's yours - and what should be done in the future.

The whole finance industry--from banks to hedge funds--is based on a simple principle: connecting folks with money to folks who need money, and taking a cut.

Banks permit individuals to open accounts, for the privilege of a little interest (and physical protection, more or less, of the assets--cash under the mattress is not safe, no matter what the outliers say). They turn around and lend that money to others--small businesses, homebuyers, auto buyers.

The bank, of course, takes a cut--the interest they charge borrowers is higher than the interest they pay depositors.

Likewise for investment banks. The investment banks issue bonds and other financial instruments which people (or other institutions--including other banks) buy, expecting a return.

The proceeds from this are then loaned out to finance all sorts of project (many of them, of course, have been prejudicial to US interests; such as construction of overseas factories).

Again, investment banks take a cut.

So what's the problem? The fundamental problem is that when financial institutions make bad loans--it's ultimately with your money.

In a normal economy, of course, it's with their money. The fact that a mortgagee defaults on his loan, or that a business goes bellyup, is normally the bank's problem--it doesn't excuse them from their obligations to their depositors or bondholders. In a normal economy, bad loans are eaten by the bank, and come out of the bank's profits.

But when a whole pile of bad debt piles up, then it's your money that is lost.

And unfortunately, the fact remains that banks make money by issuing loans. It's their primary source of revenue--giving someone money today in the hopes of getting more back tomorrow.

But when banks are publicly traded entities under market pressure to improve financial performance--what happens? They seek to increase revenue--by making more loans. What happens if there is a shortage of quality borrowers? They start making bad loans, and hoping they get paid back.

And in some cases, such as Charles Keating, it goes beyond unwise business decisions to outright fraud--loaning other people's money to croneys with little expection of being repaid.

The current mortgage crisis is, of course, excacerbated by the many interlinks between players, wherein the failure of one has a tremendous ripple effect. But the fundamental problem is that it's not Wall Street's money that's been lost; it's your money. (And China's money--it just isn't US investors and the public getting screwed here).

So a bailout does make sense--to prevent worse harm.

So--what to do? Obviously, re-regulation of the financial industry is important. Many specific proposals have been advanced. A couple of things I would like to see, both in the financial services market and in the broader stock market.

Restrictions on highly speculative investments. Tax the hell out of capital gains derived from short sales; and prohibit deductions of capital losses based on short positions.

Make it clear that corporate executives do not have a fiduciary duty to maintain stock price. Their duties to shareholders should be limited to maintaining the financial well-being of the company, and/or production of dividends.

A maximum wage, and limitations on severance packages. A big part of the problem is the immense amount of money diverted by executives--who have done little to earn it.

Restrictions on pooling of debt, coupled with tighter disclosure of exposure. One level of debt pooling (issuing bonds which aggregate a whole bunch of smaller loans) is a good risk management tool. But any more than that is unnecessary entanglement.

Capital requirements imposed on anybody who lends money that comes from someone else, whether a bank, a brokerage, or whatever else.

Increased personal liability for executives or officers who knowingly make bad loans. Sarbanes-Oxley made CEOs of corporations liable for financial chicanery affecting the stock market; likewise, there's a whole bunch of folks involved in the mortgage crisis that should be in jail--but won't be, because their avarice probably doesn't meet the threshold of "fraud".

* Disentangle the financial services market from the stock market. Prohibit financial service firms from taking both a debt and equity position in anything.

* Pay for regulation of the financial services industry by taxes/fees on that industry. Just like banks have to pay for FDIC insurance; require other financial services companies to pay for catastrophic failure insurance--both to repay the government for the current bailout, and to keep a rainy day fund around for future bailouts.

Other ideas?

Reported by Daily Kos.

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