THE BLOG
10/22/2008 05:12 am ET Updated May 25, 2011

The Plot Thickens -- Details You Need To Know About The Bailout

The Bailout Plan for our economy must completely and transparently address the ramifications of the overall exposure to credit default swaps in the global marketplace. The global market for credit default swaps is estimated at more than $60 trillion -- twice the size of the U.S. stock market and far in excess of the $7.1 trillion mortgage market. It is estimated that AIG sold over $440 billion in credit default swap protection for fixed income securities. A massive exposure to credit default swap failures could set off a global economic nuclear fusion the likes of which could destroy the entire financial system.

Credit default swaps are essentially insurance policies which guarantee the performance on fixed income securities, like mortgage pools. Because they are private contracts that don't trade on any exchange, the Fed may not have been able to adequately monitor the risk inherent in these complex products. The question is whether sellers of credit default swaps, insurers like AIG, have the financial wherewithal to pay up in the event of mass defaults of the underlying securities. After all, insurance is only as good as your insurance company's ability to pay out on a claim.

Taking distressed mortgage backed securities off the books of banks will not be enough to stabilize the financial system as the total exposure to credit default swaps is still largely unknown. For example, the American people will not see the effect of being stuck with the huge price tag of taking on AIG's exposure to credit default swaps until someone starts marking them to the market, i.e. seeing what they are worth. There is no valid way to immediately quantify the global exposure to credit default swaps as their market value is tied to the performance of the underlying security. Since loans aren't performing so well these days, the answer is still bleeding out in the market.

Our government, which now owns most of AIG stock, may be considered a company "insider" -- technically restricted in how it trades in the stock. That may also mean that since "we" are working on saving all of the other failing banks and the economy, there may be a conflict of interest with regard to how we handle "our" exposure to the credit default swap positions held by AIG.

This feels like the Great Depression all over again. The biggest reason for that is the enactment of the Gramm-Leach-Bliley Act in 1999, which effectively repealed the Glass-Steagall Act of 1933. Glass-Steagall was enacted after the losses suffered in the Great Depression specifically to prevent the exposure of banks to the volatility of the stock market. One of the main reasons we are in this mess is that Graham-Leach-Bliley allowed commercial and investment banks to consolidate, exposing depositor funds once again to the follies of Wall Street.

Congress must implement Glass-Steagall like measures on an emergency basis to protect depositor funds from further exposure. When Gramm-Leach-Bliley was enacted, many predicted economic doom. We now feel the painful reminder that allowing banks to be exposed to the securities market threatens the integrity of depositor's funds.

Our leaders need to have a full and frank discussion with the American people about how the bailout will address the long term effects of exposure to the credit default swap market. Since Congress and our bank regulators are working feverishly to put together a bailout package that will have some effect beyond the band-aid we've had thus far, let us hope they are looking beyond the immediate crisis and implementing changes that have a lasting impact on this and every other economic cycle going forward.