From The Boston Globe
By Robert Kuttner

“Simplify, simplify, simplify!”
Henry David Thoreau

Once we have a functioning banking system again, banks need to go back to the basics – taking in deposits and making loans – so that investors and examiners can once again know that their assets have worth.

I recently debated an economist from the University of Chicago on the economic value of exotic derivative securities such as bonds backed by subprime loans. “They add liquidity,” he insisted, repeating the standard wisdom. But recent events have shown that these unfathomable instruments indeed create oceans of liquidity – until suddenly they destroy it entirely.

The current crisis was supercharged by inventions of financial paper created at several removes from the real economy. For example, a “credit default swap” is an insurance contract against a bond defaulting. Many of the bonds that used this insurance were themselves derivatives, such as bonds backed by subprime mortgages.

Supposedly, these derivatives on top of derivatives “spread risk,” but in truth they spread risk the way an epidemic spreads diphtheria. Mainly, they created financial pyramids that hid risk. This is otherwise known as a Ponzi scheme.

Bad bets on swaps by a tiny unit of A.I.G., the world’s largest insurance conglomerate, took down the whole company. Though ordinary insurance is well regulated, with required reserves against insurance losses, regulation of this particular exotic insurance was nobody’s responsibility. And with their bonds insured by insurers who were playing roulette, investors were spared the need to perform the most basic of capitalist duties – to understand what they were buying.

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