Four Ways to Help Us Out of the Crisis

Furthermore, if I had cash collateral against any of these trades, or if I had prime-brokered my portfolio at Lehman (there is supposedly more than $40 billion of prime brokered assets that might be stuck), the cash and positions that are rightfully mine have yet to be returned, and the word is that it could take months. The knock-on effects of this disaster could be huge, and this will be widely felt, not only financially but also psychologically, because it undermines the validity of any and all transactions involving counterparty risk.

Ultimately, our financial system revolves around mutual trust, and not backstopping Lehman's counterparty obligations severely damages that trust. Perhaps the only good thing is that this debacle will speed up the move to a clearinghouse mechanism for the CDS market -- something that should have happened years ago.

Solution: Treasury should backstop Lehman's counterparty obligations. It may cost a lot now, but it could obviate future bailouts, since we don't yet know how widespread the damage is. They should have done this already by imposing counterparty guarantees as a condition for letting Barclays buy the assets for a song, but now it might be too late for that. Once again, Treasury needs to take on the mantle of leadership. The "moral hazard" problem should be dealt with, but not at the expense of confidence in the financial system as a whole.

Problem No. 3: The FDIC protection threshold is too low, and the FDIC is undercapitalized as it is.

With the collapse of IndyMac, "Main Street" mom-and-pop depositors already got a frightening dose of what a bank run could mean to their life savings. With Washington Mutual(WM Quote) on the brink, we are running the risk of overwhelming the FDIC, since WM's roughly $145 billion in retail deposits is three times the size of the FDIC's reserve. Obviously, depositors with more than $100,000 should be worried, but even much smaller, theoretically insured accounts are running scared in this environment.