This blog post originally appeared on RealMoney Silver on April 27 at 7:53 a.m. EDT.

On the day when

Goldman Sachs

(GS) - Get Report

executives testify in front of the Senate subcommittee in Washington, D.C., to discuss the derivative products that have been blamed for the near bankrupting of many of the world's leading financial institutions, I have come up with some simple ideas regarding how commercial and investment banks should be allowed to operate going forward.

But first, a bit of history.

Back in August 2007's "

A Wide Decline Has Been Set in Motion

," I wrote extensively about the egregious use of leverage in mortgages and in the proliferation of derivative products.

Over the past two years, I have consistently warned against the broad implications of the egregious use of leverage (in financial institutions, at hedge funds and at the consumer level), the downside to the market's broad reach for yield (and return), a protracted and severe housing downturn and, in turn, the effects of the subprime contagion on our economic and financial well being.It was a lonely journey -- Nouriel Roubini was literally the only one on my investment/economic page -- and I took a lot of abuse. It hurt in many ways, and at times I felt very stupid. I tried to apply logic of argument and analytical dissection in constructing my ursine views and to dismiss the non-rigorous use of sentiment, which so many relied on to support their optimism -- after all, the trend in prices was consistently up....Resolution of the cycle, which featured an excessive misuse and mispricing of credit, will take a long time to remedy. Economically, a number of marginal lenders -- and that number has grown -- will fail. The credit contagion will reverberate in the world's economies.

On the Monday after the Goldman Sachs suit was announced by the

SEC

, I

made

the following similar conclusions and observations:

Firstly, both the subprime mortgages that were originated and packaged into a synthetic CDO as well as Abacus itself should never have existed. The mortgages and the CDO were at the tail end of the past cycle's acid trip on credit. They were cycle-ending events that wreaked havoc on the economy and the capital markets and nearly bankrupted the leading financial institutions around the world.Similar to other structured products, Abacus was the outgrowth of a steroid-induced world of financial and economic make-believe. Worldwide economic growth (especially of a consumer kind) was exaggerated and likely borrowed from future growth. Among many other culprits, this hyperbole was abetted by: Secondly, the SEC suit is another example of the type of public outcry we should continue to expect in the years ahead. This outcry stems from the growing perception of an ever widening schism in the U.S. between the haves (the Goldmans) and the have-nots (the rest). Never before have the wealthy and large corporations been held in such contempt by the average American. This holds with it huge implications for further populist policy initiatives and even (as we witnessed on Friday) litigation. The gloves are now off and the outgrowth of populism is higher taxes and more burdensome and costly regulation (likely aimed at hedge funds, banks, Wall Street, etc.). All these factors hold the promise, in the fullness of time, of reducing the upside to equities and of containing economic growth.

  • an unregulated shadow-banking industry (e.g., Countrywide Financial);
  • a permissive, complicit and conflicted ratings industry (Moody's and Standard & Poor's);
  • Wall Street (in its "heads I win, tails I win" compensation programs), which stuffed financial weapons of mass destruction into municipalities, insurance companies, other countries and down its own throat;
  • the government, which liberalized the wide scope of activity and leverage of bankers; and
  • a too-generous Fed.

Upon reflecting on the credit crisis over the past five years, I have a couple of straightforward solutions to financial reform.

  • Commercial banks that have federally insured deposits, such as JPMorgan Chase (JPM) - Get Report and Citigroup (C) - Get Report, should be allowed to fail, should be permitted to be an underwriter and should not be permitted to engage in prop trading.
  • Investment banks, such as Goldman Sachs and Morgan Stanley (MS) - Get Report, should divest themselves of their banking operations, should also be allowed to fail, should be permitted to be an underwriter and should be allowed to be engaged in prop trading, but, importantly, they should be forced to go private. If constituted as a private partnership, it is not likely that Goldman and the other investment banks would engage in reckless "heads I win, tails you lose" proprietary activities with both immense upside profit opportunities and equally large downside risk of losses (that could literally break the bank).

Easy peasy!

Doug Kass writes daily for

RealMoney Silver

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At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is the general partner Seabreeze Partners Long/Short LP and Seabreeze Partners Long/Short Offshore LP. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.