President Obama suggested a new kind of financial regulation yesterday. He thinks it might be a good idea to slap fees on what he calls "far-out transactions." No that's not when surfer catches a gnarly wave. He means that money should be paid to the government by banks when they create exotic financial instruments. That way, if those securities go bad, the government will have a bailout fund already in place. It would kind of be like how banks pay an insurance premium for their deposits to the FDIC.

What kind of products does Obama mean? He's probably not sure. Here's a report form the Wall Street Journal:

He didn't describe what sorts of transactions might trigger the fees, though the way he described it suggests the proposal could cover exotic instruments such as credit derivatives that some believe played a key role in escalating the financial crisis.



And this is the central problem: how do you determine what products are exotic? Credit default swaps caused AIG some pretty big problems. But they're not particularly exotic. A lot of banks lost a lot of money on financial sector stocks. They're not exotic either. Heck, I'd even argue that subprime mortgage-backed securities aren't that exotic. There are only two assumptions that really matter -- losses and prepayments. If you have an Excel spreadsheet and passed Algebra 1, you should be able to figure out the rest. Their structure wasn't the problem -- their loss assumptions were an epic fail.

This problem raises another: enforcement. You would need a vast team of experts to evaluate every security out there to determine if it should require a fee. You'd have to then make sure all those fees are paid. Exotic products are also largely over-the-counter stuff, so there isn't a nice clean exchange where you can see everything that's traded to keep track of things. Should there be tiers of far-out-ness so that some fees are higher for really wacky securities? These are just some of the questions that will all result in the fees being even higher, because they will also have to pay for a new army of regulators.

Then how do we get past the problem the President refers to? Here he explains his solution regarding banks that create exotic securities:

So if you guys want to do them, then you got to put something into the kitty to make sure that if you screw up, it's not taxpayer dollars that have to pay for it.



Of course, there's an alternative already in place to take care of businesses that screw up. It's called bankruptcy. A bank gets exotic securities very wrong? It fails. If failure poses too great a systemic risk, then break it up into pieces until that risk is mitigated. I'd prefer that to creating significant new transaction costs for mostly sound capital markets.

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