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You thought the Fed had a lot of freedom? You ain't seen nothing yet. According to two MIT economists, Ricardo Caballero and Pablo Kurlat, the Fed should directly get into the credit default swap business to "prevent the next crisis." Says the WSJ:

Their proposal will be debated today at the Fed’s annual Jackson Hole, Wyo., symposium by the world’s leading central bankers and economists. Harvard’s Kenneth Rogoff, former chief International Monetary Fund economist, will present a critique.

Just in case you missed what destroyed AIG, and what, contrary to the current CEO's desire, will be the reason why AIG will be subsidized by taxpayers for centuries, is selling gluts of CDS on virtually anything that had any risk in it. But the MIT guys think next time around AIG should actually be the Fed:

The two professors say the underlying idea — selling insurance against extreme financial risk — should be in the Fed’s arsenal to manage financial crises.

“Insurance is an effective and cheap tool during a panic,” they say in their Jackson Hole paper. The Fed did provide an ad-hoc form of insurance during the crisis -– guarantees to Citigroup Inc. and Bank of America Corp. on the value of more than $400 billion in assets they held. More broadly, the Fed provided insurance to the whole financial system when officials there vowed to do “whatever it takes” to stabilize markets last fall and extended their safety net beyond banks to AIG. The professors say the bank guarantee program should be formalized in instruments called tradable insurance credits which could be triggered by banks and even hedge funds if another crisis erupts.

Alas, some red lights ahead of this proposal are imminent:

There are some practical problems with the idea. The Fed was able to offer these guarantees to Bank of America and Citigroup using legal authority only allowed during “unusual and exigent” emergencies. To make ‘TICs’ a formal part of its toolkit, it would likely need congressional approval. That would likely be a tough sell with Congress now populated by many restive lawmakers who complain the Fed used its power too expansively during the crisis.

This may be a tough nut to crack as lately over 280 members of Congress have been pushing for limited the Fed's powers, not expanding it.

Yet most interesting, is that the Fed may have well already entered the CDS arena. Recent TIC data (not Tradable Insurance Credits, but the Treasury International Capital variety) indicate that beginning in March the Fed started getting involved in derivatives classified as "Other Contracts By Risk Type", to the tune of over $1.3 trillion dollars!

Perhaps before the Fed decides to wholeheartedly dominate CDS trading in addition to every other component of the financial system, they can clarify what exactly is the nature of these various "other" derivatives.

Granted, while trillion is the new million, US taxpayers may be quite curious to know why since the start of QE the Fed has been involved with not only Credit, but Equity and All Other types of this new form of derivative contract.

hat tip Dan

Source: Proposal for Fed to Become the Next AIG