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Sheila Bair: 5 questions for the candidates on finance reform

FORTUNE — The economy has taken center stage in the drama of the 2012 Presidential race. Yet, neither candidate’s campaign script acknowledges the connection between our current economic woes and the financial crisis which caused them. Four years after the crisis, financial reform remains a work in progress.  So just what are you going to do about that, gentlemen?  The reality is, without a stable financial system, neither of you will achieve the sustainable economic growth you promise. Here are five questions I would like you to answer.

WILL YOU BREAK UP TOO BIG TO FAIL BANKS? Dodd-Frank, the financial reform law enacted in 2010, bans future bailouts of failing financial behemoths and requires instead that they be put into either bankruptcy or a government-run liquidation process. Dodd-Frank also requires big financial institutions to demonstrate that they can fail in bankruptcy without causing widespread damage to our financial system. If they cannot make this demonstration, the law authorizes, indeed requires the regulators and Secretary of the Treasury, to restructure them or break them up. Will you appoint leaders at the Treasury Department and financial regulatory agencies who are publicly committed to ending bailouts and who are prepared to fulfill their legal mandate to break up Too Big to Fail institutions?

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WILL YOU CAP THE ABILITY OF LARGE FINANCIAL INSTITUTIONS TO TAKE RISKS WITH BORROWED MONEY? Prior to the crisis, regulators let many large financial firms fund their operations increasingly with borrowed money. When the housing market turned and mortgage-related losses mounted, these institutions were unable to make good on their massive debt obligations. Indeed, leading up to the crisis, many large banks borrowed over $30 for very $1 put up by their shareholders. In contrast, banks which borrowed $12 or less to every $1 of shareholder equity generally remained healthy. Will you curb risk-taking and help avoid future bank failures by capping big banks’ leverage at this 12 to 1 benchmark, to make sure they have put plenty of their own capital at risk to absorb losses if they get into trouble again?

WILL YOU REQUIRE WALL STREET FIRMS AND OTHERS WHO “SECURITIZE” LOANS TO RETAIN PART OF THE RISK IF THOSE LOANS DEFAULT?  Securitization, or selling bonds to investors which are backed by pools of mortgages, played a key role in the run-up to the crisis. Mortgage brokers and lenders originated millions of toxic mortgages which Wall Street firms blindly snapped up and sold off to unsuspecting investors. Paid up front, without having to retain any of the risk if those mortgages went bad, the mortgage securitization industry had all the wrong incentives to produce as many toxic loans as possible. Indeed, they had a saying – IBG/YBG — for I’ll be gone, you’ll be gone – leaving investors, homeowners, and the public suffering the repercussions when those loans started to default. Going forward, will you require securitizers to shoulder a portion of the loss if the mortgages they securitize go bad?

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WILL YOU END SPECULATION IN THE CREDIT DERIVATIVES MARKETS? Many people rightfully point to bad mortgage lending as a key driver of the crisis.  Yet, hundreds of billions of mortgage losses by themselves would not have caused the crisis. The problem was the trillions of dollars of additional losses that were incurred world-wide by financial institutions who had made wrong-way bets on the performance of mortgage-backed bonds (and trillions of gains for the speculators who bet against them). Credit default swaps or “CDS” were the weapons of this mass destruction. Those who want to buy insurance protection against losses on bonds should be required to actually own those bonds, just as those who buy fire protection on a house need to actually own it. Will you require such an “insurable interest” for those buying CDS protection? Such a requirement would limit the size of this radioactive market and remove perverse economic incentives for speculators to benefit when bonds default.

WILL YOU END THE REVOLVING DOOR? The spectacle of senior regulators moving into and out of industry has undermined public confidence in our regulatory system. Will you commit to appointing individuals at the Treasury Department and regulatory agencies who will be independent and promise never to work for the industry they regulate? People who want to use regulatory positions as stepping stones to more lucrative employment in the private sector have no place in government.

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