In other words...making cheap money available only turns into an asset bubble if everyone does the same thing with it. And the reason everyone has done the same thing (favored the short volatility trade which then tightened spreads) was because it was impossible given public information, to form an opinion about the long volatility trade. But the suggestion I point to would change that. It would make it possible for sophisticated professionals to form an opinion (build a probability distribution) about the likelihood of a spike in volatility. And so long as there is enough people out there saying “today is the day it all falls down”, the crisis will never occur because they will be there to provide a bid when it does. Instead the money goes from one participant to the other rather than just driving bids to zero.
The Amaranth collapse was larger than LTCM but there was no need for a bailout. They didn't just go long NatGas like you say, it was a complex spread position identical in risk terms to the circumstance we're discussing. It was the same thing... the only difference was that there was no collapse of asset values because other market participants were there with long volatility exposure and were willing to provide a bid. That could be our model going forward if we made this one simple change. I don't think this can be explained any more plainly than that. At this point, it's really on you... if you still don't understand what I'm talking about I'll be happy to reccomend other reading material, but this is how markets actually work whether it matches your understanding or not.
Your best explanation yet. But I still disagree with your conclusion. The opinion of the "long volatility" trade was utterly obvious. Most of us saying there is a credit bubble now, were saying it in 2005. My personal posts here pointed out the absurd lending practices and subsequent asset bubble. I didn't get into the cause and effect then because I didn't know enough about it. Now I know that the demand for overrated traunches came from several factors, the main one being carry trade from low short term rates. It was trivial to borrow at 2 or 3 percent and buy longer duration securities with whatever yield was available at "AAA" (which were based on ludicrous assumptions). That is what drives down spreads, not the asset bubble, or lack of knowledge of the bubble or anything else to do with the asset bubble.
The implication that "volatility" or risk is somehow involved in all of this is about as ludicrous as the fake "AAA" ratings and fake insurance on the "AAA" ratings. The market has discovered that fraud and has now priced accordingly, but your plan will not prevent such malarky in the future.