"Common sense teaches that booksellers should not speculate in hops, or bankers in turpentine; that railways should not be promoted by maiden ladies, or canals by beneficed clergymen ... in the name of common sense, let there be common sense."--Walter Bagehot, 19th-century economist

Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, Securities and Exchange chairman Christopher Cox and James Lockhart, director of the Federal Housing Finance Agency, all warned the economy and the markets would face severe distress if the Congress does not pass the Administration's $700 bn plan to bail out the financial industry.

Fed chair Bernanke went so far as to warn the Senate Banking Committee today that a "recession" with a higher jobless rate and more foreclosures would ensue if elected officials fail to act.

It's the first of two days of testimony for Paulson and Bernanke as they explain to Congress and the public the necessity of the financial industry rescue that could cost over a trillion dollars.

The four take to Capitol Hill to defend the biggest pre-emptive fiscal strike that has ever been seen in the history of this country.

It's a pre-emptive strike that is of a piece with this Administration, a bailout plan to ward off a potentially calamitous unwinding of the financial system due to massive leveraging by financial companies across the country.

It is a debt load that has the stock markets and the economy lumbering through quicksand.

The markets moved up and down during the hearing, over fear that Congress would delay the $700 bn government fund to buy toxic assets from banks, and also over worries the plan may not work to turn around the housing and credit crisis.

Indications of a delay also sent the dollar higher, as the futures markets watched to see whether the plan would pass soon, which would start the government's printing presses, weakening the dolllar.

Fed chairman Bernanke cut to the chase and moved to paraphrase remarks several paragraphs down in his prepared statement, saying: “Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy.”

The concerns are real, the details complex.

And chilling.

Notably, SEC's Cox warns that the $62 tn credit defaults swaps "is regulated by no one," adding, "neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market." (Credit default swaps are essentially derivatives that insure other derivatives, like collateralized debt obligations).

The Heart of the Crisis

As the housing plunge has yet to find its bottom, the value of mortgage-backed securities has plummeted, triggering $514 bn in writedowns and losses that have left institutions with too little capital to support lending.

The writedowns arose from a drunken daisy chain of paper kryptonite in the form of bad credit derivatives Wall Street's printing presses pumped out that have vaporized profits earned during the housing bubble.

Many banks can't raise the money they need to finance lending and so are selling assets, hurting their earnings power and stock prices even more.

Many shares in companies, including American International Group (AIG), Fannie Mae (FNM) and Freddie Mac (FRE), as well as Washington Mutual (WM), are trading at levels around the cost of a gallon of gasoline or milk.

The writedowns and losses have been severe. For example, take a look at Bank of America's (BAC) balance sheet, which sports $1.7 tn of assets, but just $84 bn in tangible book value (the difference between "hard" assets and liabilities).

That's a tiny amount to support that big book of business, a balance sheet now digesting Countrywide Financial and Merrill Lynch (MER).

Amidst a firestorm of criticism, the US government is stepping in to save a free market that has turned into a free-for-all, with the government looking like a chaotic fire brigade hosing down crises with taxpayer money, raising voter anger hot enough to melt steel that the country is turning into the United States of Bailouts.

A costly after-the-fact refereeing because Washington, plied with lobbyist dollars, does not have the intestinal fortitude to stop problems before they erupt.

Wall Street's Reckless Borrowings

Wall Street borrowed against its assets by a ratio of 30 to one, even 40 to one, a ratio which doesn't take into account the hundreds of billions of dollars of truly noxious subprime debt held in off-balance sheet vehicles, called structured investment vehicles (SIVs).

The practice led one European official to wonder aloud that he thought off-balance sheet entities went the way of Enron.

Some $55 bn is slowly bleeding back onto Citigroup's (C) balance sheet. Fannie Mae (FNM) and Freddie Mac (FRE) are believed to hold some $3.3 tn in hedges off their balance sheets, Wall Street analysts say.

Indeed, Fannie Mae and Freddie Mac were the US economy's own off-balance sheet vehicle which only helped move the needle on the homeownership rate at some four percentage points over the last decade.

Paulson is Angry

"Am I angry that taxpayers are on the hook? Yes, I am angry taxpayers are on the hook, but taxpayers were already on the hook," by a potted financial system that Congress and the US government allowed to fester and sanctioned for years, Secretary of the Treasury Paulson testified, noting it's past time "to get to work" to fix the problems, and that he's talked to central bankers around the world to enact similar plans.

The Thinking Behind the Plan

The Paulson plan is to buy up to $700 bn in mortgage-backed securities and then auction them off to investors, which could put a floor under their price and stop the downward spiral in the credit markets.

But no one knows what these assets are truly worth.

If the Treasury underpays, banks would take write downs, hurting their balance sheets and ability to lend. If they pay too much to buy these assets from banks, taxpayers end up backing that overpayment to reckless financial companies who leveraged themselves up to the stratosphere.

Treasury Wants It All

The current plan would set up a huge fund, potentially costing $700 bn, answerable to the Treasury Secretary.

Specifically, Paulson's plan says: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency...The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this act...without regard to any other provision of law regarding public contracts."

It goes on to say, "Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure."

What to Watch Out For

But a growing number of Congressmen want the fund to be run by an independent board, with oversight by the Office of the Comptroller of the Currency.

Watch Congress move fast to dial back the blank-check powers Treasury now wants to arrogate to itself.

In his opening remarks, Paulson testified: “You can be darn glad you gave us the bazooka,” referring to his own wording several months ago in the rescue of Fannie Mae (FNM) and Freddie Mac (FRE).

Paulson then moved quickly to dismiss the idea that the Treasury was moving forward without oversight, noting that Treasury always took Congressional oversight into consideration.

“We need oversight, we need transparency we need protection and we need it to get the job done,” Paulson said, adding the plan would save taxpayers money. “Again I'm frustrated the taxpayer is already on the hook and will suffer the consequences if things don't work. The best protection is to have this work," adding he believes the plan "will protect taxpayers."

Economist Edward Yardeni notes the Treasury's plan to auction off these distressed securities might work and save taxpayers money, as an auction would set "the lowest price from banks seeking to dump the worst of their portfolios on the government,” and also because it's still unclear which investors will step forward to buy this distressed paper.

Meanwhile, negotiations between the House and Senate and the Treasury are going on in advance so that both houses pass the same bill and it goes to the President right away.

That's supposed to be this week, but House Financial Services Chairman Barney Frank (D-Mass.) says passage could slip into next week--something the markets would not like at all.

The Details Being Hashed Out Now

Along with adding things like more oversight, a growing number of Congressmen want companies who sell assets to the government to let taxpayers subsequently own shares in the company.

Treasury secretary Paulson doesn't want the government buying equity stakes in participating companies as a condition for selling assets to the fund. This would augur towards, Paulson believes, only severely weakened companies taking part in the fund.

Also, Senate Democrats want tighter measures to stop foreclosures, curbs on executive compensation and a change to federal law so that judges can modify a bankruptcy filer's primary residence mortgage, which lenders heatedly oppose.

Under current law, judges may only modify loans on second homes. The lending industry has strongly opposed such a provision.

An Optimistic Timeline

According to a proposal from Senator Christopher Dodd (D-Conn.), the Treasury's authority to buy damaged mortgage-backed assets would last only one year, and would end by Dec. 31, 2009, versus the Treasury's proposal which asks for two years from the date of enactment.

Both are overly optimistic.

The Resolution Trust Corporation of 1989 and the early nineties, set up to liquidate 747 thrifts with assets of more than $350 bn, took about six years to do its work-out. It ended up costing more than $500 bn on an inflation-adjusted basis, more than its initial estimated $50 bn pricetag.

President Herbert Hoover's Reconstruction Finance Corp. of 1931, in which the government stepped in to support lending by the manufacturing sector, including rail roads, a move which eventually didn't forestall a deepening of the Great Depression, took 21 years to unwind (though it eventually morphed into an effort to support World War II).

Bernanke Backs the Plan--and Walks the Talk

Fed chairman Bernanke testified he supported the Treasury's auction plan.

He also testified about how marked-to-market accounting rules have triggered massive writedowns on mortgage-backed securities, as the rules say companies must pricetag these assets as if they were to sell them today. Since the markets remain frozen for them, the prices are fast bottoming out.

Instead Bernanke noted “many banks” support "hold-to-maturity accounting," which means banks could sit on these assets and not have to value them under the marked-to-market rules, thus delaying the writedowns--or recording of profit--down the road until they actually sell these assets.

Curiously, economist Edward Yardeni notes that since mid-March, the Fed has held on its balance sheet an asset identified as Maiden Lane, the portfolio of toxic assets acquired from Bear Stearns when it helped orchestrate the merger between Bear Stearns and JPMorgan Chase (JPM) last March.

Yardeni notes that “apparently, the Fed isn't obliged to mark to market [these securities] since the value of this portfolio is still $29 bn, the same as the original acquisition price.”

Questions Arise

Of course it can't be ignored that the US government has at least $40 tn in off-balance sheet debt in present value commitments owed on Social Security and Medicare (costing eventually some $99 tn, says the Dallas Federal Reserve).

Now taxpayers back $5.4 tn in mortgages, too, from Fannie Mae (FNM) and Freddie Mac (FRE)--as well as an up to $80 bn credit line to American International Group (AIG), the $29 bn in securities taken on by the Federal Reserve in the Bear Stearns' rescue, and a potentially $700 bn bailout of distressed mortgage-backed securities.

But perhaps (a thin reed of hope) the $700 bn may be a ceiling amount and the bailout may not cost that much, as already some $514 bn in losses and writedowns have been taken by banks and investment firms around the world. So, the debate is whether there are still $700 bn in mortgage-backed securities still to be bought.

Economist Edward Yardeni and his team say some $600 bn in toxic assets (called "level 3" assets under accounting rules) still sit on Wall Street. It remains to be seen whether all of that sum gets dumped on the government (meaning, taxpayers).

However, if some financiers have their way, the government would also swallow all sorts of credit-backed securities, of all stripes, namely credit card, student loan, even auto loan derivatives, costing taxpayers even more.

That would be a bad move--fix the housing crisis first and the rest will follow.

Secretary Paulson, when asked about this issue, testified the "vast bulk of our efforts should be aimed at mortgage securities" but that the Treasury asked for "broad authorities" to deal "with a variety of securities as needed," as the plan might aim at helping a broader range of assets in order to "free up the financial system."

Other Questions Remain

Will all 8,400 banks and thrifts have access to the new fund, or just the sickest ones, who decides which banks and thrifts are the most ailing and how does the government define that standard?

Also, foreign banks with US backed securities evidently now have access to the portfolio, under the Treasury plan. But can hedge funds participate? Nothing on that just yet, though some Congressmen say no.

And will the government publicize the names of companies unloading bad debt securities on the $700 bn fund? The Reconstruction Finance Corp. did, publicizing names of banks borrowing government money, triggering fears of a run on banks around the country.

The Federal Reserve Opens the Barn Doors

Meanwhile, Federal Reserve chairman Ben Bernanke may have to answer questions to the fact that the Federal Reserve threw open the doors to investment in the US banking industry by letting private equity firms, with $400 bn in capital, sovereign wealth funds, with an estimated $2 tn to $3 tn in assets, and corporate investors buy stakes in banks.

All in the hope that this would direct much-needed capital to the US banking sector.

The Federal Reserve plans to raise the maximum stake a minority investor could take in a bank holding company from 25% to 33% in some instances and lift the ban on board representation for minority investors.

Already, the private-equity firm TPG (formerly Texas Pacific Group) led a $7 bn investment in WaMu earlier this year. National City has benefited from private equity capital too.

Buyout firms such as Warburg Pincus and Kohlberg Kravis Roberts & Co. have lobbied federal banking officials to loosen their restrictions, the Wall Street Journal reports.

Private-equity firms are hoping to repeat the success some enjoyed after the savings-and-loan debacle in the late 1980s and early 1990s, when they bought S&Ls on the cheap and reaped big profits, the Journal reports.

This raises conflict of interest issues. Would a Henry Kravis push a commercial bank to lend money to a risky, private client for a quick buck, and if that loan fails, would taxpayers be on the hook? (answer: yes).

And will Congress let sovereign wealth funds buy controlling stakes in US banks?

Will Congress, say, let the Russian sovereign wealth fund, the Kuwaiti Investment Authority, the SWF owned by Abu Dhabi, or China's SWF buy controlling stakes in US banks, after the US Congress has stymied foreign investments in US companies (earlier this year thwarting China's attempt to buy a stake in 3Com, for example)?

What's Next for Wall Street Investment Banks

Meanwhile, storied investment firms Goldman Sachs (GS) and Morgan Stanley (MS) have become boring old commercial banks in a day. They gave up on attempts to remain as the last two investment banks standing to become "bank holding" companies. Both already own industrial loan companies based in Salt Lake City, Utah that can easily be turned into banks, sources say.

The move lets them gain access to bank deposits as a source of funds and also gain permanent access to Federal Reserve liquidity support via the discount window, access now on a temporary basis.

The Fed's move comes as the discount window is under duress, with record borrowings, partly due to the Federal Reserve expanding the list of accepted collateral at the window.

Also, the short-term collateralized loans in the repo market are also under strain due to the run on money funds, as these funds help fuel and provide liquidity to the repo market.

In return for that access, the two must meet new, tougher capital ratio requirements, the amount of funds they must have on hand to do borrowings. To meet these tighter requirements, they'll either have to cut their leverage ratios in half or raise capital, or some combination of both. They are now levered around 20 to 1 to 30 to 1.

Their business activities are more speculative than deposit-taking banks, so their capital ratios should be commensurate with their more risky ways of earning money.

The two may potentially merge with smaller, more solid commercial banks, or continue to get funding from outfits like Mitsubishi UFJ Financial, which bought a 20% stake in Morgan Stanley for as much as $8.5 bn.

The Office of the Comptroller of the Currency would oversee the commercial banking entities for Morgan Stanley and Goldman, while the Fed will be the key oversight agency for the two firms' overall capital levels and soundness. The central bank already oversees other major bank holding companies, such as the parents of Citibank and Bank of America.

Here Comes Inflation

The U.S. government will need to print money to pay for its new plan, which is why Treasurys are trading at record levels. The plan could add up to $700 bn to the money supply, blowing out the M3 portion of the overall money supply by nearly 10%. But $700 bn may not be spent.

Whatever the sum, all of this will cause inflation. Which is why gold prices have soared higher by $40 an ounce and oil $16 a barrel-meaning more money for the Organization of Petroleum Exporting Countries [OPEC] and other oil producers, already seeing record receipts.

A Better Way?

Brian Wesbury, chief economist, First Trust offers this plan this morning-this is straight from his research report:

All of this can be avoided if a system were put into place that allowed private companies to hold these distressed assets. Rather than a centralized holding place, why not use a decentralized one?

Why not allow financial firms with structured (Tier 3), (EMAC: the most insolvent ones) assets issued between December 2003 and August 2007 to suspend mark-to-market accounting for those assets, and receive government insurance as a backstop?

This would be a temporary solution, not requiring any ultimate change in Sarbanes Oxley or mark-to-market accounting rules, and the government could even make money by selling insurance with less risk to the taxpayer than buying them outright.

In essence a firm could sequester, or firewall off these specific assets from the rest of its balance sheet, and either finance this itself, or bring in outside financing. The firm would promise to hold the securities to maturity, or until government insurance was no longer needed when it liquidated the assets.

All of these deals could be settled in the private sector, in multiple locations with the government looking over the shoulder of each deal.

If the rules had been relaxed a little bit for these specific assets, Merrill Lynch could have created its own private equity investment fund inside its corporate structure instead of selling at a huge loss to Lone Star, which created its own holding vehicle.

This plan would leave mark-to-market accounting regulations intact. It would be a temporary change in the rules. Its most important attribute is that it leaves taxpayer powder dry for another day. It also allows the private sector to price assets in an environment that is not contrived and will help avoid the loss of, or government takeover of, more private firms.

Even if the Treasury initiates an RTC-type vehicle, the slight changes in the accounting rules for these specific assets should still be made. If a firm does not want to accept the government bid for its distressed assets it would have an alternative.

It would also create a level playing field because the Treasury does not have to mark-to-market. A competitive marketplace for these securities would insure the current holders that they would get a price that is not based on a fire sale.

This plan stops the mark-to-market meltdown without undoing the good that mark-to-market accounting has done, protects the taxpayer, stops the losses at financial firms at a crucial time, and therefore helps end the shorting of stock and bonds that has kept the financial system on the rocks without making it illegal.

Best of all it keeps the government from a massive and draconian step toward financial socialism.