A gold star for anyone who guesses that $25 billion in Federal TARP payments might have had something to do with it.

It’s worth noting, too, that Merrill’s total profits over the entire nine-year period were a negative $7 billion. Those big pre-2007 profits were fake, but the compensation was real. How can we trust these guys with taxpayer money?

Last week’s horrendous jobs report actually understates the nastiness of the recession. Along with the 533,000 jobs lost in November, the government nearly doubled previous job-loss estimates for September and October, bringing total losses thus far in 2008 close to the 2 million mark. In short, we are well into what is shaping up as the worst recession of the postwar era.

Depressingly, the downturn is accelerating despite more than a year of extremely aggressive remedial actions by the Federal Reserve and the Treasury, which together have pumped some $2.5 trillion of new liquidity into the financial system, with almost no visible result.

Why isn’t the reflation program more successful?

Illustration by: Matt Mahurin

For one thing, the government seems to be encouraging the banks to mask the extent of their problems. For instance, in a deal currently being finalized with Citigroup, the government would guarantee about 90% of a $306-billion portfolio of toxic assets in return for $7 billion in preferred stock. The purpose of the deal seems to be to minimize more Citigroup writedowns, even though its portfolio’s real value is almost certainly much less than the carrying amount. The Fed is similarly propping up ersatz valuations at dozens of other institutions by exchanging hundreds of billions of its Treasuries for a variety of shaky assets at something close to par.

No wonder banks are hoarding cash. They don’t trust even each others’ numbers. There are at least $1 trillion of unrealized losses and writedowns still sitting on banks’ books, and credit markets will not revive until they are cleaned out. Here’s one way to get things moving again:

Create a temporary bank-auditing control board. Coordinated audit teams from the Fed, the Securities Exchange Commission and the Comptroller of the Currency should conduct an urgent systematic review of all bank and brokerage portfolios, starting with the biggest, forcing realistic writedowns against consistent standards. Such an expert board, with both government and private-sector members, would set the standards and resolve disputes. The goal would be force honest accounting, no matter how big the losses.

Move all assets that are underwater into a “bad bank.” A bad bank is an entity that absorbs toxic assets at realistic values. The technique has been used successfully in many other countries, and also in the United States after the banking disasters of the 1980s. The bad bank manages the collection process and/or sells off assets to specialist vulture investors. Its equity is supplied by the banks that contribute assets or by the government. Its shares can be distributed to existing bank shareholders or held in a separate entity controlled by the contributing banks. The ‘good’ banks left after the disposition of their bad assets will finally have clean books and should be able to get back to the business of lending.

In the current crisis, it would far preferable to have a single über-bad bank controlled by all the banks contributing assets rather than by the government, as envisioned by Treasury Secretary Hank Paulson’s original Troubled Asset Relief Program, or TARP. Under Paulson’s plan, the government would have been negotiating prices of hard-to-value toxic assets, which is a set-up for financial rape. In a bank-controlled bad bank, board members would be vigilant against sweet deals for their rivals, so pricing would be realistic.

Make a sufficient one-shot equity infusion to recapitalize the banks. Probably $1 trillion of new equity would be required to cover the losses disclosed by the audits and to capitalize the bad bank. That would have to come from the government, and it should be in the form of common equity. Common equity is more highly weighted in bank-capital calculations, and it doesn’t impose the drain of interest or preferred dividend payments.. Pricing should be arm’s-length, ideally negotiated by another temporary board of pricing experts. The current process of huge, opaque, midnight deals hammered out by a small group of officials has a dangerous catch-as-catch-can air. Common equity infusions on the scale required would wipe out all or most current equity at many banks. But that’s the deal equity holders sign up for, and there’s no reason why they should be subsidized.

Create a fiduciary structure for holding government-owned stock. Neither the executive branch nor Congress should have any control over government-owned bank stock stemming from the restructuring. A simple solution would be to donate the stock to the Social Security Trust Funds under the control of a fiduciary board, like those at mutual funds, to manage, or sell off, the shares in the interest of Social Security beneficiaries.

This, or some process like it, would take at least a year to complete, but it would be far preferable to the current semi-random process of throwing trillions of dollars at the credit problem with little effect. And while cleaning up the banks would be a necessary condition to ending the credit crisis, it would not be sufficient. Other things must be done.

President-elect Barack Obama’s just-announced infrastructure spending program is a good start toward creating jobs and restarting economic growth. But it will take time. It also depends on the rest of the world’s willingness to keep absorbing U.S. debt.

The new administration might also explore privatized infrastructure construction, with lenders reimbursed from tolls and user fees. Those may be attractive investments for dollar-heavy sovereign wealth funds and would help repatriate the huge international overhang of dollars.

Because new stimulus programs will not have immediate effects, they should be paired with much-improved income relief for the large numbers of lower-income workers who are losing their jobs. The United States consciously accepts a higher level of economic instability than other industrialized countries but puts a disproportionate amount of the adjustment burdens on the backs of lower-income families.

The new administration should not try to reverse the rapid decline in consumer spending that started this fall. The grossly overleveraged consumer sector created by Wall Street’s lending binge is the main reason we’re in crisis. Trying to gin up high levels of consumer borrowing again is simply crazy. Households understand that they have to pare down debt and boost their savings. They are behaving far more sensibly than the Fed or the Treasury.

The sad reality is that we’re deep in the grip of a truly nasty recession that will probably run at least through 2009. Tiding over poor families is of crucial importance. Jollying along the banking sector, and assisting in the cover-up of their true losses, will ensure only years of stagnation.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Paul Volcker and Barack Obama at the center of a panel in Lake Worth, Fla. that includes, from left to right, Gov. Bill Richardson, Gov. Jennifer Granholm, small business owner Victoria Villalba, Gov. Ted Strickland and Google CEO Eric Schmidt (Flickr: DegrassiFreak)

The announcement that Paul A. Volcker is a key economic adviser to Sen. Barack Obama – cited by the Democratic presidential nominee during the last debate and appearing with him at a campaign event in Florida last week — was met with surprise in some circles.

Volcker, 81, is celebrated as the Federal Reserve chairman who broke the plague of global inflation in the early 1980s. But he did it be engineering a violent crackdown on excess credit — at one point the short-term bank rate jumped to 20 percent — and the 1982 drop in gross domestic product was one of the sharpest in the postwar era.

Illustration by: Matt Mahurin

Volcker is certainly no liberal. He was appointed to the Fed in the last year of President Jimmy Carter’s term — but with a visible lack of enthusiasm. Carter insiders called him the “the candidate of Wall Street.” Double-digit jumps in consumer prices were destroying financial markets, and Volcker was the sheriff whose job was to restore order.

Volcker’s brand of conservatism, however, is far different from the quasi-religious, free-markets ideology espoused by the former Fed Chairman Alan Greenspan and the recent crop of Wall Street barons. Though Volcker had refrained for two decades from criticizing the policies of his successors, he unleashed a blistering, and wide-ranging, criticism in an April speech at the Economics Club of New York.

The most reported section of his speech was the criticism of the forced merger/bailout of Bear Stearns, which Volcker said took the Fed “to the very edge of its lawful and implied powers.” He forecast that it would “surely be interpreted as an implied promise” to do the same for everyone else. And the Fed has duly increased its unorthodox lending by about $800 billion since Volcker spoke.

Volcker’s harshest words, however, were not directed at current Fed policy — he fully acknowledged the gravity of the crisis — but at those of Greenspan, the erstwhile ‘Maestro’ of Wall Street. For it was Greenspan who proudly presided over the Hindenberg-like bubble that officialdom is struggling to cope with. The “bright new financial system,” as Volcker called it, “for all its talented participants, for all its rich rewards – has failed the test of the market place.”

And he went on: “[T]oday’s financial crisis is the culmination, as I count them, of at least five serious breakdowns of systemic significance in the past 25 years — on the average of one every five years. Warning enough that something basic is amiss.”

“It is hard to argue that the new system has brought exceptional benefits to the economy generally. Economic growth and productivity in the last 25 years has been comparable to that of the 1950’s and 60’s, but in the earlier years the prosperity was more widely shared.”

Paul Volcker (barackobama.com)

Volcker lamented the passing of the banks and insurance companies where employees and partners shared pasts and futures, and expected to live with their loans for many years — unlike today, when garden-variety credits are chopped into anonymous pellets, grist for the complex bonds and derivatives that have spread financial havoc throughout the world. Volcker left no doubt that it will take strong leadership, not blind reliance on markets, to restore order.

Volcker’s conservatism fits into the institutionalist tradition of the great Irishman and British parliamentarian, Edmund Burke. It has nothing to do with the Ayn Rand-style of market libertarianism that mesmerized Greenspan.

Burke’s traditionalism is easy to mock — he could not imagine Britain without its royalty and opposed Irish independence. But, remarkably, he was also the leader of parliamentary support for the American Revolution. He came to that position, he said, only because the obstinate mismanagement of the American question by the king and his party had made the “Colonies, who were once not only submissive, but most affectionate to their Mother Country…totally estranged, discontented, disobedient, riotous…and almost rebellious.”

Volcker’s embrace of Obama may be such a Burkean moment. At the conclusion of his April speech, Volcker was asked whether it was true that he had actually endorsed Obama for president. He said it was indeed true and gave his reasons.

“I do have some fairly strong feelings,” Volcker said, “and I don’t like the direction this country has been going in for some time, in many directions. Economics may be part of it, but it is only a small part of the problem….

“People have been taking surveys of American people every year for years. One of these things where they ask the same question. Do you trust your government to do the right thing most of the time? Not a very tough examination…..20 or 30 years ago, the positive response was 70 percent. Now the positive response is 25 to 30 percent. I think that tells you something.”

And it tells you even more that not only would a man like Volcker make this statement, but that he and Obama have developed a clear affinity of views.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Federal Reserve Chairman Ben Bernanke (WDCpix)

Amid the clamor over the crisis on Wall Street, the U.S. Treasury’s $700 billion Troubled Asset Rescue Program, or “TARP,” bill and the evolving collapse of the global banking system, little attention has been paid to the extraordinary credit extensions at the Federal Reserve. But these are now without parallel in Fed history, including during the Great Depression.

In the last three weeks, Federal Reserve Chairman Ben S. Bernanke, with the help of Treasury Sec. Henry Paulson Jr., has increased the Fed’s credit extensions by $650 billion — roughly the same amount as the TARP. Taken together with the Fannie Mae/Freddie Mac bailouts, new Fed credits in just the last month or so now amount to some $1.6 trillion. Here’s how they did it.

Illustration by: Matt Mahurin

The Fed, to begin with, is a bank. Like other banks, it makes loans and investments, which are its “assets.” It finances them by taking deposits, mostly from its member banks, and raising capital, its “liabilities.” In the normal case, almost all its assets are loans to the government, or Treasury bills, notes and bonds; while its primary liabilities are its own debt certificates.

You’ve seen the Fed’s debt certificates; they’re green and carry the legend “Federal Reserve Note.” In other words, money. The Fed’s role in the economy is to stabilize the money supply so it is neither too plentiful, which can generate inflation, nor too scarce. It does so largely by manipulating the rate of interest that banks charge each other for overnight loans, the “Fed Funds” rate. If the Fed issues more currency to buy Treasuries from its member banks, banks become more liquid and the Fed Funds rate should fall; and vice-versa.

Bernanke is a serious academic who devoted much of his career to extensive studies of the failure of central banks during the Great Depression. He is the lead author of a 2004 Federal Reserve working paper, exploring the Fed’s policy alternatives “At the Zero Bound” — or the point where the usual tools of interest-rate policy cease to have any effect on the real economy.

In the paper, Bernanke poses a common policy conundrum. It sometimes happens that pushing down Fed Funds rates has no effect on medium- or long-term rates — or can even make them rise, if markets are worried that too much liquidity could cause inflation.

In such a case, Bernanke suggests, the Fed could use its balance sheet in a more targeted way. “If the Federal Reserve were willing to purchase an unlimited amount of a particular asset, say, a Treasury security, at a fixed price,” Bernanke wrote, “there is little doubt that it could establish that asset’s price.” But the Princeton economics professor also warned that the Fed should be “cautious” about such a strategy, since its results could be “quite uncertain.”

Starting in late 2007, and continuing ever more aggressively through 2008, Bernanke, as chairman, started precisely such an experiment in using the Fed’s purchasing power to target asset prices. But instead of targeting specific maturities of Treasuries, he targeted the illiquid assets weighing down bank balance sheets. In effect, could the Fed establish the price of the complex subprime mortgage-backed debt instruments, known as “CDOs’:and similar paper that has been destroying bank balance sheets?

The first attempt, in December, 2007, was appropriately cautious — it was relatively small and short-term; open only to Federal Reserve system member banks, and circumspect on acceptable securities. But step-by-step, he expanded the eligible borrowers from member banks to broker-dealers, then to AIG, an insurance company, and, most recently, directly to major corporations, mostly on an unsecured basis. At the same time, Bernanke greatly increased the volume and the range of targeted securities he would lend against, to include “investment-grade” (translation: “anything not junk”) CDOs.

The Fed’s weekly balance sheet has evolved into a fever-chart of Bernanke’s interventions. Start with the balance sheet of a year ago, in October, 2007. Total Fed assets were $890 billion, of which $780 billion comprised Treasuries, with the balance scattered among gold certificates, physical plant and other miscellany — or roughly the size it had been for several years.

Now jump ahead to the balance sheet from last week. The Fed’s assets have swelled to $1.6 trillion, an increase of 80 percent. But only $265 billion are Treasuries actually held at the Fed. The rest are a mélange of god-knows-what instruments vacuumed up from banks and investment banks.

There are $149 billion in dicey securities exchanged for Treasuries in bi-weekly auctions; “Other Loans,” to the tune of $420 billion (all we know is that it includes the credit extension to AIG, which has climbed to about $100 billion); a special $29-billion line for Bear Stearns, and $145 billion in direct lending to companies. There is also $325 billion in “Other Assets” — probably mostly dollars for foreign central banks to help local banks choking on dollar-based CDOs and other poison apples from America.

The total lending expansion, therefore, was about $700 billion, with about $650 billion in just three weeks since Paulson and Bernanke proposed what became TARP to purchase banks’ bad assets, or otherwise provide them with new equity.

In other words, even as academics and Congress agonized over TARP, Bernanke and Paulson had already pumped out roughly that amount of money — without so much as asking for a by-your-leave. Paulson even engineered a special $400-billion Treasury borrowing program -– i.e., increased the federal debt — to supply part of the extra cash needed to support Bernanke’s lending.

Fascinatingly, Bernanke’s fire-hose of liquidity has so far been accompanied by a steady tightening of lending conditions. Some market watchers worry that interbank liquidity is drying up because borrowing at the Fed is so much easier. Only time will tell.

If there’s one lesson from the past few years, it is the formidable nature of the law of unintended consequences. The vast new infusions of dollars will weigh on U.S. international balances for years. It is all in the name of staving off a “recession,” which now looks something like the 1960s specter of nuclear Armageddon.

We may have reached the point where the cure is scarier than the disease.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Treasury Secretary Henry Paulson (WDCpix)

Congress’s failure to pass the Bush administration’s financial plan has triggered a wave of scare commentary -– “financial Armageddon,” a leap “off the cliff” or “into the abyss,” the trigger for “the Depression of the 2010s.”

There have been good background analyses of the $700 bailout plan in both The Economist and The Wall Street Journal. Two weeks ago, after Federal Reserve Chairman Ben Bernanke and Treasury Sec. Henry Paulson Jr. refused to rescue Lehman Brothers from bankruptcy, they were shocked at the subsequent reaction in credit markets. Sorting out claims was far harder than expected, and the losses on Lehman paper had a nasty snapback on supposedly safe money market funds.

Illustration by: Matt Mahurin

Shaken, Bernanke and Paulson decided that they couldn’t risk any more major bank failures. Instead, they decided to re-capitalize the industry by buying up its bad assets. The $700-billion price tag was just a guess. The terms of the purchase were intentionally loose to make it an offer that the banks couldn’t refuse, or even haggle over.

Paulson was called “The Hammer” on Wall Street. In a classic “bear hug” acquisition, you stampede the target’s board by the early release of an attractive proposal to shareholders. He used the same tactics with the U.S. Congress. To less effect.

By announcing the bailout to the public even before the congressional briefings, Paulson counted on, and got, a huge market recovery. He was essentially daring Congress to turn him down. But it did.

The plan was misrepresented from the start. The core problem is that banks are carrying toxic assets at far more than their true market value. If they mark them correctly, however, the accounting losses will wipe out their capital.

So the only way a bailout can “recapitalize” them is by vacuuming up the bad assets at much more than their true value. Taxpayers will get some money back at some point — but not much.

Nor does the plan have anything to do with preventing a recession. Major-market house prices more than doubled from 2000 through 2005; that’s about a 14 percent annual growth rate, the highest on record. If you bought a house with 1 percent down, which was easy, you got your investment back sevenfold in just three years!

With the value of the underlying assets growing so fast, banks lent to anyone on anything, and mounted second mortgage marketing campaigns to get current homeowners to cash in their paper gains. There were similar, if smaller scale, bubbles in corporate takeover loans, commercial real estate and auto loans.

Home-equity loans paid for 6 percent of all consumer spending from 2000-2007. Now that consumers are maxed out on debt and house prices are dropping back toward normal levels, that source of cash is gone. Consumer spending must go down — a lot. That’s why we’re in a recession, and the bailout can’t do much, if anything, about it.

How many votes would the bailout plan have gotten if the administration and the congressional leaders had told the truth — that this is a bank bailout that won’t prevent a recession or help homeowners?

Saleability aside, is the Bernanke-Paulson plan really such a good idea? One leading economist insists that it’s necessary to avoid the “destructive power of deleveraging.”

But excessive leverage is what the crisis is all about. Deleveraging, however painful, is the solution, not the problem.

Today, panicky interbank markets pushed the overnight lending rates to 7 percent. But a quarter-century ago, then-Federal Reserve Chairman Paul Volcker intentionally pushed the overnight lending rate to 19 percent(!). He had chosen to spike inflation by choking off the supply of money and credit, knowing that he would trigger a vicious recession.

Real gross domestic product dropped 1.9 percent in 1982 — the worst downturn in postwar history. President Ronald Reagan, Republicans might note, supported Volcker all the way. Together, they laid the groundwork for the strong growth of the 1980s and 1990s.

Bernanke and Paulson talk about a recession as if it’s the equivalent of a nuclear holocaust. It’s not.

The whole country has grossly overspent its income for the last half decade and is wallowing in unpayable debt. The leveraging-up process has also created a bloated and omnivorous financial sector that needs to be shrunk drastically.

In short, it’s about the same scale of problem that Volcker faced in 1982, and warrants similar resolve. Many banks will doubtless fail without the bailout, with possibly severe short-term consequences. The long-term cost of a zombie financial sector on life support might be even higher.

The bailout was a questionable idea at best, made worse by the ram-through attempt and the misleading sales pitch. And neither presidential candidate has any stake in delaying the start of a recession until he takes office, and gets stuck with the blame.

So Congress did the right thing. It’s time to let the bailout die.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Sec. Henry Paulson (WDCpix)

The ‘clean’ bailout bill that Treasury Secretary Henry Paulson Jr. sent to Congress over the weekend, is anything but ‘clean.’ It would allow the Treasury to pay up to $700 billion for whatever “troubled assets” — in the bill’s first draft “mortgage-related assets” — from whatever banks at whatever price it sees fit. And it has to be passed by Friday or the world will end. The truth is that it will make an unholy mess even worse.

In any case, the hopes for a ‘clean’ bill were gone by Monday morning, and it wasn’t because congressional Democrats were lining up to put in sweetheart provisions. Wall Street’s suits smell a goldmine and are clamoring for position to get the hundreds of millions in fees at stake. Even foreign banks – and foreign finance ministers – are lobbying hard to be part of the bailout. It could be another Marshall Plan

Illustration by: Matt Mahurin

Paulson, or course, will be out of office in a few months, and can walk away a hero to Wall Street. But the rest of us will have to clean up the mess.

Let’s take a deep breath. This $700 billion would cover at least three million homes, plus thousands of commercial developments. All of them, presumably, in various stages of delinquency or default.

Who sets the prices that the Treasury pays for this toxic brew?

Most banks are carrying their residential mortgage paper at something like 65 cents on the dollar. But when Merrill Lynch recently decided to sell off a big chunk of “super senior” triple-A rated mortgage-backed assets — like the ones the Treasury is planning to buy, it got 22 cents on the dollar. And Merrill had to provide 75 percent financing on a non-recourse basis. In other words, the real price was about a nickel on the dollar.

What army of collection and administrative agents will the Treasury hire? (Listen to the chorus of ‘Me!, Me! Me!’ coming from Wall Street.) Which mortgages will it forgive, which ones foreclose?

When the Resolution Trust Corp. took over the commercial mortgages inherited from the savings and loan crash of the 1980s, the administration was an utter horror. I once tried to work through the cost of the operation, but was told that the records were such a mess that it wasn’t possible.

The RTC decided – quite sensibly – just to dump everything, bundling it up into giant pools and selling it to vulture funds. The Bass Bros., KKR, Ronald Perelman, all jumped in, making profits of 100 percent or more a year.

If Paulson really wants a clean bill, the Treasury can just create a $700-billion, U.S. government-owned “sovereign wealth fund” to invest in troubled banks at market prices. A sophisticated board of ex-bankers and accountants could oversee the pricing of individual deals. The equity could even be contributed to the Social Security Trust Funds, under supervision of an investment panel, perhaps with reasonable rules regarding buy-backs or other dispositions.

That will re-liquefy the financial system, while leaving each bank to manage down its own bad assets as it sees fit. No huge transfer of assets, no windfall rake-offs for the bad guys, no administrative scandals. That is the definition of a “clean” bill.

Update: The original version of this story was updated to note a new draft of the bailout bill has circulated.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Yearnings for an “RTC-type solution” that could hold failing mortgages over the long term have been bandied around on Wall Street and in Congress for months. But the real RTC was nothing like the current buzz.

Illustration by: Matt Mahurin

First of all, the RTC was not a bailout for anyone, and did not buy up bad mortgages from operating banks. A stiff increase in regulatory capital requirements for savings and loans by the Financial Institutions Recovery, Reform and Enforcement Act of 1989, or FIRREA, triggered the insolvency of a large swathe of the S&L industry.

The insolvencies were intentional, FIRREA was expressly a punitive measure, passed in a mood of anger and revulsion at the fecklessness and sheer criminality of so many S&Ls

The RTC was created to sell bonds that would finance the FDIC’s deposit insurance obligations and sell off the assets of the failed S&Ls, which were mostly commercial mortgages. These were assets that the government already owned, as a consequence of paying off depositors. They were not “purchased” from banks.

The head of the RTC, a hard-driving former airline executive, Albert V. Casey, decided that a huge overhang of commercial mortgages on government books could depress property markets for years.

So he packaged them up into large pools –- essentially inventing the Commercial Mortgage Backed Security, or CMBS –- and sold them off in a fire sale that lasted for about two years.

The big Wall Street banks and other investors, like the Bass Bros., made large profits on the sales. Once the RTC portfolio had been cleaned out, commercial property markets sustained a strong recovery.

Wall Street is clearly hoping for a friendly government to reliquify bank books by buying up underwater mortgages at friendly prices, and then holding them for the long term. That may or may not be a good idea. But it has nothing to do with the RTC.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Sec. Henry Paulson (WDCpix)

After the extraordinary federal takeover of Fannie Mae and Freddie Mac on Sept. 6, Treasury Sec. Henry Paulson Jr., Washington’s capo di tutti i capi on the credit crisis, drew a line in the sand with Lehman Bros. and Merrill Lynch. That makes the sudden federal takeover of the giant insurer, AIG, all the more surprising -– especially since AIG isn’t even a bank.

After Fannie and Freddie, the total commitment of taxpayers’ money to various bailouts and rescue schemes was more than $2 trillion, without any visible slowing of Wall Street’s skid off the cliff.

When Lehman Bros. showed up with their begging bowl last weekend, therefore, Paulson summarily sent them off to bankruptcy court. Merrill Lynch would never have rushed into the shotgun merger with Bank of America if they believed there was still a rich uncle in Washington.

Illustration by: Matt Mahurin

So when AIG cheekily asked for a modest $40 billion (!) “bridge loan” on Monday, they were laughed out of the room. Undaunted, AIG was back in the afternoon to report that, er…, sorry, they really needed $75 billion. Once again, they were sent off with business cards of bankruptcy lawyers.

Surprisingly, then, at 9pm that same evening, the Federal Reserve Bank announced that AIG would be nationalized, and receive an $85-billion line of credit from the government. The stated reasons were the size of AIG, its 100,000 plus employees, the 30 countries it operated in, blah, blah, blah.

It was all smokescreen. AIG’s insurance subsidiaries, which comprise the lion’s share of its business, are separately capitalized and regulated. They’re almost all profitable, and would have been only incidentally affected by the bankruptcy of the parent. With a bankruptcy trustee in place, they would have been quickly sold off to other insurers, in the same way that Lehman’s profitable brokerage operations and its Neuberger-Berman asset management group have stayed open, and are in the process of being sold.

AIG’s problems all stem from one group, “Financial Products,” which invested heavily in the same toxic mortgages and takeover loans that have wreaked havoc throughout the financial sector. But Paulson’s change of heart was triggered by just one product, a “regulatory relief” swap, with a notional value of $300 billion — an amount that hardly raises an eyebrow in today’s high-rolling world.

But here’s why the regulatory relief swaps loomed so important. In 2005 and 2006, various European banks created CDOs, or tiered bonds, supported by residential mortgages and corporate takeover loans. The banks sold off the riskiest tiers of the CDO bonds, which stand first in line to absorb any losses from the bonds. The “super senior” CDO bonds that the banks retained on their books therefore seemed pretty safe.

For extra protection, the banks executed a swap transaction with AIG. The mechanics of the swap were that AIG sold a “put” on the CDOs to banks. The put gave the banks the right to sell their CDO holdings to AIG at a price near par. To make it easy for AIG, if the puts were exercised, the banks promised to lend AIG the cash for the purchases.

The deal was a near-sham transaction, a “regulatory arbitrage.” Regulators were skeptical of CDOs, and were increasing the amounts of capital banks had to assign to support them.

But if the banks had a guaranteed takeout from a high-rated insurer like AIG, regulators could treat the CDOs as if they were riskless instruments, minimizing the capital the banks needed to support them. The only purpose of the deal was to reduce the capital requirements of the European banks.

But no one expected that AIG might fail. And if they did, the puts would fail — since there would be no counterparty on the other side. Then the banks would have to mark their CDOs at their true value, at best probably 50 cents on the dollar. On $300 billion of CDOs, that’s a mark-down, or capital loss, of $150 billion.

The mark-downs would be booked as losses and subtracted from bank equity. At a stroke, the European banks would be in a mad scramble to raise more cash, and would be clamoring for emergency infusions from their own governments. The phone lines from Europe to Washington must have been buzzing — “Hank! You can’t let this happen!”

To Paulson’s credit, he made the bailout as unpleasant as possible. The debt will carry a junk interest rate of more than 11 percent; the federal government has first claim on all company assets, 80 percent ownership of AIG stock and effective management control.

Current shareholders will be wiped out, as the company will broken up and sold off as soon as possible. The puts will eventually fail — but at least the the Europeans will have more time to prepare.

The positive result of the debacle is that future claimants for Fed-Treasury relief will have to walk under the sign, “Abandon all hope, Ye who enter here.” The government will help you fend off the sharks, in other words — but only by turning you into fish food.

The negative is that the whole mess in the credit default swap market has been left unresolved. Credit default swaps, or “CDS” are guarantees of debt payment that are privately traded among big financial players. These are the derivatives that Warren Buffet called “financial weapons of mass destruction.”

Losing payoffs can be large: AIG’s loss on the European CDO put could have been $150 billion. Deal terms are often murky, an alarmingly high number of settlements end up in litigation, and “counterparty risk,” or the possibility that the party on the hook for a large payment doesn’t have the money, is quite high. Highly leveraged hedge funds, for example, are big players in the market since it requires little cash to take big positions.

Allowing AIG to go down would have forced a violent restructuring of the entire CDS mess. Officials have been pleading with the big players to clean up their acts for years. While there has been plenty of lip service, there has been little action. Meanwhile, outstanding volumes have grown from a notional value of $1 trillion in 2000 to $62 trillion at YE 2007, and could well be $90 or $100 trillion by the end of 2008.

Wall Street has little vested interest in a cleanup. For one thing, since most CDS trades are murky and individually tailored, the Street pulls in at least $10 billion in annual fees for matching buyers and sellers.

For another, it’s been an enormously effective tool for cowing the Feds. The only reason Bear Stearns wasn’t left to shrivel up in bankruptcy was that they were the counterparty in $2.5 trillion of CDS deals. The mantra, just as with AIG, was “Save us, or our CDS will trigger a global catastrophe” — not unlike a two-year falling on the floor and turning purple to get his way.

Paulson has turned into the star of the Bush administration. It’s hard to imagine how any other Treasury secretary, particularly one working for an uninvolved and lame duck president, could have performed any better.

Lancing the CDS tumor before he leaves office would ensure his legacy.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Sen. John McCain (Photo by: Lauren Victoria Burke)

Sen. John McCain, the presumed Republican nominee, rose to national prominence in part by taking on his fellow Republicans, particularly on the disgraceful “K-Street” project — a conscious embrace of business lobbyists reminiscent of the Harding administration. More recently, he broke ranks with the party’s libertarian wing by producing a housing rescue plan much like the one sponsored by Rep. Barney Frank, the ultra-liberal Massachusetts Democrat. His renegade stance on economic issues seemed to match his wavering on abortion and stem-cell research.

As a presidential candidate, however, McCain is redefining himself as an avatar of classic Reagan Republicanism — a free-market libertarian in economics; conservative on social issues and decidedly anti-government. The libertarian shift in economics is signaled by his loud support of deep tax cuts, even deeper than President George W. Bush’s, and tilted heavily toward companies and investors.

Illustration by: Matt Mahurin

If McCain wins the presidency, however, the first, and dominant issue he will face, just like a President Barack Obama, is the drawn-out credit crunch and its attendant economic collapse. This is territory where the split between the Republican libertarian and big-business wings is practically neuralgic. With less than five months before the new president takes office, the crisis is sure to be still in full roar.

The surprise 3.3 percent gross domestic product growth rate reported for the quarter ending in June was a fluke — a compound of tax rebates and a weirdly low official annualized inflation rate of only 1.2 percent. The government wasn’t lying about inflation as many believe; it’s just that its preferred formulas have almost nothing to do with the prices consumers pay.

Consumer income and spending figures for July were dreadful, the housing collapse continues apace. Meanwhile, the last dregs of optimism are slowly bleeding out of consensus forecasts for next year.

Neither candidate has said much about how he will generate a recovery. But Obama, the Democratic nominee, hardly needs to — the debacle itself is such a powerful argument for political change, there’s no need to fuzz it up with programmatic details.

McCain is in a far tougher position. He is the standard bearer of the Republicans, and the credit crash happened on their watch. The recent housing rescue legislation was mostly written by Democrats, but it was strongly backed by Bush and Treasury Secretary Henry Paulson, who made important contributions to the final bill. Still, two-thirds of House Republicans, almost all from the libertarian wing, voted against it.

Paulson himself embodies the Republican conflicts. He came into office determined to reel back Fannie Mae and Freddie Mac for abusing their privileged borrowing status. But once the crisis hit, he reluctantly endorsed a massive increase in Fannie and Freddie lending. As Paulson clearly feared, he found himself the chief engineer of a Fannie and Freddie rescue.

Paulson is a strong figure who has played a weak hand unusually well. A new Republican administration will be in a weaker position still. McCain has a good record of bipartisanship. But if he is elected, he will have to bargain with frustrated and infuriated Democrats, burning for a replay in 2012. Finding a Treasury secretary of the same stature of Paulson, or prevailing on Paulson to stay in office for another year or two, will be of crucial importance.

The split between the two hemispheres of the Republican brain is also glaringly evident in the published McCain economic program. The energy program, for example, in sweep if not in detail, reads almost like a 1990s Democratic “industrial policy” text.

It includes a big push for nuclear power, stricter automobile mileage standards, big investments in clean coal, more stable and permanent tax credits for wind and other fossil fuel alternatives and a crackdown on oil market “speculators.” Bravely, the platform calls for an end to the absurd corn ethanol mandates so beloved by the U.S. grain belt, along with dropping import restrictions on the more energy-efficient sugar ethanol. The main discordant note is the pandering tax holidays for gasoline.

McCain’s health-care proposals are also spiked with statist flavorings. So there is a call for “a new public health infrastructure” and initiatives in early intervention, healthy habits, new treatment models, managing care for chronically ill patients, helping to creating a comprehensive electronic records systems and much else.

But libertarianism still rules. How will all the health-care plans be accomplished? By turning everything over to private markets. The platform proposes making what are effectively cash grants of $5,000 to “every family” ($2,500 to singles) and eliminating the tax advantages for employer-based insurance.

The idea is that every family will go shopping for its own insurance, instead of being stuck with whatever its company offers. Heightened consumer awareness will drive providers toward the high-quality, cost-efficient care that the United States now sorely lacks – in much the same way, presumably, as consumers have insisted on a high quality, cost-efficient automobile industry.

But even with its libertarian tilt, the health proposals are not seriously intended. They will cost money, and the core of the platform is that the government will be starved of financial oxygen. The Bush tax cuts will be made permanent, of course. The Alternative Minimum Tax, which is beginning to bear more heavily on middle-income families, will be eliminated (estimated cost $1.2 trillion in a decade). And then McCain has a long list of new tax cuts all his own.

The virtue of the platform is that it is clear. Whatever the gestures toward government activism, this is a small-government manifesto. The electoral contest on economics is therefore starkly drawn.

Democrats trace the current economic ills directly to the libertarian approach to the economy, especially with respect to financial regulation. Interestingly, by so wholeheartedly adopting Bush’s libertarian economics, McCain seems to suggest that the administration’s incompetence must have been the problem.

Yet if McCain does win the election, his newly-avowed libertarianism could greatly complicate his working with the majority in Congress. He is likely to have a very unpleasant first couple of years.

Sen. Barack Obama (D-Ill.) (Campaign Photo)

Whether Americans choose Sen. Barack Obama or Sen. John McCain as the next president, the first term’s economic agenda is already largely determined. Whoever takes office five months from now will inherit a deep-frozen economy, comatose housing markets, rising unemployment, gasping banks, falling tax receipts and soaring debt. Today’s article will look at the economy through the lens of a President Obama, and next week’s will take a look from the perch of a President McCain.

Should it be Obama who sits down at the at the president’s desk in the Oval Office on Jan. 21, 2009, he will bring a substantial list of economic priorities – tax reform to ratchet back the yawning income gap between the richest Americans and everyone else; jobs-creating public infrastructure programs; a national health-care bill, and a new regulatory regime for the runaway financial services sector, among others.

Illustration by: Matt Mahurin

The mantra of “Obamanomics’ is that it blends Clintonian market-friendly attitudes with the Democratic tradition of using government to offset the winner-take-all tendencies of raw markets

A President Obama would enjoy an unusual luxury for a new leader, but also face a dangerous trap. The luxury is that the current economic crisis is clearly stamped with a Republican label and strongly tied to President George W. Bush.

The “Bush prosperity” has been exposed as a fake, built on heavy borrowing against bubble-priced assets. Republicans cheered as Wall Street buried the country under mountains of unpayable debt and extracted hundreds of billions in bonuses in the process. Characteristically, the administration’s reaction to the crisis has been to throw public money at Wall Street – some $2 trillion so far and still counting.

The trap is that if Obama hasn’t fixed the crisis by 2011, when his second-term campaign should begin kicking off, this will be labeled the “Obama recession.” When the crisis first surfaced last summer, the mantra among professional economists was that it was just a short-lived market correction. But that is rapidly giving way to the far grimmer view that it will stretch into 2010, and possibly beyond

Some recent history is on point. In 1980, Ronald Reagan endorsed Fed Chairman Paul Volcker’s grim crackdown on price inflation at the Federal Reserve. By 1982, after Volcker had plunged the country into one of the steepest recessions of modern times, Reagan was widely regarded as a failed president.

But when the economy decisively righted itself in 1983-84, it became clear that the crackdown had restored U.S. competitiveness and set the stage for a long period of solid growth. Reagan not only won his second term by a landslide, but “Reaganomics,” or the religion of free markets and minimum government, became the ruling paradigm for a generation.

A President Obama has a similar opportunity. His most critical economic decision will be whether to stay on the Bush-Henry Paulson-Ben Bernanke road, or to address the credit crisis head-on. Should the Democrats gain firm congressional majorities in November, Obama could use his regulatory powers to force writedowns of all bad assets in one brutal swoop — purging the infection. Some big institutions could go under, and the government will have to step in with new capital — which should be in the form of stock, so the public also gets the upside

Democrats can cushion the blow on working folks by enriching unemployment benefits and extending Medicaid to poorer working families. Yet a real cleanup will be neither pretty nor easy — and everybody will get hurt.

Congressional Democrats, meanwhile, have instinctively climbed on the Bush administration’s bandwagon of covering up bad credits with taxpayer money. That path, however, risks keeping the economic needle stuck on “empty” for years. This would kill Obama’s reform hopes in any case. But if the strong medicine works the way it did in the 1980s, Obama can ride the “Obama economy” to an even broader triumph in 2012.

What about the rest of the Obama program? Once again, there is an important lesson from Reagan: keep it simple. Cleaning up the banking sector will be an all-consuming process. Possibly the only other priority that demands the same level of attention is health care.

National health care has eluded the Democrats for 75 years. A President Obama, with solid congressional majorities, looks to have a rare chance to pass a reasonable bill. But this opportunity could fade away with the 2010 mid-term elections. So it’s crucial to pass a decent bill, to at least establish the principle of a national system that’s neither means-tested nor limited to sub-groups, like the elderly.

It won’t be perfect. But once it’s in place, it can be expanded and improved at leisure. In any case, getting such a huge undertaking right is sure to take a decade or more.

The other big priorities -– public works, tax reform, regulatory overhaul – are important. A President Obama will inevitably make important proposals in each area. But he shouldn’t spend his strength — and his chips with Congress — to push them through in his first two years. None is as important as fixing the credit mess and getting decent national health legislation on the books. (The tax code gets a major overhaul every three-five years in any case.)

Political time-tables are cruelly short. The mid-term election campaigns will start in the fall of 2009, and the next presidential campaign in mid-2011 — just three years from now

But the longer-wave American political cycles tend to run for 25-30 years. Reagan kicked off a new cycle in 1980. The year 2008 could mark a tidal shift in another direction – that was the implicit premise of the Obama campaign. There is indeed high ground for the taking, but he will have to be fast and focused to seize it.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”