Behind closed doors, employees at AIG’s Financial Products division — the very unit whose trading had hastened the insurance giant’s collapse — were defiant, saying they were merely getting what they were due, recoiling at public accusations that they were behind their capitalizing on the company’s massive taxpayer bailout.

It’s worth reading the whole piece to get a full taste of the pomposity inherent in some of these folks, who after all, had recently contributed to the collapse of the global economy. The arrogance award, though, goes to the nameless employee who said this of taxpayers:

To be honest with you, I really hope it blows up. I think the U.S. taxpayer deserves to lose a trillion dollars over this thing for the way they have behaved.

That same guy also had some choice words for the politicians critical of AIG’s dealings:

They only care about the next election, just like we only care about the next bonus. Well, none of them cares about the country, none of us cares about the institution. They really don’t care, and I really don’t care. And frankly, if a trillion dollars gets lost, fine.

It’s unclear whether this particular angry person was aware that he had just conceded precisely how shallow he really is.

Senate Democrats, of course, have shown little interest in considering the reform bill, which restricts the Treasury Department’s spending of the second half of the $700 billion Wall Street bailout. Leaders in the upper chamber have indicated instead that they’ll put their faith in the promises of the Obama administration to spend the cash more effectively than the last White House did.

Time will judge which chamber — the House or Senate — was the wiser.

General Motors assembly line (by habfam flickr)

In a blizzard of partisan rhetoric, congressional leaders sparred Friday over whether America’s struggling auto makers should be the next benefactor in the lengthening series of federal bailouts.

Key Democrats have pushed furiously for an additional $25-billion infusion to help the sinking industry. Earlier this year, Congress approved $25 billion in low-interest loans to help the Big Three retool their factories to produce smaller, more fuel-efficient vehicles. Those funds, however, have been held up because of red tape. The Bush administration announced last month that it could take between six and 18 months for the money to reach the companies.

Senate Majority Leader Harry Reid (D-Nev.) vowed Friday to bring the proposal to give General Motors, Ford and Chrylser more money to a vote in next week’s lame-duck session. The $25 billion would come from the already approved $700-billion financial rescue package.

Illustration by: Matt Mahurin

But the plan has hit a GOP wall of opposition. Many Republicans, who begrudgingly signed on to a bailout of the financial system, seem to have drawn the line at rescuing Detroit.

“I’m afraid it will be sending money down what we call a rat hole,” Sen. Richard Shelby (Ala.), the highest-ranking Republican on the Senate Banking Committee, said in an interview on MSNBC Friday. “It might be a temporary fix … but until some fundamental things are changed about their [auto makers'] model, it’s not going to work.”

Democratic leaders, including President-elect Barack Obama, have called repeatedly on Congress to pass legislation this month that would spend billions of dollars to buttress state Medicaid programs, extend unemployment benefits, make loans to auto makers and build roads and sewers. Obama has said his support for the Big Three hinges on their willingness to use the cash infusion to retool factories to produce more a fuel-efficient fleet.

In a letter to Senate Minority Leader Mitch McConnell (R-Ky.), Reid said that, at the very least, he intends to proceed Monday with two of the items — extension of unemployment benefits and more money for Detroit.

“These two provisions,” the Nevada senator wrote, “both address especially urgent needs and seem most likely to win your support and the support of your caucus.”

Reid shouldn’t hold his breath for passage. The administration opposes any new stimulus measures, contending that its $700-billion bailout strategy is enough to repair the economy — if it’s given the time to work. Officials in the Treasury Dept. also have rejected using any of that money to help Detroit. They have argued that the money would be more effective if it targets the finance industry.

GOP congressional leaders, already disgusted by federal interventions in the private sector, seem ready to let Detroit go under.

“There is a better way to get the economy moving,” Rep. Jeb Hensarling (R-Tex.), head of the Republican Study Committee, told CNBC Friday. “And it’s not helping out these [auto makers] who are the slave to the big labor unions and are making products that people don’t want to buy.”

Reid’s office said Friday that details of the Democrats’ plan are still being worked out.

McConnell issued a noncommittal statement questioning how anyone could endorse a proposal that has yet to be introduced.

“Taxpayers deserve to know if this bailout [of Detroit] would increase the national debt and raise their taxes,” McConnell said. “Perhaps when a bill is actually written, and its costs are known, both Republicans and Democrats can take a position on the legislation. But it sure would be helpful to actually see the bill before commenting on it.”

McConnell is hedging his bets on an Detroit bailout for another reason: The industry has a big presence in his home state of Kentucky. In 2005, roughly 20 percent of the state’s manufacturing workforce was employed by car manufacturers and related businesses, according to the U.S. Bureau of Economic Analysis. The auto and related industries accounted for $5.4 billion of the state’s gross domestic product. In 2006, Kentucky ranked third in the nation, behind Michigan and Ohio, in total light-vehicle production,

Kenneth Troske, director of the Center for Business and Economic Research at the University of Kentucky, said McConnell might not be a favorite of the auto unions but the industry’s prominence in Kentucky puts him in a bind. “He’s obviously in a difficult position,” Troske said.

Still, Troske added, an auto maker bailout would do more harm than good over the long run because it would set a precedent that some companies are too big to fail. The better alternative for the Big Three would be a Chapter 11 bankruptcy filing, Troske contended. Stockholders and pensioners would be hurt, but the companies would keep operating.

“They’ll continue to produce cars; they’ll continue to sell cars,” Troske said. “The executives would get fired, but they’ve already proven that they don’t know how to run a company.”

Auto industry representatives blame their predicament on external factors. Stephen J. Collins, president of the Automotive Trade Policy Council, which represents Ford, Chrysler and General Motors, pointed to high gas prices, less consumer spending and the credit freeze.

Still, U.S. auto makers are hardly blameless for their troubles. For years, the industry kept making gas-gulping SUVs while fighting tougher fuel-efficiency standards that would have made them more competitive when gas prices skyrocketed this summer.

But the question some lawmakers are asking is not who’s to blame, but what would be the economic consequences if one or more of the Big Three is allowed to fail.

In an interview with CNBC Friday, Sen. Debbie Stabenow (D-Mich.) said the effects any company declaring bankruptcy would be dire. She argued that the debate is not merely about the Big Three but about “whether or not we’re going to make things in this country — whether or not we’re going to manufacture anymore. … This is a bottom-line question of jobs and the future of the economy in America.”

Detroit’s woes should be a cautionary tale for the protectors of the industry. Many lawmakers, led by Michigan’s powerful Democrats, defended the auto makers’ opposition to new fuel-efficiency standards. Blind defenders of labor, which created a costly pension and health-benefits system that has made the Big Three increasingly less competitive in the global economy, also contributed to the problem. For example, the cost of health benefits owed by GM to employees and retirees over the next 80 years is estimated to be $55 billion, The New York Times reported last year.

Complicating Detroit’s plight, the Detroit Free Press reported Friday that Chrysler is paying its top executives $30 million in retention bonuses, even as the company is hemorrhaging cash and employees. Company leaders, who are scheduled to appear before Congress next week, will no doubt hear an earful from lawmakers over their priorities.

Such news will likely not sit well with Sen. Charles Grassley (R-Iowa). Grassley, the ranking member of the Senate Finance Committee, wrote to Democratic leaders Friday urging that any legislation to help Detroit should “include restrictions on executive salaries, compensation packages and excessive internal spending.”

Maybe Congress has learned something from the finance bailout after all.

That’s why you should expect to see more sad stories like the one Peter Viles at L.A. Land notes. A Pasadena woman, facing eviction and foreclosure, apparently killed herself. Wanda Dunn, 53, may have set her house on fire first, then committed suicide, police said.

From The Los Angeles Times coverage:

…Neighbor Scott Harden, 36, said he had heard from others that Dunn was going to kill herself because she was going to lose her house. He said he also knew that she was apparently going to be evicted on Monday, “so I was on red alert.”

On Sunday night, he said, he saw Dunn moving boxes and packing up her car. About 5 a.m. the next morning, he said he saw smoke coming from the house and immediately called 911.

It’s unavoidable that people are going to lose their homes; lenders can’t just give them away. But surely, in all this mess, if we can come up with a $700-billion rescue package for Wall Street, we can think of a way to add some humanity to the foreclosure process. In some Michigan counties, tax collectors use social workers to help people facing foreclosure adjust to losing their homes and move on to renting.

It’s just a small thing, and it’s not hard to replicate elsewhere. It’s a recognition that among the tangle of credit default swaps and subprime mortgage-backed securities is a person who faces the pain of losing her house.

If we can take all sorts of unprecedented steps to intervene in the private market and provide banks with capital, couldn’t we also do a little bit more for the people with their boxes on the sidewalk — and their dreams down the drain?

flickr (TW Collins)

In “The Arabian Nights,” the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the king, who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.

The worldwide economic drama and tumult are not symptoms of the disease but the cure. The “disease” is the excessive debt and leverage in the financial system — especially in the United States, Britain, Spain and Australia. The “cure” is the reduction of the level of debt — the great “de-leveraging.”

In 1931, Treasury Sec. Andrew Mellon explained this process to President Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. … Enterprising people will pick up the wrecks from less competent people.”

Illustration by: Matt Mahurin

The first phase of this cure is reduction of debt throughout the financial system. So far, overall losses to financial institutions are $400 billion to $600 billion, and that may well go higher. This requires cutting balance sheets — assuming banks are levered around 10 to 1 — of around $4 trillion to $6 trillion in in lending and asset sales.

For example, the bankruptcy of Lehman Bros. meant about $600 billion of debt was eliminated. This inflicted losses on holders of Lehman debt, and that  flows through the chain of capital. The destruction of Lehman Bros.’ capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.

The second phase of the cure is the higher cost and lower availability of credit. This forces corporations to sell assets, reduce investment and raise equity — for example, as General Electric has done. It also forces consumers to cut debt by reducing consumption or selling assets.

Reducing investment and consumption lowers economic activity. That puts stress on corporations and individuals that may result defaults that trigger losses in the financial system, which further reduces lending. De-leveraging continues until overall debt levels reach a sustainable level, set by lower asset prices and available cash flows.

This process of destruction echoes W.B. Yeats’ words: “All changed, changed utterly: A terrible beauty is born.”

Within the financial sector, de-leveraging is well advanced. In the real economy, however, it is still in the early stages. Fairy tales in financial markets focus on the “superhuman” abilities of regulators and governments to avoid this de-leveraging.

Central banks and governments,  accepting an increasing range of collateral, have aggressively supplied liquidity to the money markets. Central banks may soon accept items akin to baseball cards — maybe, for example, Lehman, Bear Stearns and Fortis memorabilia, like mugs and tote bags.

Central banks are acting as “buyers of last resort” rather than “lenders of last resort.” They are providing cheap funding. The loans will have to be rolled over, as the banks cannot repay them. They will only be repaid from the underlying cash flows of the assets counted as collateral.

Government and central banks have also “bailed out” a number of financial institutions using a variety of strategies. Lower interest rates and increased government spending have been used to reduce the effects of the financial crisis.

The U.S. government’s $700-billion bailout package is the latest magic potion. It is puzzling why this initiative is seen as the “silver bullet” that can “fix” the problems.

A look at the Troubled Asset Relief Program, or TARP, reveals confusion about what problem it is addressing. The plan to purchase up to $700 billion in “troubled” assets is not dissimilar to existing support provisions. If assets are correctly valued on the books of the banks, then purchase at fair value only provides funding to the bank. The difference is that the risk of the securities is now transferred to the government — but so is any potential recovery in price.

There are different views about how much the government should pay. Under one approach, the government would pay a “hold-to-maturity” price that may be, perhaps significantly, higher than the “market” price, or the value on the bank’s book. This would give the bank liquidity as well as capital.

The alternative approach would be to pay “market” values. This would provide liquidity to the banks but no capital. It could even trigger additional losses where the assets are carried at higher values — creating incentives against participation.

There is also a small problem in that nobody has a  clear idea what these securities are worth.

Purchases of troubled assets are also conditional on (correctly) protecting the taxpayers against losses. This requires banks to provide the government with equity, or equity-like interests, in exchange for participating in the program.

Alternatively, the institutions selling the assets will need contingent arrangements to minimize the risk of loss to the taxpayer. Commentators have gone into rhapsodies about the ability of the taxpayer to “profit” from the program. This creates potential conflicts for financial institutions, whose fiduciary duties require maximization of returns for shareholders.

It is not clear what securities will be eligible for purchase and who will be allowed to participate. Amusingly, the recent short-selling ban on financial institution stocks saw a curious array of companies claim that they were financial institutions! Gaming the system will be practically difficult to control.

In fairness, the final form of the bailout plan is not yet settled and may provide greater clarity. But the bailout could merely transfer the problem onto the U.S. government and taxpayer balance sheet.

Government support for financial institutions in this crisis is already approaching 6 percent of gross domestic product — compared to less than 4 percent in the savings and loan crisis. This could ultimately place increasing pressure on the U.S. sovereign debt rating and undermine Washington’s ability to finance its requirements from foreign creditors.

Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. But the failures are unsurprising.

At the height of the boom, banks used various techniques to increase the velocity of money. Now, as the system de-leverages, the velocity of money has sharply decreased.

Money being supplied to the banks is not being lent through. Banks are parking the money in short-dated government securities, in anticipation of their own funding requirements. Around $2 trillion to $3 trillion of assets are returning to bank balance sheets from the “shadow” banking system that can no longer finance itself.

In addition, banks have large amounts of maturing debt — estimates suggest $1.5 trillion by the end of 2008 — that they must fund. Fear of bank failure, especially after the Lehman bankruptcy, and shortages of capital also limit the banks’ ability  to lend.

Ultimately, nothing can prevent the de-leveraging of the financial system now in progress. At best, actions can smooth the transition and reduce disruption of the economy.

The risk is that well-intentioned steps would prevent the required adjustments from taking place, delay recognition of big problems and discourage action that must be taken by financial institutions, corporations and consumers.

The extent of de-leveraging is substantial and likely to take time. For all asset prices must adjust significantly. The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, an illusion. As the system de-leverages, it seems clear that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in U.S. Treasury bonds, GSE paper and AAA rated asset-backed securities. It will be difficult to convert them into the home currencies of investors without large losses.

Government and central bank actions, meanwhile, need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas.

First, banks must be forced to write off bad loans without delay — even if this means breaching minimum solvency capital requirements. Second, bank capital needs must be addressed by forced mergers and restructuring, new equity issues and even nationalization or liquidation. Third, central banks need to guarantee (for a fee) all major bank transactions, enabling normal transactions between banks and other parties in the financial markets to resume.

On Wednesday, Oct. 8, Britain announced a program that addressed some of the above issues. However, coordinated global action is needed so that people do not merely move money from one country to another to take advantage of superior government protection.

A global conference along the lines of Bretton Woods, under a respected chairman — Paul Volcker is the obvious choice –  should be convened. It could bring together all major players — including vital creditor nations, like China, Japan, Russia -– to develop a framework for the major economic reforms in areas like currency policy and fiscal disciplines, to work toward resolving the crisis.

A principal objective could be ensuring supply of funding for the U.S. in the transition period. Recent comments by China about Washington’s responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed the U.S. financial may “affect the whole world.” All creditors have much to lose if the de-leveraging process becomes disorderly.

Like a giant forest fire, the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit  damage to the U.S. economy and the international financial system until the fire burns itself out.

“The Arabian Nights” had a happy ending. The king, after 1,001 night of enchantment and three sons, pardons the beautiful  Scheherazade — who becomes his queen. Despite the fairy tales that investors are now putting their faith in, the de-leveraging at the heart of the current financial crisis may not have such a happy ending.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

Sen. John McCain (WDCpix)

PHOENIX—Lost amid the Senate’s Wednesday night passage of a $700-billion Wall Street bailout plan was an effort by Sen. John McCain and others to “fix” an accounting rule that they believe has helped create the crisis.

The Securities and Exchange Commission and the Financial Accounting Standards Board, or FASB, on Tuesday issued “clarifications” regarding the rule, known as mark-to-market. The new directive allows companies to value their assets according to their estimated future cash flow, rather than current market prices.

Illustration by: Matt Mahurin

There are few buyers for many of the assets on the books of financial institutions, especially mortgage-backed securities. That makes them difficult to value. The price uncertainty has driven their market value down as much as 80 percent, threatening the solvency of many banks.

Banks and securities firms have already written down $500 billion worth of mortgage-backed paper as home prices have fallen and foreclosures skyrocketed.

The Senate bill calls for the SEC to issue a report to Congress on the effect of mark-to-market accounting on the financial industry within 90 days of the legislation becoming law. It also gives the SEC authority to suspend the mark-to-market rule.

The bill now moves to the House, where a vote is expected Friday. Members of the House Republican Study Committee are saying they want the mark-to-market rule scrapped.

McCain first called for repeal of the accounting rule in March. His presidential campaign issued a statement Tuesday supporting the SEC decision to relax the rule.

“John McCain is pleased to see that the SEC had finally decided to permit alternative accounting methods to mark-to-market accounting for securities where no active market exists,” McCain’s senior policy advisor Doug Holtz-Eakin said.

The American Bankers Assn. also praised the SEC’s action, saying “This guidance will help auditors more accurately price assets that are difficult to value under current market conditions.”

Critics, however, contend that allowing companies to base the value of their assets on unknown future cash flows will only cloud their true financial condition.

William Black, former deputy director of the Federal Home Loan Bank Board, said Tuesday that the SEC’s decision to relax the rule is an attempt to “cover up” the extent of the financial problems facing lenders. Black blames a similar accounting change for worsening the savings and loan blowup in the 1980s.

The SEC, McCain and others “want to use the same phony accounting to try and cover up losses, which will only make the losses much greater in the future,” said Black, now an assistant professor of law and economics at the University of Missouri at Kansas City.

But many economists, business leaders and politicians are urging modification or suspension of mark-to-market accounting for lenders holding huge amounts of mortgage-related securities that have no market.

“Assets should not be marked to unrealistic fire-sale prices,” wrote William Isaac, former Federal Deposit Insurance Corp. chairman, in a Sept. 19 Wall Street Journal op-ed article.

Bob McTeer, former president of the Federal Reserve Bank of Dallas and now at the National Center for Policy Analysis in Texas, said on NYTimes.com on Wednesday that suspending the mark-to-market rule “would make a big difference” in easing the financial turmoil. “Mark-to-market was never intended for use in a declining market,” he said.

And in a commentary appearing Monday on Forbes.com, former House Speaker Newt Gingrich urged Congress to suspend the mark-to-market standard to “relieve stress on banks and corporations.”

Accounting groups, consumer advocates and bank analysts, however, oppose scuttling the mark-to-market rule.

The Center for Audit Quality, a nonprofit group funded by accounting firms, sent a letter Tuesday to Congress urging lawmakers not to abandon the rule, arguing that proposals to revoke it “are not in the best interest of investors or the capital markets.”

“The principles of mark-to-market accounting are rooted in the fundamental virtue of transparency and are central to informed market decisions and efficient allocation of capital,” Cynthia M. Fornelli, the group’s executive director, stated in the letter.

Representatives of the nation’s big four accounting firms also object to the rule change. “It’s just bad for investors,” Beth Brooke, global vice chair at Ernst & Young LLP, in Washington, told The Wall Street Journal Wednesday. “Suspending mark-to-market accounting, in essence, suspends reality.”

And Barbara Roper, director of investor protection for the Consumer Federation of America, told The Journal that, “Allowing companies to lie to investors and lie to themselves is not the solution to the problem–it is the problem.”

Black, the former bank regulator, said there is substantial evidence that many lenders have already abandoned mark-to-market accounting by overstating the value of their mortgage-related assets. He said the recent takeovers of Washington Mutual by JP Morgan Chase and Wachovia by Citigroup revealed that losses at the two acquired banks were far greater than anticipated.

“These were enormous losses in the subprime mortgage market that they pretended didn’t exist,” Black said. “That’s called fraud.”

Rather than suspend mark-to-market accounting, Black said federal regulators should conduct more thorough bank examinations of all lenders heavily invested in the mortgage-backed securities. “Look for the ones that have heavy subprime exposure and take supervisory control of the institutions,” Black urged.

Beyond the politics of Washington, one thing seems clear to many homeowners on the verge of foreclosure, there is no significant relief in sight from the government or Wall Street.