Treasury Secretary Geithner has released his plan to mop-up the toxic assets held by banks that threaten their solvency and the global financial system. Accordingly, the plan purposes that private equity firms partner with the Fed to purchase bank assets at some discount set by the private firms at auction. Then the Fed will leverage the purchase six-fold to buy more bank assets and assume all the risk of leverage. In other words, private firms will set the price and then put up half the initial purchase price. The Fed will then put up non-recourse loans to purchase six times more debt at the same price to be owned by the joint venture partners. If the deal works private equity splits the booty equally. If the deal fails, the government loses upwards to six times taxpayer's money and private equity loses only its original equity match equal to 1/6 the total loss.

Flabergasted? Don't be. Very often you can cut a deal where you get to set the price and your partner puts in six times your money and you split the profit. If these deal terms don't underscore why the government should not handle your money and why the government should stay out of business, what does?

There is an economic WAR going on and the way SB sees it the US is losing it primarily because of the shortsightedness of Congress to do the right thing. Almost like a scratched record stuck in a rut left unattended at a radio station, the US Congress is playing the same verse over and over and getting nowhere with the people’s business. Before long, listeners, not in the US but overseas, will tire of the scratched groove and change to a different station.

US leadership must develop a strategic plan and stop focusing on tactics. Assuming Congress eventually fixes the banks and restores lending, the question is where will the US be then, and how will we be positioned vis a vis the competition? Better question, how long do we have?

Federal Reserve Chairman Bernanke and Treasury Secretary Paulson have proposed what they say is a comprehensive bailout plan that promises to restore the US financial system to health.

A key component of their plan is to overpay for US banking assets with hopes that down the road, time will bail us out when the crisis passes and the assets again re-appreciate to their "true value."

Wednesday night the central bankers huddled and decided to inject $240 billion into the worldwide banking system in an attempt to thaw the credit lending freeze—a result of the turmoil engulfing Wall Street and risky banks. This liquidity move addresses any shortage of capital to lend, but not the issue of trust that has been lost. It will then help the commercial credit market so that companies can continue to get affordable short term credit to keep their payrolls paid, but it does not address the central theme of this credit crisis which centers around Credit Default Swap [CDS] derivative contracts.

CDSs were created by Wall Street almost ten years ago. They now total some $60-65 trillion and in aggregate are some multiple, and growing, greater than the combined net worth of the world. There is yet no central clearing house to clear CDSs like there is for stocks, bonds, options, and futures contracts. Instead, dealers clear trades manually and assume the risk of default in all the trades they do. CDSs were infamously considered contracts to off-load risk by former Fed Chairman Greenspan who counseled Congress not to regulate them and to eliminate the Glass Steagal Act which kept a wall between traditional banking and investment banking. Without regulation the market grew 100 fold over the last seven years, according to a Bloomberg News report.

The US economic picture by all accounts (except George Bush's) is deteriorating with forecasts that as many as 300 US banks may fail and that Stagflation is becoming an ever greater reality (stagnant growth accompanied by rising inflation).

US investors concerned that Fannie Mae (FNM) and Freddie Mac (FRE) would not be able to manage their debt service when combined with their payoff guarantees on $12 trillion of US mortgages, sold both companies' stock, calculating that a Fed bailout was certain and that stockholders would lose out. Russia, and perhaps other sovereign investors, likewise have reason to sell their US government sponsored holdings. Russia is paying back the Bush Administration for its aggressive and unfriendly behavior, missile defense systems in the Czech Republic and the US intervention to derail World Bank loans for Russian oil pipelines.

One day after the Sino-US Economic Dialogue, China announced it was raising prices on electricity, gasoline, diesel oil and aviation kerosene to reduce demand and help its domestic refiners. US investors were surprised by the news announced late in the day and oil fell almost $5.00 a barrel. This weekend Saudia Arabia will host a Oil Producers Meeting in Jeddah to discuss how to deal with the rampant, worldwide rise in the price of oil.

China's announcement explains Secretary of Treasury Hank Paulson's ear to ear podium grin following his remarks at the conclusion of the dialogue. Unfortunately it doesn't add up.

The Bank of England Monday announced a plan to swap government bonds for mortgages held at its banks for a term of 1-3 years. Under the BOE plan this would give British banks some long term capital to continue lending, and similar to the plan in America, not add to the central banks' debt because they would eventually return them.

But banks in both the US and England have been hoarding cash even as their Central banks have lower interest rates. Banks, uncertain about the financial condition of one another, have not wanted to lend funds to other banks or to their own customers creating a credit freeze-up. The Auction Rate Securities market used by companies, schools, municipalities, and hospitals as a source of long term funds, but repriced every 7, 28 or 35 days, shut down over similar concerns of the credit worthiness of the issuers and the price of the underlying securities. Now financial institutions and money market funds which had lent to these issuers have found themselves holding ARS fixed income debt without a market and/or market price. US Security regulators have granted some short term relief in pricing these securities, but the end result has been to create an aversion to ARS and Preferred ARS securities further causing a giant quake-like disruption across all credit markets.

The feel-good rally following the latest Fed rate cut would be believable if anything had changed. Ah, but it has - or will.

On Wednesday, Fannie Mae and Freddie Mac had their capital reserve requirements lowered from 30% to 20% permitting them to hold a greater amount of mortgages with less collateral on hand. We have to assume that the Fed figured out the clock was ticking and soon 28 days would pass so that the ugly problem of nobody wanting the underwater mortgages would resurrect itself. If the government sponsored agencies could just step up, that would get the illiquid securities off the Fed’s Balance Sheet. OK. We’re for that.

One thing you can count on from government is that they will eventually notice a problem and arrive at cogent mix of regulation and scapegoat once it's too late. Great that Treasury Secretary Paulson today wants stronger oversight of mortgage lenders to avoid future debacles and credit crisis. Bad that he and the others responsible for the financial solvency of the United States didn't notice that when things were obviously awry, when regulatory oversight was missing, or when housing inflation that could bankrupt the government ws rampant and being government guaranteed--think GNMA.

Good, likewise, that all these savants are busily working to stave-off a collapse of the financial system, but bad that at the same time they fail to see that banks, so desperate to make profits to offset losses, are gouging the consumer, hoarding the rate cuts, and foreclosing at such record-breaking rates that they are setting off a consumer led recession. One would expect more. One would expect them to notice that since two-thirds of the US economy is driven by consumer spending, sending out (loan) checks and offering counseling to consumers is hardly what it will take to avert a deep recession.

Last week, the credit markets again seized up culminating in across-the-board sell-offs of mortgage-backed security holding entities. Thornburg Mortgage (TMA) reportedly was forced to liquidate some high quality mortgages at 70 cents on the dollar to meet margin calls. Soon thereafter, Carlyle Capital, a subsidiary of private equity firm Carlyle Group, reported receiving substantial margin calls that they did not have capital to meet, and began liquidating its 21 billion + morgaged-backed secuirities portfolio. As of the close Thursday, Thornburg's various preferred series had lost 50%-58% of their value while Carlyle Capital's bond fund closed off 60%.

In response to this malaise, and on top of the pending news of an inevitable, declining US jobs report, the Fed vowed to increase its Short Term Auction Facility size and extend the range of eligible securities banks may offer for collateral. The Fed also said it would pump additional funds into the credit markets by boosting repurchase agreement amounts to a total of $200 billion.

This week, Federal Reserve chairman Ben Bernanke once again gave a sobering speech to update us on the credit crisis. Basically, he said that delinquencies and foreclosures would continue for some time principally for three reasons: (1) there was an on-going imbalance in supply and demand for housing (2) about one and a half million Adjustable Rate Mortgages (ARMs) are expected to reset in 2008 increasing payments to an average of $1500/mo at an average mortgage interest rate of 10%, and (3) banks have greatly tightened lending standards and for the most part stopped sub-prime lending while new securitizations of "nonprime mortgages" have virtually halted.

After detailing steps already taken to help borrowers and mitigate foreclosures, the Chairman then proposed that banks consider writing-off as much as 50% of the principal value of a mortgage to keep from foreclosing as data on foreclosures show that the aggregate costs to foreclose, including missed payments, taxes, legal costs, and time could approach that amount on a present value basis. In other words, the Fed was urging banks to bail out lenders to keep the additional homes off the market. It's sound business judgement akin to the old adage that 'you can't get blood out of an turnip' so instead, recognize it and do some moral good.

Federal Reserve Chairman Bernanke responded appropriately when he lowered the Federal Fund and Discount rates again on Thursday in an effort to thwart bank failures—creating generous loan spread to boost bank profitability. By lowering rates again, the Fed made a clear and dramatic statement that banks required help to remain solvent, and he came to their aid. This is not a bad thing. We do have an emergency, and surely having the U.S. financial system implode serves nobody.

Undoubtedly, the next step will be the Fed, in collaboration with Treasury, engineering a bailout of private insurers, MBIA (MBI) and AMBAC (AKF). This is required because absent a bailout, money market funds, banks, broker dealers, pension funds, etc. will lose capital and/or capital reserves resulting from the reclassification of securities that no longer qualify to be held, or used, as dollar for dollar collateral. The resulting downgrades would set off a domino sell-off both here, and around the world.

The Federal Open Market Committee faces a perplexing deliberation over the next 36 hours. They have backed themselves into the corner and either must again cut interest rates just after last week's emergency 3/4 percent cut to maintain the market's momentum, or they must act prudently to hold the line disappointing the market and suffer the criticism of destabilizing the markets. Either way its looks like a lose-lose proposition, because the Fed can hardly be seen as acting on the dictates of Wall Street nor be seen as not acting prudently to aid the economy when benchmark Treasury rates already support a substantially lower Federal Funds rate.

There is of course an alternative course of action. They could just ask the President to issue an executive order to cap credit card interest rates at 12-15% to end the choking-off rates bank issuers are charging to make up for bad sub-prime loans. This would have a far greater immediate and multiplier impact on consumer spending than any further rate cut ever could and would keep Treasuries attractive as an investment to finance US deficits. At the same time it would keep some gunpowder dry, if as they claim, the US is not already in a Recession. Furthermore it would align US rates and monetary policy more with those of our long term allies.

Stock markets gyrated from misery to euphoria when news broke that a proposed cash infusion into the monoline insurers, namely MBIA (MBI) and Ambac (ABK), was being sought by New York Superintendent of Insurance Eric Dinallo. At risk is an estimated $2.5 trillion worth of debt securities, issued with guarantees by the insurers, whose combined stock market value is less than $2.5 billion. Under the formula seriously floated, $5 billion would be infused immediately by banks who have the most to lose in a default, followed by an additional $10 billion follow-on capital, all to secure their AAA credit ratings. The plan being that injecting fresh reserve capital would shunt a domino effect from sell-offs required by holders who can either not hold less than top rated securities in their money market accounts, or whose statutory reserve capital would be at risk (banks, broker, and insurers). Dinallo’s plan echoed an earlier bailout call by Jochen Felsenheimer, head of Credit Derivatives at UniCredit, Spa in Munich who advocated that “monetary authorities or governments” should back a bailout or see the monoline industry fail.

This is incredulous on two counts: First, that insurers could guarantee thousands of billions of dollars worth of debt in exotic debt securities and anyone would think that they had a guarantee in the first place; and secondly, how a credible regulator, after the fact, can think that institutional investors understanding the enormity of the risk exposure and uncertainty of payoff they now face with micro-fractional reserve capital at a ratio estimated to be 250:1, would think such a plan would float or be viable! (The failed ACA Holdings (ACAH.PK) which defaulted on $60 billion in credit swaps is required to add capital at a 35:1 ratio).

We began 2007 with S&P 500 companies forecasting earnings growth of +9.4% from a year earlier. This week, as fourth quarter earnings releases roll out, the revised estimates for companies is for a 6% decline in earnings instead of a gain, according to Standard & Poors. Barron’s, in their article titled: “It’s Time to Buy,” published on July 2007, forecast a 15.2% return for the S&P for the full year 2007 yet the market has been falling ever since. It actually went on to lose 4.3% since Barron’s call back in July, and an additional 5.6% as of yesterday for an alarming 10.3% decline since July 2007. Indeed the markets have begun 2008 continuing to sell-off, such that all broad market indices have fallen through their support bands like a falling knife trying to hit the floor. Now it seems highly unlikely, given the financial mess the U.S is in, that the 15.5% forecast by S&P 500 companies for their 2008 earnings growth can be near their targets.

The fact is that no one can reliably predict what will happen with earnings or the markets with any consistent reliability, but the facts also are that you don’t try to catch a falling knife. We have already stated that a return to the average Price Earnings Ratio means a much lower market and has pegged the index floors at their significant support levels. (Read: Is it time to bottom fish? And Dow 10,000?).

Thursday Fed Chief Bernanke articulated both how and why investor confidence has been so severely shaken in the US financial markets—not just in the sub-prime mortgage market but also in the insured, high quality mortgage market as well as in money market funds. His speech was well-prepared and served as a sobering explanation of what has occurred and why this problem will take some time to resolve. The Fed Chairman acknowledged poor underwriting, fraud, exotica in lending, and importantly, told of the complex, structured, derivative, credit products which banks participated in and guaranteed to enhance credit ratings before being sold to investors around the world.

Accordingly the Fed Chief said legislators, "regulators, accounting boards, central banks and others who have responsibility for oversight of the financial system are hard at work distilling lessons to be learned from this experience." He concluded by disclosing details of recent Fed Policy actions to deal with the credit crisis by adding liquidity through the Discount window and by using Term Auction Facilities to permit a wider range of collateral for loans from banks. He discussed how the Fed viewed their role as both supporting growth and protecting the US economy. He then gave assurances that the Fed would vigilantly watch the unemployment and inflation data and implied that additional rate cutting may be necessary and forth coming as "monetary policy was the best tool available to accomplish sustainable employment levels and price stability."

Remarkably, the bulk of U.S. Economists still forecast the likelihood for Kudlow’s “Goldilocks” economy to continue through 2008. Indeed it’s hard to find an Economist willing to project greater than a 50/50 chance of recession. Yet the Center on Budget and Policy Priorities recently released its report (pdf file) of how states see the economy. According to their budget survey asked of states, almost half of the states (24 states) already are experiencing, have projected, or expect revenue shortfalls over the next few years out to 2010. Those states cite a decline in Sales Tax revenues and falling property values as uncontrollable factors impacting revenues and are bracing for Federal cutbacks particularly in Transportation and Medicare spending. Many states, according the Center, additionally have revenue imbalances derived from costs of providing services rising more rapidly than the revenues collected. The report concludes that many states will require above average revenue growth to restore their budgets.

Prior to the economic slowdown brought on by the Housing debacle, states largely ignored other budgetary imbalances. For example, most states have huge, unfunded pension liabilities that have been undisclosed to the public until last year and now require dramatic spending and service cuts as recurring revenues are insufficient to meet growing liabilities. This fait accompli is further exacerbated by the widespread competition of states to offer incentive programs for jobs while major corporation’s have started PIC programs to avoid paying state taxes–a corporate income tax avoidance strategy that is based on transferring ownership of the corporation’s trademarks and patents to a subsidiary corporation located in a state that does not tax royalties, interest, or similar types of “intangible income." States have been reluctant to close this corporate loophole, desiring to be perceived as a “business friendly” place to locate.

Eighteen months into his job and I have to ask: Is Henry Paulson the right man to be Secretary of the Treasury? Oh, he has impeccable credentials, coming from Goldman Sachs (GS) where he was CEO. But just maybe therein lies a problem.

As a condition of accepting the job, he reportedly received White House assurances that he would be able to run U.S. China Policy. U.S. news media have well covered his "Sino-U.S. Strategic Economic dialogues"" forum to persuade Beijing into revaluing their currency, opening their financial markets, and working on food & product safety issues, not to minimize the need, or effort, to address the myriad other "market access" (trade) concerns. His 'reasoned patience' speeches to the press have won both support and forbearance from Congress to impose trade sanctions against China. And admittedly Mr. Paulson has been clever conducting U.S. Dollar Policy: Seeing little progress on the China currency front, he has obviously opted to accelerate the devaluation of the dollar, while talking strong Dollar Policy with the Chinese. Moreover, as an outward demonstration of friendship, and to convey the U.S.'s view of the strategic importance of U.S.-China trade, Mr. Paulson recently swiftly moved to appease Beijing by streamlining U.S. Food & Drug Administration inspections, with 'special handling' access and reporting--all in an effort to maintain the integrity of inspection without shutting down trade.

The Bush Administration angered members of the European Union by its demand to exclude any specific greenhouse gas emission cuts in the final climate agreement due in 2009. The U.S insists that the developing nations, particularly China and India, must also make similar cuts to those demanded of the US. The developing nations argue that they have largely not been responsible for the pollution levels present and that therefore they should not have to bear an equal burden. The negotiations have not reached dead-end though; delegates are continuing to negotiate under the assumption that new U.S leadership in 2009 will actually lead and not inhibit progress toward this most important global issue.

President Bush recently stated that he takes the issue seriously. But he also made a 'freudian slip' that may be the key to understanding his administration's seemingly neanderthal stance on an issue all his allies agree on. In his words:

Bowing to the dictates of Wall Street, the U.S Fed has now twice cut the federal funds rate to demonstrate that it is listening to the markets. But to us, such policy is one part delusional pandering and one part wishful hope that demonstrates a scary arrogance of the financial problem at hand.

Indeed, lowering current mortgage rates by an extra percent point does little to address the quandary ravaging the U.S housing market. The fact is banks made exotic loans with no down payments, required inadequate proof of income, offered low debt servicing requirements, all done based on inflated appraised housing values. Now when it's time to reset the loans to conventional terms homeowners are faced with negative equity and inadequate collateral values. These double-negative factors are driving the foreclosure rate and make a workout impossible for banks and homeowners alike. The unfortunate owners simply can't come up with the extra cash to satisfy traditional loan to equity ratios. This means that banks have quite a huge inventory of houses to foreclose on and re-sell. As each house is foreclosed, the banks themselves are put in a more perilous financial condition, since they ordinarily leverage each loan at a ratio of 20:1 for deposits held. Before long, with deficient asset-liability ratios, banks are short of capital reserves. They must get loan-shark deals or shut down lending.