Many other very bright contributors have demonstrated much about what has occurred to this point.

If you haven’t already read these pieces, please read Kevin Hassett, Jeff Goldstein, and Michelle Malkin. They do far more justice to a number of key issues than I can construct.

It’s clear that the precipitous events that have gotten us here are rooted in bad mortgage paper, supported de facto by the Government Sponsored Enterprise(s) (Doesn’t that say enough?) – Fannie Mae and Freddie Mac – and propagated by their MBS (Mortgage Backed Securities) that they’ve sold throughout the entire financial market place.

It’s also clear that there are a number of social political objectives that have influenced this process under the guise of ‘affordable housing’ and – as dear Mrs. Malkin points out – even motivations to provide mortgages to illegal aliens. This has created a crony capitalism that has partnered many people in the Congress and the Senate with the GSEs and Wall Street firms. The links above name the names so I won’t do it again here.

It’s also true that assumptions about the real estate market, and people that were dishonest or foolish in mortgage acquisition are part of the problem. As is often the case, there is plenty of blame to go around.

But, my friends, this is just the precipitous straw that holds us all above the abyss.

It is much, much worse than what it seems.

Because, what is underneath the mortgage paper noise is a bank liquidity problem and a troubled unregulated market that is many times larger than the entire US economy. And it is the threat to this monstrous house of cards that has Paulson and Bernanke calling for carte blanche fiat intervention by Treasury.

What’s the bank liquidity problem? You may remember at the beginning of this year that some economists were alarmed at the sudden appearance of negative values in the Non-borrowed Reserves column of the Federal Reserve Statistical release. It was all just a false alarm you know. Looking back it is pretty clear that the explanation was troublesome:

Last December, the Fed concluded that open market operations weren’t providing relief to some quarters of the interbank funding market and introduced the TAF. Like open market operations, the TAF enabled the Fed to lend a predetermined amount of funds to the banking system, with the interest rate at which they were lent determined through an auction process. But like the discount window, the money was lent directly to banks rather than primary dealers, and against a wide range of collateral rather than just Treasurys and agency securities. The TAF didn’t add to the money supply because for each dollar lent through the TAF the Fed was careful to liquidate a dollar of its holdings of Treasury bills and bonds to keep its overall balance sheet unchanged. [Ed. Emphasis added.]

A bit of translation is warranted to get past this inscrutable prose: Some banks weren’t willing to loan to each other because they couldn’t tell how solvent the other parties were. Banks are required to keep reserves on hand – and because of extraordinary demand on their reserves they were in need. And because a bank showing up at the discount window gives the appearance of weakness the Fed decided to create another method of access to liquidity for the banks called the TAF (Term Auction Facility). We’re told that it’s just some creative accounting directly between the Fed directly with banks – but in hindsight it’s apparent that the Fed has been accepting collateral that is suspect because in large part it’s made up of mortgage tranches (of which there are more bad mortgages than were projected on property that is now diminishing in value) and credit default swaps (which we’ll have to explain in a minute).

The false alarm back at the beginning of the year was based on the Non-Borrowed Reserves column going negative a few billion dollars. As is apparent from the latest publication of the Federal Reserve Statistical Release  this few billion has now grown to over 120 billion dollars. That’s in nine months. Fundamentally, this means that banks don’t have reserves and are putting up more and more of their ‘assets’ to obtain their reserve requirements from the Fed – and instead of the Fed seizing insolvent banks – it continues to loan them funds directly – against collateral that we now all know that no one knows what it is actually worth. For the Fed to keep their balance sheet unaffected at this scale has to have required some extraordinary creativity – a printing press perhaps.

But beyond this banking fiasco is the giant elephant in the room – the unregulated, over the counter derivatives market – what Warren Buffet called a time bomb. The simplest description of what has happened is that the GSEs, the investment firms, and the banks, in an attempt to reduce risk have sold each other insurance policies (in the form of a derivative instrument called a credit default swap in the context of the mortgage crisis) without having the actuarial requirements of an insurance company to underwrite the insurance. That’s certainly an issue for liquidity – but the most significant issue is that the sheer size of this market is staggering – the notional value of these derivative instruments far exceed the value of the mortgages they are theoretically hedging – and are indeed massively larger than our entire economy – I’ve seen estimates between $60 trillion to ’several hundred’ trillion. Who really knows since this entire market is not on an exchange, and therefore has no official measure.

And the problem is, of course, that these all can’t be unwound quickly. And no one really knows whether those that are holding derivatives that are now responsible for supporting bad mortgages actually have the wherewithal to meet the claim.

Long term market participant and market analyst Karl Denninger runs a forum site that should you have read it a year ago, you might have been forgiven if you thought he and his minions were a bit paranoid. Now they seem prescient. From his letter yesterday to Treasury (can be found on this link):

Let me briefly chronicle the various regulatory restraint and market manipulations of the last year…

- Administrative removal of Rule 23A restrictions from certain “favored” banks” (Spring 2007)

- The (Selectively Leaked) Shock and Awe Discount Rate Cut on Options Expiration (August 2007)

- The Bank Super SIV (October 2007)

- The Fed Term Auction Facility (December 2007)

- Bear Stearns/JP Morgan bailout and subsidy (March 2008)

- 325 basis points of rate cuts in less than six months and unprecedented additions of liquidity to defend them (Fall 2007 – Spring 2008)

- Primary Dealer Credit Facility (March 2008)

- Reverse MBS Swaps (April 2008)

- Fannie Mae/Freddie Mac nationalization (September 2008)

- Equity investment and collateral (September 2008)

- Administrative Repeal of 23A (September 2008)

- AIG nationalization (September 2008)

- Expansion of the Fed Balance Sheet through unprecedented Treasury refinance without appropriation by Congress (September 2008)

- Central bank dollar liquidity draws (September 2008)

- Ban on short-selling 799 financial stocks (September 2008)

- The Mother-of-all-Bailouts/Taxpayer-funded Super SIV Redux (pending)

And his assessment of how we got here:

The root cause of this dislocation in the economy has been three-fold:

1. The SEC, OTS, OCC, and OFHEO permitted firms to “lever up” at close to unlimited degree. Fannie and Freddie were operating with an 80:1 leverage ratio on their entire book of business, while in 2004 the SEC removed the 12:1 leverage limit that formerly applied to broker/dealers. Five of the seven firms covered by these two examples have collapsed due to excess leverage.

2. Permitting firms, including both investment and commercial banks, to hold assets in “Level 2″ buckets where this is no disclosure of exactly what those assets are or how their declared values are determined. Many have called this “mark to make-believe”; I call it by its more common name – fraud. As a consequence it has become impossible to determine whether any particular financial institution is in fact solvent, and, if so, what its true value is.

3. Unregulated, over-the-counter derivatives. There are scary numbers floated out there (in the hundreds of trillions of dollars or more) of “notional value” outstanding. The problem with these numbers is that they don’t represent actual amount-at-risk, and in fact nobody seems to know what that figure actually is. The lack of a regulated exchange and central clearing means that there is no margin supervision of any sort; ergo, you have no way to know if your contract is in fact good (that is, the other guy has the money.) AIG, as an example, had $500 billion of exposure outstanding in these contracts, and while this sounds somewhat reasonable when one considers they have a $1 trillion balance sheet in fact it is not because most of AIG’s balance sheet assets are committed to cover liabilities (e.g. insurance policies, annuities and the like.) The lack of margin and regulatory supervision is directly responsible for this. These derivatives have become nothing more than a fancy game of “pick pocket” where Broker “A” sells protection to Client “A” for $X, and then tries to find someone to buy that same protection from for “$X – something.” While speculation in the marketplace is fine, speculation without being able to prove capital adequacy to back up your bets is not.

Denninger’s prescription for what to do about this involves deleveraging the banks, requiring better asset declarations, and an orderly unwinding of the dervatives markets. While these directly target “on the ground” actions that will salve the house of cards, he doesn’t directly propose stimulus to the economy.

The Club For Growth condemned the bailout on September 22nd and offered ideas for stimulus as well:

“The Treasury’s bailout proposal will likely cause more harm than good,” said Club for Growth President Pat Toomey. “Instead of launching the largest government bailout since the Great Depression, the government should be implementing policies to stimulate the economy. These include, at a minimum, cutting the tax on capital gains, cutting corporate taxes, reviewing and considering repeal of FAS 57 which requires banks to mark-to-market most securities, and emphasizing the need for a strong dollar.”

Solutions like these should be seriously evaluated – and it should be done before or at least simultaneously to writing checks on the taxpayers’ account. It’s certainly time for everyone to call their Congress person’s and Senator’s offices.

Treasury is likely going to put their fingers in the dike. But it’s most important that American enterprise – specifically small business, the engine that creates jobs is unleashed as part of this process. It’s why I think that it’s now past time to adopt the FairTax legislation – do away with all Federal taxes and adopt a revenue neutral embedded consumption tax. As long as we are making bold moves – along with the unprecedented taxpayer burden being thrown into this fray – let’s finally stimulate the economy so that the working citizenry can take this economy on its back and we will all have a chance to survive.

Cross posted from Pull On Superman’s Cape.