Washington regularly moves entire cadres off the unemployed list, once they are satisfied that they have no hope of finding employment.

I could reference the latest report from the American Bankers Association, which warns that adding 6 million to the unemployed rolls has driven consumer loan delinquencies to an all-time high. The ABA notes that the number of borrowers behind 30 days or more has risen to 3.22% while the amount of money that is overdue has risen to 3.35%.

The credit card situation is even worse: 4.75% of all accounts are now delinquent, as compared to 4.52% in the previous quarter. And the balances on those delinquent accounts is up 108 basis points to 6.60% of the value of all outstanding bank card debt.

I suppose I could list the seven banks that the FDIC has closed in July. Or all 52 that failed in 2009. Or even the 80 financial institutions that have been shuttered since the crisis began back some 19 months ago.

“We misread how bad the economy was.” – Vice President Joe Biden

It would not be difficult at all to go on like this at great length.

My desk is awash in such depressing reports. I am literally drowning in ugly economic statistics. Even the spinmeisters in Washington are conceding that its “green sprouts” are shriveling up. Turns out, the situation is considerably more dire than anyone predicted, and the stimulus is not working.

Of course, Washington’s solution is to borrow even more, spend even more, regulate even more, and keep interest rates at zero for the foreseeable future, because in the end, it’s the only trick they know.

But all that generalized economic pain and degradation is not what I wanted to bring to your attention today. Rather, I wanted to point out a specific news item I have found, buried on page six as it were, that has the hairs on the back of my neck standing on end.

Bad Medicine Indeed

Remember all those awful mortgage-backed securities that were blamed for laying Wall Street low in the first place? The toxic assets that the TARP fund was supposed to buy up, except that no one could figure out how to price them or break them up, so they are still rotting away in Wall Street’s dank basement?

Guys in New York got fired for inventing them, right? Heck, guys in Asia got shot for buying them! And it seems like no one can figure out what to do about these ugly tar babies.

As the evil genius in the old serials used to say: “Maybe yes – and maybe no.”

This brings us neatly to our friends at Morgan Stanley (MS:NYSE), who are in a bit of a pickle. They would dearly like to go back to the good old days of million-dollar bonuses. In order to do that, they have to ditch their Washington nannies by paying off some $10 billion in TARP loans.

The Fly in Their Pudding

Problem is, this massive payout would cause them to come up short for the third quarter in a row, to the tune of some -32 cents a share. (Or maybe even -50 cents a share: depends on whom you ask). And then there’s all those “shriveled brown shoots” of economic overhang.

Investors want to know how the heck the bright boys at MS are gonna fill a hole like that. And if they don’t get a good answer but soon, they are going to cut MS shares in half.

But these folks are America’s best and brightest, right? So they have come up with a really cool solution. They are going to pedal off $130 million in collateralized debt obligations or “CDOs.”

Sorry about that. Let me give you a moment to wipe up the coffee you just spit out your nose.

Didn’t Kill Us the First Time, So Why Not Try It Again?

Here are the details on the scam (courtesy of a trio of investigative reporters at Bloomberg). The bonds were the result of some sort of squirrelly deal between Goldman Sachs (GS:NYSE) and a private New York outfit called Greywolf Capital Management.

As is, the horrid things were worth zilch. That is, after all, why the world’s biggest institutions have taken $1.47 trillion in write-downs and losses on CDOs and their ilk.

But with a cut here, a snip there and a little paint, and Shazam! Now you’ve got $87.1 million in AAA-grade bonds and $42.9 million in bonds Moody’s has labeled “Baa2,” a polite Wall Street euphemism for “toilet paper.”

What! You say you don’t have any faith in this magical transformation? Don’t feel bad. Neither does anyone else.

You Can’t Fix Stupid, But You Can Sell It Short

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Here is your Technical Chart for Morgan Stanley (MS:NYSE), showing the breakdown signal as traders began to head for the exits. It generously posits support at $22.63 and $20.26. A rebound off either of these levels could still be construed as bullish in the long term.

However, should this short-term drop build some real strength, a genuine fall from grace could see MS shares hit $16.12 with relative ease. And I should like to point out that a 37% drop like that could power select put options up to 191% gains.

Source: How to Dine in High Style on Shriveled Brown Sprouts

Surprisingly, two key ingredients of this turnaround formula will be structured investments, such as asset-backed securities, and leverage – the combination and poorly policed use of which acted as the accelerants that helped fuel the financial inferno that’s now sweeping the globe in wildfire fashion.

But the reality is that new U.S. Treasury Secretary Timothy F. Geithner probably realizes that he has little choice.

Nevertheless, there are problems throughout this plan, says Shah Gilani, a retired hedge fund manager and credit-crisis expert who is a contributing editor to Money Morning.

“Maybe I don’t get it because I’m not on the inside of the new Treasury fire-fighting team,” Gilani said. “But it strikes me that the part of the proposed plan to stimulate consumer loan growth by courting opaque hedge funds with an offer to lend them as much as $95 for every $5 they put up, at a giveaway interest rate, so they can buy new security pools of already overly leveraged consumers’ additional borrowing obligations, is like trying to put out a fire with gasoline.”

As Democrats and Republicans continue to tussle in Congress over a controversial economic-stimulus package worth an estimated $825 billion, Geithner will today (Tuesday) formally unveil a financial-markets rescue plan that’s going to be heavily reliant on private investors buying the “compromised” debt-backed securities that are clogging bank balance sheets like “plaque” clogs the arteries of a heart patient.

The plan Geithner is scheduled to outline represents a revamped approach to the $700 billion Troubled Assets Relief Program (TARP) announced by the Bush administration and then approved by Congress last fall. About half the money has been spent in that program, which was initially designed as a way for the government to buy troubled bank assets, but which ended up with the federal government taking direct stakes in the banks themselves.

TARP has been heavily criticized for its lack of accountability and lack of controls. As the ongoing Money Morning investigation has demonstrated, banks have used the money for everything from buying other banks to paying out bonuses – although they often refuse to admit it.

While most investors will refer to today’s proposal as another “banking bailout plan,” the reality is that fixing the banks is the end game, and not the actual strategy. The misconception is easy to understand; after all, most investors believe the credit crisis is due chiefly to a decline in lending, the truth is that this lack of liquidity is due to a decline in “securitization” – the process under which loans made on Main Street are bundled together and repackaged on Wall Street and then resold to investors worldwide as highly rated bonds.

Geithner, in a speech last year when he was still serving as the president of the New York Federal Reserve Bank, said the total value of assets in the “shadow financial system” – a system consisting of hedge funds, investment banks and financial “conduits” such as “structured investment vehicles” (SIVs) – outstripped the those in the traditional banking system as early as 2007.

That’s no surprise: Just one year before that (2006), securitization was for the first time responsible for more than twice the volume of loans being made by regular lenders, Mark Sunshine, the president of middle-market lender First Capital in Boca Raton, told Fortune.

Through securitization, a lot more credit could be created than when banks just originated loans and then held them on their balance sheets. This new reality substantially boosted the “velocity” of lending and credit growth, and provided much of the financing consumers needed to buy cars, houses and other wares.

Then came the subprime-mortgage debacle, which caused a shutdown of the shadow financial system and a virtual halt to lending.

According to First Capital’s Sunshine, between the first quarter of 2007 and the third quarter of 2008, bond issuance fell 93% in asset-backed markets, 73% in corporate-debt markets and 47% in mortgage-related areas. And without those asset-backed bonds being issued, lending dried up.

Bond issuance has “just fallen off the cliff,” Sunshine told Fortune. “The reality is that the banks don’t have the infrastructure or the capital to lend in the kind of volume to make up for the collapse of the credit markets.”

Though the problem is fairly clear, there’s no single obvious fix. When he makes his speech to unveil the latest bailout initiative today, Treasury Secretary Geithner is expected to announce a multi-pronged effort – including government guarantees of losses on some assets and greater assistance for troubled homeowners.

With Congress already angry about how much is being spent on rescue programs, Geithner must find a way to make the needed fixes, while keeping the final price tag as low as possible.

“We want to get the private sector to take responsibility for a situation that in many ways was created in the private sector,” Lawrence H. “Larry” Summers, a top economic aide to President Obama, told CNN yesterday (Monday). “If the government is going to be putting money at risk, we want to make sure somebody in the private sector is willing to take the same risk the taxpayers are being asked to take.”

Thus, to get the “shadow financial system” re-started, Obama administration insiders had to think creatively, and possibly accept a higher level of risk than taxpayers might realize or be comfortable with. That includes attracting private-sector investments – no easy task, given that the securitization market is still frozen, U.S. unemployment is soaring, and the American housing market remains in a free-fall.

“The administration is having to juggle three different chain saws,” Brian Olasov, a managing director at the Atlanta office of law firm of McKenna Long & Aldridge LLP, told Reuters. “The key question is, does the plan make it attractive for the private sector to participate?”

Geithner must generate support for a greater flow of investor funds into key areas such as the markets for mortgage-backed securities, auto loans and asset-backed bonds, Reuters said.

Olasov says plans like the U.S. Federal Reserve’s Term Asset-Backed Lending Facility, or TALF, hold great promise for jump-starting private credit flows. Under the TALF program, buyers of “AAA-rated” securities backed by credit cards, student loans and other assets can swap those bonds for U.S. Treasury securities that they can use to get new financing.
In The Fed created TALF as a $200 billion program back in November, but never deployed it, for it was too complicated to roll out that quickly.

Already, however, federal officials are considering expanding the types of securities eligible for the TALF, as well as related plans to include residential and commercial mortgage securities. That’s creating some real concern about the level of risk the federal government may be taking on, especially since the potential exists for private-sector investors to “game” – manipulate – the financial system, if the guidelines aren’t strict or specific enough, some experts worry.

Under the $200 billion TALF program, the central bank will loan money to virtually any U.S. firm that’s willing to use this government financing to buy securities that are tied to  auto, credit-card, small-business or student loans, The Wall Street Journal reported.

In other words, since the government doesn’t want to buy these securities itself, it is lending money to make it possible for professional investors to buy the securities – and in some cases is even guaranteeing payment on the loans that back these securities in order to make this happen.

Some hedge funds – the shadow-financial-system players that borrowed money to boost returns for clients – are “are lining up to get in on the Fed program, seeing a chance to make high double-digit-percentage returns with little downside using low-cost loans made on easy terms,” The Journal reported. Some Fed officials are admittedly nervous about relying on unregulated and often opaque hedge funds, but see the arrangement as a necessary trade-off to increase the velocity of lending and utlimately get capital into the hands of consumers.

“This is exactly what the financial system needs,” Andrew Feldstein, chief executive officer of Blue Mountain Capital Management LLC, a multibillion-dollar hedge fund that is gearing up to participate in the Fed program, told The Journal. “Sending help through the banking system is like sending an ambulance through a traffic jam.”

Others see big risks, however, since the program essentially combines the very same elements that led to the financial crisis in the fist place – leverage, asset-based securities, and questionable credit ratings on debt.

“Between setting up an aggregator bank to buy toxic assets that still no one has any idea how to value and setting up “foxy” hedge funds with their own henhouse of government-backed consumer-weary loan pools, it’s probable that the Treasury will succeed in bringing in private capital,” Money Morning’s Gilani said. “It’s just too bad that if the scheme actually works, it will be the rich-money hedge funds that win and if it doesn’t work, it will be poorer U.S. taxpayers that get their necks rung.”

Source: Obama Administration Must Revive “Shadow Financial System” to Revive U.S. Banks

Editors Note: This is the eighth installment of an investigative series in which Money Morning examines how U.S. banks are using federal bailout funds.