- Henry Blodget at Clusterstock says this will turn the US Treasury Department into the world’s biggest private equity firm, which is actually a good idea:

These potential changes are actually positive, but they still don’t address the elephant in the room: writedowns.

Historically, the most successful financial system bailouts have done two things:

• Recapitalized banks (by injecting capital)
• Forced banks to write down asset values to nuclear winter levels, thus staving off the need for future writedowns (and, in so doing, encourage private investment).

It is hard to believe that, say, Citigroup has written down its $546 billion of on-balance sheet consumer assets to nuclear-winter levels, let alone the off-balance sheet ones. Thus, any new investor will likely get its equity wiped out by future writedowns and additional capital. This is a major deterrent to investing in Citigroup.

The new TARP modifications will deal with this to some extent by forcing financial institutions to raise private capital alongside the government money. Private investors, presumably, will be more concerned about preserving their capital than the government will be and therefore won’t invest unless the banks have written their assets down appropriately.

Forcing banks to raise private capital will also get the government out of the business of picking winners, which has created the potential for unfairness, corruption, and a whole host of perceived improprieties, as well stoked the fires of senators like Chuck Schumer who complain that the taxpayer money is only going to healthy companies, not the ones who need it most.

- Of course, this isn’t stopping a lobbyist frenzy at the Treasury Department. The New York Times reports that the department “is under siege by an army of hired guns for banks, savings and loan associations and insurers – as well as for improbable candidates like a Hispanic business group representing plumbing and home-heating specialists. That last group wants the Treasury to hire its members as contractors to take care of houses that the government may end up owning through buying distressed mortgages.”

- Despite commodities traders’ brief surge in optimism over China’s $586 billion bailout, oil is down below $59 a barrel – a new 18-month low.

- Gold isn’t faring much better. An ounce of the stuff is now selling for $733 this morning.

- For those of you worrying that were experiencing another depression, David Levy in Institutional Investor says we’ll get one, all right, but it will be “contained” by government intervention. The following extract was picked up by Kedrosky at Infectious Greed:

Without the government’s containment the economy would indeed ace another Great Depression, but fortunately, nothing so dire will occur. The government will prevent a collapse of the financial system and partially buffer the damage to the economy, containing the depression. The government will succeed not because it is wise about economic affairs or because it won’t make mistakes. Rather, it will have no choice but to keep patching holes in the financial sector, and its sheer size and presence guarantee a sizable fiscal stabilization. The government has virtually unlimited power to intervene to protect the basic functioning of the financial system, and in an emergency can spend whatever is necessary. Although government solutions will not fix the fundamental problems that will cause the depression, they will limit the financial fallout. By the end of the contained depression, the government will likely have committed trillions between rescue operations and running huge deficits. And although some may complain about the price tag, it will be a bargain for enabling us to avoid another Great Depression.

- Levy’s theory is predicated on the rather absurd notion that the US has “virtually unlimited power to intervene to protect the basic functioning of the financial system.” According to a report on CNBC that “virtually unlimited power” might be a lot more limited than Levy imagines.

The United States may be on course to lose its ‘AAA’ rating due to the large amount of debt it has accumulated, according to Martin Hennecke, senior manager of private clients at Tyche.

“The U.S. might really have to look at a default on the bankruptcy reorganization of the present financial system” and the bankruptcy of the government is not out of the realm of possibility, Hennecke said.

“In the United States there is already a funding crisis, and they will have to sell a lot more bonds next year to fund the bailout packages that have already been signed off,” Hennecke told CNBC.

In order to solve or stem the economic slowdown, Hennecke suggested the US would have to radically reduce spending across all sectors and recall all its troops from around the world.

- The wrangling between Bush and Obama comes in the wake of news that GM’s shares tumbled to 1946 prices, closing down 23% to $3.36, as analysts downgraded the stock on worries it would soon run out of cash and shareholders would be wiped out by any federal bailout.

- GM has 263,000 workers worldwide. If it does go under, that’s a hell of a lot of people joining dole queues.

- This, of course, would have disastrous consequences in the US, where unemployment rates are spiraling. If you take the U6 count of unemployed, which includes “marginally attached” workers and those who are employed part time for economic reasons, unemployment in the US is now at 11.1%, up from 7.9% last year at this time.  According to Karl Denninger on The Market Ticker:

While this is not in “Depression” territory the trend is especially bad, the revisions are stunning, and we haven’t even had an official recession declared yet.  With more than one in ten people who want a full-time job unable to get and hold one along with the rest of the economic outlook things are definitely getting worse and the only light I see in the tunnel is an oncoming bullet train.

- Or take this humdinger from John Crudele in the New York Post:

Each month Washington adds many thousands of jobs that it believes – but can’t prove – are being created by newly formed companies.

The logic behind this calculation – which is called the birth/death model – is as simple as it is extraordinary: even in a horrible job market and during a credit crunch as we have today, Washington believes courageous entrepreneurs are forming businesses and hiring people.

The October report – the one that reported the 240,000 loss of jobs – includes a guess that 71,000 of these uncountable, new-company jobs were created.

Included in those 71,000 made-up jobs are 7,000 that were supposed to have been created in construction and 13,000 in “financial activities.”

- Job losses are also reaching alarming rates in China. Paul Kedrosky on InfectiousGreed.com notes that 2.7 million job losses in Guangdong province alone in last seven months.

- Even more worrying is the impact China’s $586 billion bailout plan could have on the US Treasury market. To finance its plan, China “could have sell its holdings of U.S. Treasury and agency securities or slow its rate of accumulation in these securities,” according to MarketWatch.

China holds roughly $1 trillion of U.S. securities, including $541 billion of US Treasurys and $200 billion in agency securities, according to Miller Tabak.

Massive selling of those securities, at a time when the US government is already expected to issue large amounts of debt to finance its own economic stimulus measures, could further raise borrowing costs, such as mortgage rates, which are benchmarked to bond yields.

There’s only $60 billion left of the first $350 billion tranche of what was once known as the Trash Asset Removal Plan (and is now known as the only pot of available money in the world). So many companies of all shapes, sizes, and flavors are demanding cash that Treasury can barely process the requests. Congress will presumably order the Treasury to immediately begin doling out the second $350 billion, which, a few months ago, was seen as a sort of “just in case” reserve fund. No more.

- Italy may be the next country to ‘rescue’ its economy with taxpayers’ money. According the The Times the Italian government was working on plans over the weekend to pump as much as $26 billion into its biggest banks.

- Uncle Sam is about to bailout AIG from its bailout. Apparently, the original handout was too tough on poor old AIG. So now its going to get a sweeter deal. This from the WSJ:

The U.S. government reached a deal Sunday night to scrap its original $123 billion bailout of American International Group Inc. and replace it with a new $150 billion package, according to people familiar with the matter.

While the arrangement stands to considerably ease terms on the faltering insurer, it gives the government an unprecedented role as an actor in financial markets. It could also spark a political backlash, especially from congressional Democrats, because the Treasury, while adding to its AIG obligations, has thus far refused to extend a hand to the struggling Big Three auto makers.

- According to Infectious Greed blogger Paul Kedrosky, AIG “is serving as a kind of orifice via which the global credit default swap system pushes out its collateral calls, and it is forcing the U.S. government (read: you and me) into levering up on the other side. As long as asset prices keep falling, increasing the amount of collateral required in AIG’s ‘policies,’ these calls will keep coming, making AIG’s liabilities – and therefore ours – frighteningly open-ended.”

As Milton Friedman once put it, ” Nothing is so permanent as a temporary government program.”

- Of course, the story of AIG’s demise and its now near “zombie” status – it now relies on taxpayers’ money to stay afloat – is replete with ironies. AIG’s immediate problem is that it is neck deep in credit default swaps (CDSs), which it now must cover. As George Soros points out in the December issue of the New York Review of Books, the same administration that let the $50 trillion market for CDSs go “entirely unregulated” is now essentially left on the hook for these instruments.

Take for example credit default swaps … instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.

- Turns out Hank Paulson gave his bank pals and even sweeter deal than was oringinally reported under the terms of the $700 billion bailout bill. This from The Washington Post:

The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal. But they have worried that saying so publicly could unravel several recent bank mergers made possible by the change and send the economy into an even deeper tailspin.

“Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no,” said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. “They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks.”

The story of the obscure provision underscores what critics in Congress, academia and the legal profession warn are the dangers of the broad authority being exercised by Treasury Secretary Henry M. Paulson Jr. in addressing the financial crisis. Lawmakers are now looking at whether the new notice was introduced to benefit specific banks, as well as whether it inappropriately accelerated bank takeovers.

It sure does pay to have friends in high places…

- All of this is small potatoes next to the Fed’s spiraling loan portfolio. Accoridng to Addison Wiggan and Ian Mathias at The 5 Min Forecast:

Ben Bernanke’s balance sheet expanded to a record $2 trillion this week — $2.058 trillion, if those billions even matter any more. That’s more than twice its size at this time last year.

The Fed’s loan portfolio is so bloated, we hardly know where to begin: Average DAILY bank borrowing from the Fed exceeded $359 billion last week… the Fed’s Commercial Paper Funding Facility has nearly doubled, and now holds $243 billion in “no one else will buy it” cooperate debt… primary dealers and brokers are running a $71 billion tab… AIG still owes $81 billion… it just keeps going and going. Over a third of the balance sheet is made up of some sort of bank loan or toxic asset.

Who’s paying for it? The U.S. Treasury has set up a supplementary funding account with the Fed, which is fueled by T-bill sales. That fund now exceeds $558 billion.

– “The once unthinkable prospect of zero interest rates moved closer to reality yesterday,” says The Times. “Interest rates going to zero in our heroic struggle to become Japan,” says Henry Blodget on Clusterstock.

– Even Japan is racing to become the next Japan. Today, Japan announced it’s joining the global bailout bonanza. Prime minister Taro Aso says he will pump $275 billion of public funds into world’s second-largest economy. This will go toward expanded credits for small businesses and a cash payback to every household.

– Uncle Sam is also considering spreading more government-funded love around, too. This from the NYT:

Senior Bush administration officials are discussing a plan that could help up to three million homeowners struggling to pay their mortgages to stay in their homes, three people briefed on the proposal said Wednesday.

The initiative could be the most sweeping government effort directed at mortgage borrowers since the financial crisis began last year. Under the plan, the government would agree to shoulder half of the losses on home loans if mortgage companies agreed to lower borrowers’ monthly payments for at least five years, according to the people briefed on the plan who asked not to be named because details were still being negotiated.

– U.S. stock futures pointed to strong gains this morning ahead of data that will likely show that GDP is contracting — further evidence, if any were needed, that Mr. Market doesn’t give a hoot about the ‘real’ economy. Yesterday the Fed handed the market another rate cut. And there’s nothing the market loves more than a rate cut…all that easy money to play with.

– “Talk about priming the pump for the next bout of excessive exuberance,” says a commenter on Paul Kedrosky’s Infectious Greed blog. “If the next big problem isn’t hyperinflation, it will mean that we have crashed and burned. I believe there is a movie called No Way Out that basically says it all! Nothing good can come out of where we are at the present moment economically.”

– We’re already seeing a massive rally in commodities, just one day after the Fed cuts. “Gold, crude oil and corn extended the biggest surge in commodity prices in five decades on speculation interest rate cuts in the U.S. and China may revive demand for raw materials consumption,” reports Bloomberg.

The Reuters/Jefferies CRB Index of 19 raw materials jumped 5.9 percent yesterday, the most since at least 1956, when the data begin. The index is still down 24 percent this year. China, the world’s largest industrial-metals user, trimmed interest rates for a third time in two months, and the Federal Reserve slashed bank borrowing costs in the U.S., the biggest oil user, to 1 percent.

– Yesterday, the Dow surged 11%. It was the second-largest gain in the the history of the index (all 112 years of it). Before you pop the champagne corks, it’s worth remembering that despite yesterday’s show-off surge Dow indsutrials are still 36% off their October 2007 record close. That puts U.S. blue chips deep in bear territory.

– While analysts desperately pour over their charts and numbers in search for a bottom in stocks, economists are on the lookout for a turnaround in the U.S. economy. It’s not looking promising. This from the WSJ:

The current downturn is shaping up to be worse than the recessions of 1990-91 and 2001 and the prolonged downturn that ended in 1982. Banks are cutting back on lending, consumers are spending less, companies are shedding jobs amid sinking profits, and the housing bust that triggered the slide persists.

According to the paper, economists are focusing on five key indicators: 1) interbank lending rates such as Libor; 2) house prices; 3) consumer confidence; 4) jobs; and 5) stock prices. So far, only interbank lending rates, which have been greatly boosted by government bailout money, are showing signs of recovery.

– Take consumer confidence. Yesterday, the NYT reported that the Conference Board measure of consumer confidence, a widely wathced measure, “plunged to its lowest reading on record in October as Americans reported fewer jobs and smaller incomes and curtailed plans for major purchases like cars and appliances.”

– Or take U.S. housing, which to a large extent influences how American shoppers feel about spending. (The more money their house is worth, the more money they are willing to spread around.) According to AP:

Home prices tumbled by the sharpest annual rate ever in August, with little indication of a turnaround in sight, a closely watched index showed Tuesday.

The Standard & Poor’s/Case-Shiller 20-city housing index dropped a record 16.6 percent from August last year, the largest drop since its inception in 2000. The 10-city index plunged 17.7 percent, its biggest decline in its 21-year history.

– Another great way to measure economic woes is the so-called “misery index.” According to Infectious Greed blogger Paul Kedrosky, “The Peterson Institute has brought back the ‘misery index’, a combination of the inflation rate and the level of unemployment, and added to it a measure of asset price declines. The upshot? The modified misery index is now at record highs.”

– At least the government’s on the case. Cafe Hayek blogger Don Boudreaux argues, however, that this could actually be sinking the markets, rather than helping:

We now have proof that government is a god that failed — a poverty-inducing and economically destructive institution that humankind should finally learn must be kept on an extraordinarily tight leash, lest it wreak havoc in the lives and on the fortunes of innocent parties.

The facts are crystal clear.  Since the March 24 promise by the Fed to guarantee $29 billion worth of mortgage securities held by Bear, Stearns, the Dow has fallen 34 percent (as of mid-day on October 28, 2008).  Since the September 8th announcement by the U.S. Treasury Department that it will take over Fannie Mae and Freddie Mac, the Dow has shed 28 percent.  Since the October 3 enactment of Uncle Sam’s massive bailout bill, the Dow is down 20 percent.

Our instincts say Don is right. The problem with this argument, however, is that cause and correlation are two different beasts. Are the markets plunging because of the government bailouts or are they simply plunging after after the government bailouts?

– Eric Roseman on ContrarianProfits says Swiss money manager Felix Zulauf attributes America avoiding worse pain to the recent bailouts:

Zulauf believes we’re entering a soft economic depression. If not for the government’s backstops on October 13 to prevent further stock and credit market seizures, a depression would have followed. Zualauf is convinced the markets would have crashed.

Zulauf may believe in the power of government to positively influence the markets, but his outlook isn’t exactly rosy for U.S. stocks:

His prediction of a severe recession will take the S&P 500 Index down all the way to 550, possibly 500, or 35% lower from current levels. Stocks have already plunged 40% from their October 2007 highs. Zulauf is adamant: “U.S. stocks are still not cheap. The S&P 500 Index trades at 1.7 times book-value and the Dow more than 3.5 times book. This is still expensive.