Paulson says we’re over the worst. Meaning – the worst is yet to come.

This from the guy who said over and over again – no, things are great. Things are fine. Nothing to worry about – right until his call turned into OMG WE’RE ALL GOING TO DIE UNLESS YOU GIVE ME ALMOST A TRILLION DOLLARS RIGHT FRACKING NOW!

Now Treasury Secretary Paulson says that we’re over the worst and things will get better.

This said while another 50,000 jobs are lost from the economy and the big three automakers might be about to collapse. Sure, Paulson. All better now. Right.

It’s not just $700 billion – there’s $2 trillion more in the bailout. Surprise!

It seems that the $700 billion bailout isn’t just $700 billion. Turns out the Treasury has also been issuing $2 trillion in emergency loans – without telling anyone whom they’re too, what collateral is being issued, or anything useful.

Ms. Naomi Klein, who’s book “The Shock Doctrine” you should be reading right now if you haven’t already, breaks the news that the Bush administration is doing to crazy shenanigans – and the Democrats aren’t blameless either:

Yes, there is only one president at a time, but that president needed the support of powerful Democrats, including Obama, to get the bailout passed. Now that it is clear that the Bush administration is violating the terms to which both parties agreed, the Democrats have not just the right but a grave responsibility to intervene forcefully.

I suspect that the real reason the Democrats are so far failing to act has less to do with presidential protocol than with fear: fear that the stock market, which has the temperament of an overindulged 2-year-old, will throw one of its world-shaking tantrums. Disclosing the truth about who is receiving federal loans, we are told, could cause the cranky market to bet against those banks. Question the legality of equity deals and the same thing will happen. Challenge the $140 billion tax giveaway and mergers could fall through. “None of us wants to be blamed for ruining these mergers and creating a new Great Depression,” explained one unnamed Congressional aide.

More than that, the Democrats, including Obama, appear to believe that the need to soothe the market should govern all key economic decisions in the transition period. Which is why, just days after a euphoric victory for “change,” the mantra abruptly shifted to “smooth transition” and “continuity.”

Yes, there’s only 60 days until we get President Obama and a new cabinet – but at the rate the Bush administration is trying to rob the taxpayer piggy bank, will there be anything left?

Focus on the Bailout Part I: Why the Old Stuff Don’t Work

Let’s get this out of the way: people aren’t sure if the bailout is working or not. It’s only been a few weeks, and let’s face it – a crisis almost a decade in building isn’t going to be fixed in two weeks.

On the other side, we’ve been seeing companies using the bailout money as their own personal piggy banks to give bonuses and stock dividends. And, in a weird way, I can hardly blame them.

You see, if you haven’t noticed, things are kind of in a mess. So let’s have a quick sit down about why it’s a mess, why some things that are going to be tried aren’t working – or just aren’t going to work at all, and what we can do to ride it out.

How did we get into this mess?

Probably the three quickest methods is to check out How SubPrime Really Works in stick figures, and the very well done This American Life Show: The Giant Pile of Money and their follow up, Another Frightening Show About the Economy.

Now, that should take you about 2 hours and 15 minutes to go listen to and digest. Come on back when you’re done.

(Meanwhile, I get a pedicure. My toes are so pretty!)

Ok – got it? So here’s where we went wrong: instead of just offering mortgages to people who had the chance to afford them, financial institutions started going crazy because:

1. They had a new way of offering investments that were free of government control.
2. The housing market would always go up!
3. People were taking out loans to invest in strange insurance like systems that (again) weren’t regulated, set up that if one piece fell, the whole thing did.
4. The sub-prime market fell. And then – the whole system fell apart.

Now, I’m not going to go into the whole why’s and hows – you’ve listened and read all of that already. But let’s talk about why the bailout might not work the way we hope it will.

So – What was the Bailout Plan Again?

If you remember, when the Treasury Secretary Paulson bailout was first proposed, it was submitted in about 3 pages – practically the back of a napkin – and it went something like this:

Holy Frack everything is going to crap! We need some money, we need a lot of it, or else we’re going to die! And whatever you do, don’t ask me what I’m going to do with the money, or ever let the courts ask what I’m going to do with it! Oh, man – somebody hand me a paper bag, I’m about to get sick. Oh – and I’m going to use the money to buy up all of those really bad, toxic assets out there.

Since then, things have changed. The bailout bill went under some revisions throwing out the “golden parachutes” of CEO’s, and putting some limits on Paulson’s power. And over time, Paulson’s plan has also changed – first he hinted he’d look into buying some stock instead of those bad assets, into deciding you know what, screw the toxic assets – I’m just buying stock from now on.

So why the shift? What happened to buying up those bad mortgages and trying to help people through the bad times? What happened to trying to prevent the collapse of the housing market?

What happened was: Paulson realized that the situation was way more complex and dirty than he expected. And that there may be no good way out.

Problem 1: Liquidity

Companies run on cash, and credit. There’s money always coming in, there’s money going out. There’s money you expect to come in, so you use a line of credit to tide you over until the money comes in, then you pay off your debt and do it all over again.

The problem right now is that companies – and we’re talking huge, multi-billion dollar companies, can’t use lines of credit. Banks are hardly lending to each other, terrified if they loan out money even to another bank, that it’ll disappear. So if you’re a company, and you want to build a new factory, or hire a bunch of new workers – you’re stuck. You can’t do anything, because you don’t have the cash (especially as nobody’s buying anything in a bad economy), and you can’t get a line of credit.

But – there is one other way to earn some money: stock. Stock serves two purposes: it spreads about ownership, and it raises capital. Two two ideas are always competing with each other. Issue too much stock, and you could find your company owned by your competitor, or worse, a corporate raider that just splits you up and sells off your pieces, leaving you without a company any more. Issue too little when you don’t have a line of credit, and watch your competitors run away with the profits because they invested while you fiddled.

So the last thing you want to do is issue a bunch of stock to raise capital if you an avoid it, because then people can own your ass. Maybe it’s best just to sit on it a little while, wait until things get better. Problem is, if everybody does that at once, the economy doesn’t go anywhere.

And then – along comes an angel! An angel with wings of money! Paulson comes down and says “Financial institutions – here is some money! Take it, and use it to shore up your cash reserves! Go forth and lend again, so businesses may have lines of credit to build factories and pay employees! Go! Go and lend!”

Which, as it turns out, these financial institutions just aren’t going to do. They’re going to offer dividends on their stock, so people holding the stock will continue to hold it, and the financial institution has enough cash to just survive until the financial crisis passes. Or perhaps they have enough to buy up other companies in trouble who are in trouble.

See, no matter what, these companies still own those bad assets. They can’t get rid of them, because nobody wants to sell them. And they can’t raise enough money just off the stock.

So – why isn’t Paulson buying up those bad sub-prime mortgages, the ones that were bundled up and sold as those bundles for investors (as in the “Giant Pile of Money” you read about up above).

Why doesn’t Paulson buy up the sub-prime mortages? Because – he can’t.

Why Paulson Can’t Buy Bad Debt

Let’s try a simple thought experiment. Suppose there’s a bank, and you want to get a mortgage. It’s a pretty simple arrangement. The bank, after checking your credit, your finances, how much money you make, how much you can deposit, decides to offer you a mortage loan for 25 years. Every month, you pay them $1000. By the end of the loan, you’ll have paid $300,000 – on, say, a $200,000 house.

Back in the 1930’s, when there was a problem with mortgages, Franklin Roosevelt was able to set up a government owned and run company that bought mortgages from banks. If you couldn’t pay your mortgage, then this new organization – called Fannie Mae (you may have heard of them) would show up, see if you had a chance to pay off the mortgage at a better rate or a lower principle amount, and then make an offer.

In this case, the government might go to the bank and say “Look, you have the ownership of this house. This person can’t pay the terms right now, and you know the housing market is so bad, you’re not going to sell this houses, and when you do, you’re not going to get the value out of it you once did. In the meantime, you’ll be paying the property taxes, paying to maintain the place – it’s just not worth it for you. So, we’ll give you $150,000 on a house you originally bought for $200,000. You at least get some money out of it.” Then they go to the current occupant and say “OK – you’re in trouble. We’ll give you a loan for $150,000 instead of $200,000, and you can pay us $750 a month.”

Everybody has a chance at winning. The bank at least gets something when they were about to get nothing. The home owners gets a place to live, and if things work out, they keep their house. The government, if they made a good bet, actually can make a profit off of it – taxpayers get their money back, and if it doesn’t work, well, they can sell the house off themselves.

That’s how it worked in the late 1930’s, and for a time, a lot of houses were saved from foreclosure. So you may be asking – why don’t we just do that now? Why doesn’t Paulson just start buying up these bad mortgages?

Because: he can’t. Things changed with the creation of those mortgage investment bundles.

Here’s how it worked now (I’ll refer back to that Sub-Prime mortgage market explained with stick figures). A bank gave loans to people that turned out to be pretty credit unworthy. And they didn’t have to worry about it – they just sold the banks to an investment firm, which packaged them all up as an investment.

So here’s this bundle of 1,000 mortgages, with 100,000 people owning shares. Which means that everybody owns a piece of all of the other mortgages. Every mortage is owned by 100,000 people, each holding a tiny piece.

Now, negotiate. Go tell that 100,000 people that you need to buy that one mortgage, because that person is going to foreclose. How are you going to get the majority of 100,000 people to agree that their share of the bundle of mortgages should be reduced.

Yeah. Just try that one. And no investment firm is going to entertain the idea, because if they told their investors “hey, guess what – I’m going to reduce the share of your stock” – people are going to bail on it like crazy.

The Rock and the Hard Place

So what does Paulson, or any other future treasurer, do? Sure – you could just take the libertarian “Ron Paul” approach, let the whole system collapse in a meltdown, allow hundreds of thousands of people to lose their homes and savings, and let the entire system collapse.

Or you could keep trying to reward massive failure, and feed the financial system that caused the problem – and doesn’t have the scones to dig themselves out.

Which is why I’m going to propose a third way. This crazy idea called –

Wait until tomorrow morning, and I’ll tell you.

Hey, Banks – forget the taxes! Love, Paulson

In a move that may not be legal (but hey, it’s an emergency, who cares about the law, right?), the US Treasury has privately moved to change 20 years of tax law to give banks another $140 billion. But what about that legality issue:

“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.”

Now we know why Paulson’s original bailout request came on 3 pages and said “Don’t question everything I do, bitches.”

How the Paulson meeting with banking heads went – duck!

Evidently, things didn’t quite go all that well when Treasury secretary Paulson met with banking heads. Let’s say some of the CEO’s were a little, uh, angry.

Gee, I guess I’d be angry if I had wasted billions of dollars and had to get bailed out. Yeah. I’d be totally steamed about that. You know? Or maybe I’d be on my knees thanking God himself for a second chance to save my company.

Then again, that’s just me. Because I’m not an irresponsible prick who lost billions of dollars while giving myself and other executives bonuses.

Paulson wants all of the bank heads in one room at once

Treasury Secretary Paulson has called for a meeting with all of the bank heads to discuss the bailout plan. Yeah – like that’s not going to be awkward at all.

The question is, will he stage a takeover a la the scene with Jack Nicholson in Batman, or is this going to be more of a “I say, old chap, could you pass the cheese?”