It seems that there is a problem with our financial system. That could be why Bear Stearns collapsed, the government took over Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE) and American International Group (NYSE: AIG). This problem could also explain why Merrill Lynch sold out to Bank of America (NYSE: BAC), why Lehman Brothers went bankrupt, and why JPMorgan Chase (NYSE: JPM) bought Washington Mutual (NYSE: WM). Problems with our financial system could also explain why the Commercial Paper market is freezing up -- making it harder for companies to come up with the short-term cash to pay employees and buy inventory.

But how did our system get to this point? There are five key principles of our current financial architecture that brought us here:

• Securitization. Up until about 30 years ago, people took out mortgages from an S&L and paid their loan officer every month until they owned their house. In the 1980s, Wall Street invented securitization -- the process of buying up, say, 1,000 mortgages from mortgage companies, creating a security based on those mortgages, paying for a AAA rating, and selling the securities to investors worldwide. Securitization is a problem for reasons I'll describe below.
• Too much borrowing. Over the last several years, Financial Institutions (FI) have made some $2 trillion in fees from securitization, according to DealBreaker. One reason for this is that they have been able to buy these securities -- of which there are $13 trillion on the market between Mortgage-Backed Securities (MBSs) and Collateralized Debt Obligations (CDOs) -- with a sliver of capital, roughly $340 billion. The typical FI had a ratio of assets to capital of 30:1. This meant that a mere 3% decline in the value of these securities would wipe out all the capital.

Picture an industry where you raise capital then assertively invest that capital to the tenth degree, highly leveraged.

What's more, you take large risks, investing in one speculative project after another, sometimes in regions of the country that are showing signs of a loss of economic momentum.

And all the while, you collect a handsome fee for each investment project.

Even better, if the investments work out, you're enormously profitable, and a large bonus heads your way by the end of the year.

And if the investments turn out to be foolish and don't work out? Noooo problem. Noooo problem at all: the U.S. government will step in and take over your business, make peace with your business's creditors and share holders, while you're free to take on an executive post in another corporation.

Does the above remind you or any business/sector you know. Yes, that's right: it's the U.S. banking sector as currently configured.

Bloomberg News reports that the price tag for the bailout being discussed this weekend in Washington just went up another $200 billion. That's if you believed the initial $500 billion estimate bandied about yesterday. According to Bloomberg, the plan will be broken into "$50 billion tranches which would last for at least two years" and would "accept mortgage-backed securities [MBS] and collateralized debt obligations [CDOs]." Since there are $13 trillion such securities out there -- I am not sure whether $700 billion will be enough to buy them all up -- unless this agency buys them at a steep discount.

That $700 billion price tag will increase the national debt ceiling to $11.3 trillion, that's more than double where it was in 2000 and it represents 80% of U.S. GDP. Why is that important? Because in international banking circles any country whose debt exceeds 60% of GDP is considered at risk of not being able to pay back its debt. So the U.S. is surely turning itself into one of the riskiest borrowers in the world. Thus it's too bad that the rest of the world seems to be entirely dependent on what happens here for the global economy work.

And it wouldn't shock me to wake up Monday morning that that $700 billion having hit $1 trillion or more. As the saying goes, when you owe a bank $100,000 and can't pay it back, that's your problem. But when you owe that bank $5 billion and can't repay, it's the bank's problem. That's the way the rest of the world must feel as the U.S. goes out to the beg the world to buy another trillion dollars worth of our national debt.

The head of the Senate Banking Committee has indicated that the U.S. Federal Reserve has the authority to create a new 'debt fund' to buy, warehouse and dispose of distressed / bad debt resulting from the subprime mortgage crisis.

"The Fed has the authority to move in this area," U.S. Sen. Chris Dodd, D-Connecticut and chairman of the committee, told Bloomberg News.

Many economists and analysts argue that a step integral to stemming the cycle of foreclosure / housing price decline / bad bonds / stock run / collateral call / bankruptcy is for a special agency to buy up and strategically restructure, then sell, distressed / bad assets. Economist Peter Dawson is one of those economists who favors the tool.

"Ideally, you'd like to have a private-sector consortium of banks or other financial institutions to coordinate the effort, but right now there aren't exactly a lot of banks stepping up to the plate to take a swing," Dawson told BloggingStocks Thursday. "There's a considerable amount of fear in the market, frankly, and banks are hoarding cash. If this remains the case then we'll need a public sector effort to put this new institution in place."

Barron's (subscription required) reports that the news this week about Auction Rate Securities (ARS) leaves $220 billion worth of the $330 billion market still frozen. Those among the two-thirds of ARS holders who have not gotten any good news must have mixed feelings -- happy that some of their colleagues have the potential for relief, but wondering when they will get their money back.

The ARS market is complicated because the securities were issued in many different forms. Barron's reports that these issuers include "municipalities, closed-end funds, student-loan trusts and collateralized debt obligations [CDOs]." Many of these issuers have announced little, if any relief for those frozen in ARS hell. For example:

• Municipal ARS market has fallen 40% from $175 billion to $105 billion since the beginning of 2008 and only "5% to 8% of muni auctions are proceeding -- at interest rates of 8% to 15%."
• Closed-end funds have reduced the amount of ARS outstanding by 37% from $64 billion to $40 billion. For example, Nuveen's closed-end funds sold $500 million of variable-rate demand-preferred shares (VRDPs) last week to replace the same amount of ARS. (VRDPs' interest rates reset in auctions but have a put option that allows an investor to sell the VRDP to the bank running the auction if it fails). Barron's thinks that if the VRDP market functions, "more than 50% of closed-end-fund ARS could be redeemed" by the end of 2008.

Barclays is expected to receive a $927 million capital investment from Japan's Sumitomo Mitsui Financial Group as part of a plan to restore depleted capital, Bloomberg News reported Friday.

Barclays (NYSE: BCS), the United Kingdom's fourth largest bank, has been hurt by write-downs stemming from the end of the U.S. housing boom and subsequent mortgage and related asset-backed bond defaults.

Barclays' shares fell $1.29 to $24.28 on the news in Friday morning trading.

London-based economist Mark Chandler told BloggingStocks there are three positives stemming from the announcement. First, banking regulators in the U.K. will view it as "a coming to terms, something markets around the globe will also appreciate." Second, it demonstrates that investors "are still willing to jump into the pool and commit capital for less than ideal ventures, so you can see how the markets will look favorably on that." Chandler added that he does not have a rating on nor own shares in Barclays.

Japan's banks: capital to deploy

Finally, Mitsui's commitment to a bank abroad indicates that Japanese banks have repaired the worst of their balance sheets. "A Japanese bank would not commit funds abroad if their balance sheet was not solid," Chandler said. "Japan's banks have rebuilt their businesses, and are in better shape than they were a decade ago. Unfortunately, I'm afraid it looks like the world's bank concerns have shifted to the U.S. and U.K. for this decade."

Like water-torture, the drip, drip, drip of bad news out of Wall Street keeps coming. According to a report in The Wall Street Journal, Merrill Lynch (NYSE: MER) will report mortgage securities write-offs of another $6 billion to $8 billion, raising the question whether the firm will have to bring in more money by selling shares..

The newspaper reports that "The latest would bring its total since October to more than $30 billion and mean that Merrill reports a third straight quarterly net loss." Merrill compounded its problems by getting further into the CDO markets as 2007 went on.

While some experts believe that the worst is behind big banks and brokerages, that may not be true. The paper based on mortgages still carries risk as the housing market continues to fall.

Statements from Wall Street firms about a near-term recovery is a victory of hope over reason. The truth of the matter is that they have no idea how much more the economy will slide. That raises the question of whether home equity loans, credit card debt, and auto loans will begin to fail at a faster rate. There are securities held by banks based on pools of all of this debt. The value of LBO debt could also continue to drop as business profits are squeezed by a poor economy.

The Merrill write-down is a sign of one thing and one thing only. Wall Street's numbers could get much worse and there is little reason that the economy will help them get better.

Douglas A. McIntyre is an editor at 247wallst.com.

With the Fed rumored to be contemplating a rare 100 basis point rate cut, it's worth considering whether this policy is doing any good. I'd say those rapid rate reductions are doing more harm. Here's why: non-stop interest rate cuts make business lose confidence in the Fed – since those cuts are ineffective – while signaling that economic conditions are desperately bad or that the Fed is panicking and unable to fix the problem.

I think the problem is that banks and other owners of Collateralized Debt Obligations (CDOs) and other asset backed securities have not accounted yet for the true loss in value of these securities. Therefore corporations and others that deal with the banks don't know whether those institutions are solvent. The solution would be to write down the value of those assets and then recapitalize the banks to the extent of the write downs.

While the non-stop interest rate cuts do not solve what's ailing the credit markets, they also accelerate inflation. This causes businesses to hoard their money because they expect that it will be worth less in the future. In effect, the Fed is creating very high inflationary expectations which creates a very high hurdle rate for investments – and in a slowing economic climate, there are not many investments that can earn a high enough return to get green-lighted.

Nobody knows why the market rose 416 points yesterday. But The New York Times reports that the Fed made an extraordinary move yesterday -- it offered banks $200 billion for a month -- letting them use Collateralized Debt Obligations (CDOs) as collateral for the loan. This inflationary move helped drive oil to $109.72, up 357% since 1/19/01 and cut the dollar declined to one Euro to $1.5469, down 68% since 1/19/01.

But beyond the inflationary impact of the move, there's less here than meets the eye. Certainly, the surprise effect might have forced investors who had a short position to cover by buying back shares. That short-covering may have had a snowball effect. But there's also this -- if banks take those $200 billion off their books, there's still $6.1 trillion worth of CDOs on the market. And what will happen to those $200 billion worth of CDOs at the end of the month?

But there is an interesting twist -- the Fed claimed in a conference call with reporters that it was minimizing risk by accepting only securities that still had the highest triple-A ratings and that they would impose a discount, on mortgage bonds that appear to carry additional risk. If there is any meaning in those AAA ratings then the banks will end up pledging their highest quality securities as collateral and retaining more of the dodgy ones.

It seems as though every week, the public is forced to learn another one of Wall Street's strange names for a surefire deal that couldn't miss. But the reason we're learning about those strange names is because -- contrary to promises -- the can't miss deals are shutting down -- taking Wall Street's credibility down along with them.

The latest of these is auction rate securities (ARSs) -- a $330 billion market for long-term bonds that are supposed to pay lower rates because their interest rates are set through auctions. The New York Times reports that municipalities who issued ARSs are suffering because 1,000 of these auctions failed and instead of paying 3% interest rates, they have to pay 20%. And if that wasn't bad enough, the investment banks that oversee these auctions are refusing to let investors withdraw their money.

Which investment banks are imposing this pain? Goldman Sachs Group (NYSE: GS), Merrill Lynch (NYSE: MER), and Lehman Brothers Holdings (NYSE: LEH) and the problem with ARSs is not limited to municipalities entities such as the Port Authority of New York and New Jersey. Closed-end mutual funds, student loan companies and corporations also issue them.

Reuters reports that this morning's futures markets point to a 251 point drop in the Dow. Unfortunately, Fed Chairman Ben Bernanke's rate cuts over the last several months have had the perverse effect of making the market fall. Unlike Alan Greenspan, whose moves put a floor under the market -- the Greenspan Put -- as I posted earlier in the month, Bernanke's moves put a ceiling on the market below which it keeps falling -- the Bernanke Call.

The basic idea here is that Bernanke cuts rates in response to a crashing stock market. And while it generally recovers in response to that cut, that response is temporary and the market continues marching down. Here's a brief summary:

• September 50 basis point cut. After the Dow plummets 244 points last August, Fed cuts 50 basis points in September to 4.75%. Market rallies 979 to its October 12 high 14,093.
• October 25 basis point cut. Between October 12 and October 19, 2007, the Dow drops 571 points so Fed cuts rates 25 basis points on the 31st and the Dow falls an additional 541 points by November 23rd due to disappointment with the lower than hoped for cut.
• December 25 basis point cut. Between November 23 and December 7, 2007, the Dow rises 645 points to 13,625 -- I have no idea why, but on December 12, the Fed cuts another 25 basis points to 4.25% and the market is again disappointed -- the Dow falls 1,526 points to 12,099 by January 18, 2008.

Although short selling -- the practice of selling borrowed shares with the hope of repaying the loan by buying back the shares at a lower price -- goes against the American belief that stocks always go up, I have long been fascinated with it. Short Stories discusses what works, what doesn't, and what some of the leading lights in shorting stocks think about its opportunities and threats. I describe possible short trades and seek your comments and questions for story ideas. I don't offer any investment advice and I don't trade on any of the posts I write.

Alesco Financial (NYSE: AFN) looks like it will have trouble coming up with the money to repay its debts. This Real Estate Investment Trust (REIT) uses borrowed money to buy into the alphabet soup of securities -- such as Collateralized Debt Obligations (CDOs) and Mortgage Backed Securities (MBSs) -- that could cost Wall Street up to $400 billion in write-downs. With 22% of its float sold short, many investors have already figured out that Alesco, at $3.28, is on life support. But it pays a 31 cent a share dividend, for a 9% dividend yield -- 36% if it was annualized (but I doubt Alesco will be able to continue to pay it) -- which those short sellers are willing to pay because they think the stock has further to decline.

The question about whether to sell short this stock revolves around whether Alesco can pay off its $11.2 billion in debt. Here are some factors to consider:

• Debt repayment. In its most recent annual report of March 2007, Alesco said it was on the hook to repay $3.6 billion It owed in less than a year and then nothing in the intervening years and in more than five years it would owe $6.8 billion. If it has already paid off the $3.6 billion it could be OK. But its most recent quarterly report said it had $91 million in cash so if it owes more than $91 million in the next few months, it could be in trouble. And it's already dedicated $19 million of that cash to dividends.

The research arm of Goldman Sachs (NYSE: GS) is predicting that Citigroup (NYSE: C) will have to cut its dividend by 40% due to CDO write-offs of $18.7 billion. Goldman believes that Citi will need the cut to raise $6.2 billion in additional capital.

According to Bloomberg, the Goldman report said "It will be a couple of quarters before the current credit crisis is fully digested by the markets."

Keeping the dividend high makes little sense. The yield on Citi's stock is now over 7%. But, very few investors would put money into such risky shares to get a long-term high yield. An announcement of more significant trouble at the big bank could certainly drop the shares another 10% or 20%, making gains from the dividend appear modest.

Citi is no longer a stock that investors look to for a pay-out. It is a volatile investment which could gain a stockholder 30% over a quarter if the company sold a large division or had better-than-expected earnings.

Cut the dividend to get some dry powder.

Douglas A. McIntyre is an editor at 247wallst.com.

Last week, Citadel Investment Group, a Chicago hedge fund, bought E*Trade Financial (NASDAQ: ETFC)'s collateralized debt obligation (CDO) portfolio for 27 cents on the dollar according to The Wall Street Journal [subscription required]. If this price was applied to the Level 3 assets of nine of the largest banks, it would wipe out the capital of three of them.

It's important to point out, before presenting this analysis, that the 27 cents on the dollar price that Citadel paid applied only to E-Trade's CDOs. It may represent a worst case scenario price for these banks. Furthermore, the Level 3 assets of these nine banks include other illiquid securities besides their CDOs. Finally, the calculations I'll show are based on the most recent Level 3 assets and equity of these banks as of last month.

Having said that, here are the three banks whose capital would be wiped out if that 27 cents on the dollar valuation was applied to their Level 3 assets and written off from their most recent capital levels:

The Dow lost 237 points today according to The Associated Press. The stated causes?

• The HSBC bailout of $45 billion worth of SIVs
• Citigroup Inc.'s (NYSE: C) announcement that it would fire as many as 45,000 people
• The Fed's announcement that it would inject $8 billion worth of liquidity -- in the form of short-term loans -- into the financial system

The daily explanations of market movements are not really that meaningful. But I am inferring three very disturbing messages from these market moves:

• There are serious unrealized losses in the banking system as a result of their holdings of Collateralized Debt Obligations (CDOs) and Mortgage-Backed Securities (MBSs) that nobody wants to buy.
• The banks may not have enough capital on their books to take the big bath write downs needed to account accurately for these bad assets.
• The banks and the government are hoping that if they can stall for time long enough, the problem will take care of itself.

The market will keep dropping until these messages are no longer true. This could take years to clear up.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup shares.