I have to hand it to Secretary of the Treasury, Hank Paulson. He is willing to go in front of the country and admit that he made a mistake. I was there two months ago. Soon after he proposed the idea that the only way to save the financial system was to spend $700 billion in reverse auctions to buy toxic waste from financial institutions, I became convinced it would not work.

Why? Because there was no way to put a solid price on those assets. If the Treasury bid more than they were worth to the bank, then the taxpayer would take a loss. If the Treasury bid less than what the bank thought the assets were worth, then the bank would need to write off that loss against its capital. Since it would not be able to raise more capital, the bank would become a zombie.

The question is what to do with that money now that Paulson has realized that he was wrong. So far he's given away $159 billion to 24 banks. But there's nothing to stop them from using the money to pay $26.6 billion in bonuses. I think a cull and capitalize plan would work better. Such a plan would create a smaller number of very profitable and well capitalized banks -- and get rid of the rest.

It's only been a few weeks since Henry Paulson begged Congress for $700 billion to bail out Wall Street, but Americans already seem to be coming to terms with the mountain of cash that they have had to lay out. Then again, one can only maintain self-righteous anger for so long and, with the onset of winter, finding ways to pay for heating and Christmas trumps the desire to set fire to the local bank. Still, as today's outrage becomes tomorrow's history, it is vital that America find a way to package this episode.

The first struggle has been to come up with a name for the Wall Street meltdown (I still like "Bernanke Panky"). However, as that plays out, it's time to begin finding a villain to blame. This is tremendously important stuff. For history to be written, complex events must be boiled down to a single cause, preferably an individual who can take responsibility for everything. For example, as every schoolchild knows, LBJ caused Vietnam, Hoover caused the Great Depression, and Nixon caused Watergate. Never mind that these men were the products of their ages or that history is a complex process. Children need villains, history demands explanations, and Americans crave resolution. Never mind that millions of homeowners signed up for mortgages that they couldn't pay, that millions of investors blindly purchased worthless securities, and that the groundwork for this disaster was laid by Democrats and Republicans demonstrating an impressive, albeit bipartisan, ignorance. History must be written and blame must be laid. Chances are, it will end up falling on one of the following people:

It appears from today's Senate Finance Committee testimony that Hank Paulson and Ben Bernanke are getting eaten alive on both sides of the aisle. Since the world has not ended since Sunday night passed without another weekly multi-billion bailout, it looks like their desperate pleas for unfettered authority to spend $700 billion of our money are not working.

I was just watching the hearings and Paulson and Bernanke are looking like they have no idea what they are talking about. They keep mentioning how 'market mechanisms' will help people want to buy toxic waste when such mechanisms failed before their proposed $700 billion plan. They want to hire people from Wall Street to run 'reverse auctions' which will ask banks to compete to sell their toxic waste -- whoever is willing to sell for the lowest price wins.

This is an idea that comes from Bernanke because he thinks auctions work, based on academic research. But the simple fact is that the banks will need to write down their assets and raise capital if they sell below book value. So they will not participate in the auction.

The New York Times reports that Hank Paulson's desperate plan to use $700 billion of your tax money to buy toxic waste from banks could wipe out their capital. Either that or it could saddle taxpayers with losses that could hit unprecedented levels. To avoid this unpleasant choice, I have an idea -- I call it Tax Shield Preferred (TSP) -- that could provide capital to banks that sold their toxic waste at below market prices.

And make no mistake -- that is what Paulson's plan proposes to encourage. He wants financial institutions (FIs) that hold mortgage-backed securities (MBSs) to participate in so-called reverse auctions which will reward the FI willing to accept the lowest price with a part of that $700 billion. If an FI had booked its MBSs at 60 cents on the dollar and it sold them for that price to Paulson, then if their market value was 20 cents on the dollar, the taxpayers would take that a bath on the 40 cent difference. On the other hand, if the FI sells its MBS for 20 cents on the dollar to Paulson, then the FI takes that 40 cent loss as a reduction to its capital.

To explain the significance of this, I will have to do something a bit painful -- use some numbers. For example, if an FI holding, say, $10 billion worth of MBSs on its books and $8 billion worth of capital sells those MBSs for 20 cents on the dollar, it would need to take an $8 billion loss on the sale. Technically, this would leave the FI with no capital. And it's hard to see how that would help solve the problem. This is where TSPs come in.

Hank Paulson said that "the American people can be very, very confident about their accounts in our banking system," according to AP. This means you should be very, very skeptical about the truth of that statement. And that's because there is a good chance that Washington Mutual (NYSE: WM) will fail and take the Federal Deposit Insurance Company (FDIC's) reserve fund down with it.

How so? WaMu's failure could cost $20 billion or more, and the FDIC's fund has $45.2 billion in it, according to AP. If that WaMu cost is right, no problem. Unless, as Wilbur Ross predicted, there are 1,000 bank failures before this is all over. If so the FDIC would need to raise more money to pay off all the deposits in the failed banks. But there's plenty of money available, right? Just this morning, the Treasury sold securities -- dubbed a Supplementary Financing Program -- to pay for its little $85 billion loan to buy American International Group (NYSE: AIG).

And with WaMu getting its credit rating downgraded to junk, who will want to do business with it? Will another firm want to step in and buy it before it files for bankruptcy? That would be nice because if it costs much more than $20 billion for the FDIC to rescue it, we are going to see inflation spiking as our government prints more and more money to bail out all these failed financial institutions. And that won't make Americans feel confident about their banking system at all.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns AIG securities and has no financial interest in the other securities mentioned.

Lehman Brothers Holdings Inc. (NYSE: LEH) is likely to file for bankruptcy today. The reason is that the Treasury and White House are smarting from criticism of their $29 billion bailout of Bear Stearns and the $200 billion to $800 billion Fannie and Freddie nationalization. Neither of these moves has stopped the serial sell off in the shares of investment banks and other firms saddled with crumbling real estate assets. So now the powers that be have decided that they'll tighten up their moral standards and refuse to bailout Lehman.

As I posted, the basic problem is that Wall Street thinks the Treasury will cave in and put money into the Lehman bailout. But despite reports of a proposal to hive off the good part of Lehman from the bad part -- financed by other Wall Street banks -- such a resolution does not appear likely. That's because Wall Street does not want to risk its slim capital shoring up Lehman's bad part -- $85 billion worth of commercial real estate and mortgage-backed securities (MBS). These banks rightly fear that they would lose their investments and sink the entire industry in the bargain. In addition, these bad bank financiers don't want to provide the backstop to enable the winner of the bidding on the good bank to surpass them by picking up Lehman's assets cheaply.

Assuming that plan does not work and that the government refuses to step in to finance the bad bank, this leaves two basic options: Lehman files for bankruptcy or other banks liquidate Lehman in an orderly fashion. Bankruptcy might be a relatively orderly process. According to FOXbusiness, "if Lehman entered into bankruptcy protection, the brokerage units would enter Chapter 7 liquidation and a court-appointed trustee would liquidate the firm's assets and give customers back their money. Generally, securities a customer holds at a brokerage firm are legally the investor's property, and aren't exposed to the claims of the firm's creditors." A bankruptcy would likely wipe out Lehman common shareholders.

With its stock down more than 40% in pre-market, I am getting the same sickening feeling I had during that week in March when Bear Stearns' stock made its swan dive into an empty swimming pool. As I said yesterday on CNBC's Power Lunch, investors seemed disappointed that Lehman Brothers Holdings Inc. (NYSE: LEH) had not actually closed any capital raising deals.

Now Lehman -- which lost 7% yesterday -- was down over 40% in pre-market. That's because four analysts "widened loss estimates and cut price targets for Lehman," according to Reuters. And Art Hogan of Jeffries & Co. said that Lehman's best hope -- its plan to auction 55% of Neuberger Berman, may not work. "We are not even sure that the auction process for 55 percent of their asset management group is going to work because the people that win the auction need to find the money to buy it," he told Reuters.

I would not be surprised if Hank Paulson is now wondering why he ever took the job of Treasury Secretary. If Lehman stock keeps dropping 40% a day, there won't be much left by the end of the week. I have to believe that there are all sorts of people on Wall Street wondering whether they simply can't take the risk of continuing to do business with Lehman. And if that happens, Paulson will need to decide whether to let it fail, force a merger or bail it out.

It looks like Halloween could be coming early to Wall Street this year. Thanks to the Treasury Department's announcement of a plan to bail out Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), it looks like the week could be starting off with pain for investors. That's because although their common and preferred stock will continue trading throughout the period that the government runs them, those issues will lose much of their value.

Much of the plan is consistent with what was leaked yesterday: firing the CEOs, replacing the boards, and putting the companies into conservatorship. The details that are new today have to do with the balance sheet restructuring that will take place. Bloomberg News reports the following key elements:

• Senior preferred stock. A new class of stock will be created that earns 10% dividends and gets access to the cash from these companies ahead of any other investors. Bloomberg wrote, "Treasury will receive $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie and Freddie. The government will receive annual interest of 10 percent on the initial investments."
• Forced liquidation of mortgage holdings. The plan forces Fannie and Freddie to reduce their mortgage holdings dramatically over the next several years. Bloomberg reports, "As a condition for the assistance, Fannie and Freddie will have to reduce their holdings of mortgages and [mortgage-backed securities (MBS)]. The portfolios shall not exceed $850 billion as of December 31, 2009, and shall decline by 10 percent per year until it reaches $250 billion."
• Quarterly capital injections. Depending on the net worth of Fannie and Freddie each quarter, Treasury will purchase more senior preferred. "The Treasury will purchase up to $100 billion of senior-preferred stock in each company as needed to maintain a positive net worth. It will also provide secured short-term funding to Fannie, Freddie and 12 federal home-loan banks," according to Bloomberg.

Three weeks after Barron's reported that a senior administration official -- my guess is it was Hank Paulson -- leaked details of a "rescue" plan for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) -- Bloomberg News reports that its implementation could be imminent. And in after-hours, shares of both companies are down 20%. If what Barron's reported -- wiping out common shareholders and slashing preferred dividends -- proves prescient, both stocks have further to tumble -- as in all the way to 0.

Bloomberg reports that Paulson met with Ben Bernanke and the CEOs of Fannie and Freddie and the head of the Federal Housing Finance Agency which oversees the two. And they have catering set for the entire weekend. I wonder what they are serving? I think PIMCO bond guru Bill Gross knows. He said, "There's probably a 95 percent chance that the moment that something will happen is Sunday or Saturday," according to Bloomberg.

Yesterday Gross called for the government to use $500 billion to bail out the real estate market. As I posted yesterday, this bailout is for the benefit of people like Gross and China's central bank which owns $340 billion worth of Fannie and Freddie mortgage-backed securities. If you happen to be among the holders of their common or preferred stock -- you are going to lose it all. As I suggested this morning, after the market lost 345 points yesterday, the government needed to announce another rescue plan by Sunday night.

Since China owns $1 trillion worth of U.S. Treasury bonds and $340 billion of mortgage-backed debt, when China gets a cold, the U.S. catches pneumonia. And -- as I posted -- when we think about the $800 billion bailout bazooka for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), we should remember that our money is going to help China out of an investment jam. But since we are at China's mercy, it may be self-help.

This comes to mind in reading the New York Times, which reports that China's central bank, the People's Bank of China, has kept its capital modest as it has gobbled up assets. Now it seeks a bailout from China's finance ministry. According to the Times, "those [$1 trillion worth of U.S.] investments have been declining sharply in value when converted from dollars into the strong yuan, casting a spotlight on the central bank's tiny, [$3.2 billion] capital base [that] has not grown during the buying spree, despite private warnings from the IMF."

This need to replenish capital puts the U.S. economy in the middle of a bureaucratic battle on the other side of globe. The People's Bank wants a stronger yuan while the finance ministry wants a weaker yuan. The Times writes that "as the yuan slips in value, China's exports gain an edge over the goods of other countries." Treasury Secretary Paulson has been on the side of the People's Bank, advocating for a stronger yuan, so his push to bail out Fannie and Freddie can be seen as using U.S. taxpayer money to help it in its battle with China's finance ministry.

BBC News reports that another hedge fund has closed down thanks to its failure to bail out of the oil speculation trade that boosted oil to a peak of $147 in July. This is yet another piece of evidence that people like Hank Paulson, who insisted that record oil prices were due to supply and demand, were either being less than honest -- particularly since his former employer Goldman Sachs Group (NYSE: GS) was a big beneficiary of this speculation -- or ignorant of reality.

The hedge fund in question this time is Ospraie Fund, which invested in commodities like oil and gold. It "has lost 38% of its value since the start of the year." Gold is down 22% to $800 from its $1,030.80 an ounce high in March. Oil has tumbled 25% to $109 since peaking in July, according to BBC News. But 1440 Wall Street suggests that the biggest commodity culprit in Ospraie's demise was copper's tumble. The lesson here is that if a sufficient number of big money speculators get together and decide to, say, short the dollar and go long commodities, there will seem to them to have safety in numbers.

But when the government started investigating the cause of spiking oil prices, the trade got very unprofitable very fast. As I posted, the Commodities Futures Trading Commission (CFTC) recently found that 81% of oil trading volume was driven by speculation. Then we witnessed the failure of SemGroup and the indictment of Optiver Holding for manipulating energy prices -- those funds who were too slow to reverse their positions and got creamed.

The New York Times reports that since we've had such a catastrophic run with home mortgages, it's time to watch the collapse of commercial ones. The same names surface when it comes to the collapse of our financial system -- in the case of commercial mortgages Deutsche Bank (NYSE: DB) ($25.1 billion), Morgan Stanley (NYSE: MS) ($22.1 billion), Lehman Brothers (NYSE: LEH) ($40 billion in commercial mortgages and property), and Citigroup, Inc. (NYSE: C) ($19.1 billion) are among the biggest holders. They are also big names in Auction Rate Securities (ARS).

Why do people think that commercial real estate could be tanking? Here are four reasons:

• Declining property prices. The Times reports that the Moody's/REAL Commercial Property Price Index has dropped 12% since its peak last October.
• Commercial mortgage write-downs. According to the Times, Morgan Stanley reported commercial mortgage write-downs of $400 million and Wachovia (NYSE: WB) said it would take at least $1 billion worth of such write-downs.
• Potential Riverton default. The Times reports that Riverton, a 1,230 unit Harlem development, was premised on the idea that developers could convert "lower-priced rentals to apartments priced closer to the higher market average." But the Times reports that Monday Fitch "issued a negative watch on part of the Riverton Apartments trust" since the developers had not made much progress -- threatening commercial mortgages that Citi and Deutsche Bank hold.

Upset about paying $3.80 a gallon for gasoline? Hank Paulson, former Goldman Sachs Group (NYSE: GS) CEO, argued that it was all supply and demand so quit your bellyaching. I thought speculation was playing a big part -- traders who bought oil and sold the dollar to drive up the price. Indeed, a few months agao I found a source who thinks 60% of the volume was from speculators.

Seems even that was too low an estimate. The Washington Post reported Wednesday that the Commodities Futures Trading Commission (CFTC) has analyzed the books of oil traders and calculated that 81% of oil trading volume was conducted by speculators.

Guess who broke open the opportunity for oil speculators to trade oil in a loosely regulated fashion? Goldman. The Post reports that In 1991, its J. Aron unit argued that "it should be granted the same exemption given to commercial traders because its business of buying commodities on behalf of investors was similar to the middlemen who broker commodity transactions for commercial firms."

Henry Paulson is maneuvering himself into the history books by forcing Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) into a spiral of doom from which they can't recover. He had plenty of help from the directors and executives who sit atop them. But it's becoming clear that since Saturday's Barron's article, laying out the path to failure, events are spiraling out of Fannie and Freddie's control.

The anonymous senior government source in the Barron's article said that unless Fannie and Freddie could raise at least $10 billion each, the government would bail them out while wiping out common shareholders and eliminating the preferred dividend. This would lead to a sell off of bad loans, a split into smaller pieces, and maybe selling those pieces back to the public. All these activities are a government gift to Wall Street, which will get to do all these deals.

Events are following this predicted pattern as Fannie and Freddie struggle to raise capital. The New York Times reports that investors are not enthusiastic about the most recent efforts to raise capital by Freddie Mac. It reports that on Tuesday, Freddie Mac raised $3 billion in five-year debt but the "1.13 percentage points [premium] over the rate the federal government pays for comparable borrowing" was more than double the "0.6 points" premium it paid earlier in the year.

The Associated Press reports that the House passed a bill that will increase the amount of debt available to buy houses. In the process, it will make the U.S. a much riskier place to invest. That's because when a country's debt tops 60% of its Gross Domestic Product (GDP), lenders consider it a risky credit. The House bill will lift the U.S.'s ratio to 75%. And the dollar will continue to plummet.

Of course, the bill is not being sold that way. Instead its stated goals are to help 400,000 people with foreclosures and to save Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Here are six key provisions according to AP:

• Puts distressed real estate on the government's books - Provides $3.9 billion in grants for "devastated neighborhoods" -- a provision the White House hated since it looked like the S&L bailout's RTC, that Bush I approved.
• Gives Paulson unlimited Fannie/Freddie bailout power - Gives the Treasury Department an unlimited line of credit to bail out Fannie and Freddie and to buy an unspecified amount of their stock.
• Creates new debt for drowning borrowers - Lets 400,000 foreclosing homeowners refinance into more affordable, fixed-rate loans backed by the Federal Housing Administration (FHA).