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 is spending this morning on the talk show circuit trying to scare up $700 billion of our money. And he wants that money by tonight. Not only that, but he wants to be able to spend it without anyone ever being able to question his decisions. Paulson and his colleagues have already thrown $800 billion at the problem and that didn't work. So what's the big hurry? And exactly what does he think will happen if he doesn't get the money?

This administration has a penchant for secrecy that seems to be at odds with how a democracy is supposed to work. For instance, a judge ordered the vice president to retain records that he was planning to destroy. There is a small chance that he has done things in office that he doesn't want anyone else to know about. Meanwhile, Section 8 of the Act Paulson is pushing so hard to pass says "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." In other words he wants absolute power and complete secrecy.

As I explained to janelanaweb.com, Paulson perceives that the global financial system will cease to function unless he gets his money. Now the New York Post provides a little detail from anonymous sources -- which if true -- could help shed some light on what's irking Paulson. According to the Post, if the Fed had not injected $105 billion into the money markets on Thursday, the Dow would have dropped 22% to 8,300. That's because, "money market funds [which have $3.4 trillion in assets] were inundated with $500 billion in sell orders prior to the opening," according to the Post.

Historians are likely to look back on this week as one of the most significant in American economic history. This was the week that the government let Lehman Brothers Holdings Inc. (NYSE: LEH) fail -- a record $639 billion bankruptcy, lent $85 billion to keep American International Group (NYSE: AIG) from collapsing, and pumped $300 billion into global financial markets to keep them from seizing up. But that turned out not to be enough to keep the markets afloat -- for that Hank Paulson needed the ultimate bailout.

While I don't remember much of the American History I studied in high school, one thing sticks with me today. It always seems that it takes a major crisis to get America to make big changes. It is never possible for leaders to foresee problems and take action to avert them before they turn catastrophic. The averting catastrophe approach always struck me as far smarter than the crisis approach. However, it seems that lawmakers need tangible evidence of prior bad outcomes to make the case that the status quo is deeply flawed and must change.

While he had already loosened up $800 billion in taxpayer money by Wednesday, Paulson needed an even scarier story to get Washington to agree to an additional $500 billion to create an agency to buy illiquid assets from financial institutions. What exactly did he tell Congress and the president to scare them into agreeing to this plan? AP suggests that he described evidence of the global financial market ceasing to function and painted a frightening picture of the economic and political chaos that would ensue if that functioning ceased for an extended period of time.

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.

Hank Paulson is keenly aware that his Goldman Sachs Group (NYSE: GS) and Treasury predecessor, Robert Rubin, helped save the market by encouraging the then-head of the New York Fed to force Wall Street leaders to team up to save Long-Term Capital Management's collapse from taking down the financial markets. Just as George W. Bush needed to recap Iraq, so now does Hank Paulson need to recap that famous meeting in lower Manhattan.

Bloomberg News reports that the meeting -- which took place yesterday afternoon -- involved a rogues gallery of Wall Street executives coupled with Paulson and New York Fed president Tim Geithner. The message these regulators delivered was reportedly a simple one: "You need to solve your own problems, and we're not going to provide any more capital." But Wall Street -- as represented by the likes of "Citigroup, Inc. (NYSE: C)'s Vikram Pandit, JPMorgan Chase (NYSE: JPM) 's Jamie Dimon, Morgan Stanley (NYSE: MS)'s John Mack, Goldman's Lloyd Blankfein, and Merrill Lynch & Co., Inc.'s (NYSE: MER) John Thain" -- are convinced that the Fed will blink when it comes to the 158 year old Lehman Brothers Holdings (NYSE: LEH).

Bank of America (NYSE: BAC) reportedly wants to put in a bid for Lehman contingent on getting government help -- such as the $29 billion JPMorgan got in its Bear Stearns acquisition and its nationalization of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). After these two precedents, Paulson now wants to reverse himself. He says Lehman is different because people have known it was in trouble for a long time and it can access the Fed's discount window. But I think this could just be a little show for the President who is worried about how this will look to history. He may not realize that he has already opened the Pandora's Box of moral hazard and can't shut it now.

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.

Now that we know Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are likely to cost taxpayers as much as $800 billion in a government bailout, I thought I'd provide some background on how we ended up in this mess. Here goes:

Fannie and Freddie buy mortgages, bundle them together, guarantee the payments, and sell them to investors. Between the two of them, they control 43% of the $12 trillion mortgage market -- or $5.2 trillion worth of mortgage-backed securities.

In the last year, with housing prices in free fall and foreclosures spiking, they've lost $14.9 billion between them -- about 0.3% of those assets. And at the end of June, they held $84 billion in capital -- $12 billion more than the $72 billion regulators require, according to Bloomberg News. Do these conditions warrant radical government action?

The government thinks that they do. As I posted, yesterday, Treasury Secretary Hank Paulson is likely to announce a plan to put Fannie and Freddie into conservatorship. The government will run them and will wipe out the value of the common shares and slash the value of their preferred stock.

Plus, it will dismiss the executives and board members of both firms while doling out as much as $800 billion -- spread out in chunks to be determined each quarter based on what the government thinks Fannie and Freddie need to keep functioning.

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

And now what could become history's biggest transfer of tax dollars to bail out bad lending begins. Last month Congress passed a bill that gave the Treasury Department $800 billion to bail out Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). And while it is unclear how much money will be used to bail them out, the general outlines of the soon-to-be-announced terms are becoming clearer than they were last night.

The New York Times and The Washington Post report on five key features as follows:

• Government bankruptcy. Fannie and Freddie will be taken under a conservatorship -- which is similar to a bankruptcy wherein a trustee operates the company so it can be fixed and ultimately sold back to public investors. The bailout would reduce the value of their common and preferred shares "to little or nothing," according to the Times.
• Taxpayers bailout defaulted mortgages. Some share of the $800 billion in taxpayer funds will be used to pay "any losses on mortgages [Fannie and Freddie] own or guarantee," according to the Times.
• Payouts on a quarterly basis depending on reported results. Treasury is trying to dribble the bailout over time. "Instead of giving each company a big capital infusion up front, the government could make quarterly injections as the companies' losses warrant. This would be an attempt to minimize the initial cost of the rescue," according to the Washington Post.

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.