The global financial crisis started with the U.S. subprime housing market. Mortgage brokers extended credit to customers who probably should never have qualified for their mortgages. The brokers then sold those mortgages to banks and trading houses, which packaged them into blocks with other (healthier) mortgages and sliced them up to sell as tradable securities like stocks or bonds. Because mortgages normally are considered among the safest types of assets — homeowners tend to bite many bullets before failing to make their payments and becoming homeless — these securities traded at very low risk levels. As subprime borrowers began defaulting on their loans, however, those holding securities linked to the subprime market were forced to revalue their assets sharply downward. The entities most affected were Fannie Mae and Freddie Mac, two quasi-government corporations that serve as the primary packagers and holders of mortgage securities. Fear that the problems of the “twins” could collapse the entire housing industry, as the two firms hold roughly half of all mortgage debt, sparked the U.S. Treasury Department to action. On Sept. 8, with congressional approval, the Treasury took the twins into conservatorship, directly guaranteeing their bonds and, by informal extension, the mortgage credit they provided. The price tag for the action remains unclear because, so far, it has only guaranteed the debt; the true bill will only be known when the twins are fundamentally restructured. (More on that later.) But the Treasury’s action failed to stop the damage, as it was not only Fannie and Freddie who held these mortgage-backed securities. The balance sheets of traders and banks alike had been similarly darkened — particularly for those who had taken out loans to purchase the securities. The only way for banks to rationalize their books is to pay cash for the losses. This had two consequences: Banks had less cash of their own to lend, and banks that did have cash were less willing to lend to banks that had a lot of these securities. The entire lending structure of the country began grinding to a halt. Incidentally, if you are looking to blame someone for the whole mess, the majority of the fault lies with the mortgage brokers who made the loans in the first place. Nearly all of those brokers are already out of business, along with the ratings agencies that disregarded the fact that mortgage-backed securities contained elements (subprime) that degraded their value. This is where the government first intervened in a major way. On Oct. 3, President George W. Bush signed into law the Troubled Asset Relief Program (TARP), a bailout funded with $700 billion of taxpayer money. The original TARP would have seen the Treasury buy up blocks of subprime mortgage-backed assets. The idea was that if these questionable assets were removed from banks’ balance sheets and replaced with cold hard cash, the banks would look and feel healthier and start lending again. Over several years, the Treasury would leak those assets back into the markets (probably after breaking them up and reassembling them based on the quality of the mortgages) at a hefty profit. After all, these securities are ultimately based on real property and structures with innate worth. All that was what the original TARP would have done, but the law was not implemented as it was originally planned. A few weeks after the TARP was approved by Congress, the Treasury came to the conclusion that the situation was evolving too quickly for the original TARP plan to work. Simply pricing the mortgage-backed securities would take a lot of time; the securities involved were now several steps removed from the mortgages, and with banks afraid to lend to each other, the economy was stalling. Thus, the decision was formalized on Oct. 14 to evolve TARP I into TARP II. (This is a STRATFOR moniker — the Treasury refers to all variants of its efforts as “TARP.”) Instead of buying the asset-backed securities, the Treasury would instead use half of the $700 billion Congress allotted in TARP I to buy up preferred shares in American banks. Using the influence that comes with being a major shareholder, the Treasury would pressure banks into refinancing troubled mortgages and extending fresh loans to each other and to consumers. In the past 24 hours, there have been two more major developments, enacted not by the Treasury but by the U.S. Federal Reserve, which, unlike the Treasury, enjoys both policy independence and control of the money supply. First, the Federal Reserve is using its resources to take over the original idea contained in the TARP I program, launching a $600 billion package to purchase mortgages and mortgage-backed securities that started the problems in the first place. All of this funding will be applied to Freddie Mac, Fannie Mae and their immediate satellites. Because the Fed will be negotiating the terms of the debt purchase with the Treasury (the twins are currently under government conservatorship), price points will be determined very quickly. And because the Fed enjoys policy independence and control of the money supply, it will not have to go back to Congress for approval or funding. If it deems necessary, it can simply print currency to “pay” for the effort. In essence, the sticky parts of the bailout program have now been handed to the institution with the most capability for unfettered action: the Federal Reserve. Second, the Fed is using a new $200 billion credit facility to purchase AAA-rated debt — credit card debt, car loans, student loans and the like — that is currently foundering because of the dual impacts of the recession and bank skittishness. This program is less of a bailout and more of a reward for good behavior. The Fed will purchase only debt that is new; banks can swap their new loans for cash and then immediately turn around and lend again. Simply put, the Fed is offering the buy-up program as a sort of bait to draw skittish banks out of their holes. (The Treasury tossed in $20 billion for this as a sort of insurance policy.) What the government essentially has done in this admittedly confusing shell game is split the rescue program into two categories: a “good debt” management scheme and a “bad debt” management scheme. With the exception of the $200 billion AAA facility, the Fed is in charge of the bad debt — primarily the questionable mortgage-backed securities that touched off the problems to begin with. Because the Fed operates largely free of congressional and even presidential oversight, and because it controls the printing presses, it has the authority and ability to turn on a dime and make the serious decisions about how to reform or even (probably) liquidate Fannie Mae and Freddie Mac. If there is a financial loss, and there certainly will be, the Fed can handle it “off the books,” so to speak. After all, it can print currency if need be. There would obviously be negative (inflationary) side effects to this, but the impact on the government’s bottom line and the taxpayer’s pocketbook would be less direct. In turn, the good debt will go to the Treasury. Assuming Western civilization as we know it does not collapse, the government will be able to sell back the shares the Treasury purchased in the banks. In fact, profit levels for the government are actually written into the agreements with the banks. Not only will the government get the $350 billion allocated in TARP II back, it will make a healthy profit to boot — if all goes according to plan.