The past few days my head has been spinning. If you’re like me, then you’ve probably been reading everything you can get your hands on to understand how we went from Treasury Secretary Henry Paulson’s assertion that, “Everything’s under control” to “We need 700 billion dollars now, or we’re headed for financial Armageddon.”

So what gives?

First, let me clearly state that I support Secretary Paulson’s attempt to save us from ourselves. Something needs to be done. With deregulation, Wall Street has been gaming the system for too long, but there are many issues here beyond the play in the media about limiting the golden parachutes that failed executives are bound to receive.

What sent a ripple of panic through everyone paying attention last week is that money markets, which are supposedly super safe, were suddenly at risk. This is important because it was the first indication that the chaos was spreading. See, apparently the financial industry is all interconnected, and while the experts have told us since early 2007 not to worry, it’s now apparently time.

This whole crisis reminds me of Hurricane Katrina: I remember watching the weather reports from four days out and hearing that it was on course for New Orleans, but no one thought much about it. Just another crazy looking storm that hit Category 5 out in the ocean. What’s that mean anyway? . . . well, I guess we found out.

With this situation, any average real estate investor knew that something was rotten at the banks. But hey, it’s a free unregulated market, right?

I find it interesting how the administration says one week that, “Things are just fine” and then suddenly reverses course the next and shouts, “The $#!% is hitting the fan!” Somehow I just know they knew all along. So why wasn’t anything done sooner? Well, that’s a topic for another time.

Then over the weekend I began hearing about a new villain suddenly on the horizon…something called a credit default swap, that combined with sub-prime lending and a blind faith in deregulation has brought our financial kingdom to its knees.

Credit default swaps are a type of insurance that are written and sold mostly by financial institutions like banks, but also companies like AIG. What they do is insure against possible default by an issuer of debt. They’re written as a contract . . . and are not securities. More importantly, even though they act as insurance they’re not, and therefore are not regulated.

Banks saw the premiums that they could collect as another revenue source, and the only way they could get into trouble with them is if the financial industry collapsed. They never thought that they would have to pay them off. When things went from bad-to-worse with the sub-prime crisis, banks attempted to raise additional money, but many either fell short or are now tapped out.

By the way, the estimated amount of credit default swaps is 62 trillion.

For the past few weeks, Treasury Secretary Henry Paulson has been attempting to perform triage on various financial companies whose failure is already but radical shifts in American capitalism (say goodbye to investment banks). Last week we crossed that line.

Do you know what investment banks are? Here’s the short version: They borrow money and then re-invest it at a higher rate (hopefully) trying to make a spread between the two. This differs from commercial banks – the brick and mortar ones – who take in cash deposits, like cds, checking deposits and savings deposits and then re-lend that out at a higher rate (ie: mortgages and HELOCs). Commercial banks have CASH backing. Investment banks have debt backing –– which is some very unstable footing.

Paulson’s request is notable for many reasons, first because no one knows if it will work. He’s looking for any way to stop the bleeding and quickly buying bank debt and allowing them to get healthy is the only way that he and Fed Chairman Ben Bernanke see as a possible solution. What’s striking is that they are “hoping” to head off disaster by providing this bailout, but nothing is guaranteed: No one really knows what’s going to happen…

Also, no one really knows what the cost is going to be.

And what about the dollar? It use to be that we would bail out other countries (Mexico and Japan come to mind), but these days it’s us . . . And such a bail out will make us vulnerable by raising questions about the worth of government bonds. In effect, with inflation comes a decrease in our buying power, and foreign countries might decide that the dollar is no longer attractive as a tool to secure their interests.

So what’s on the table is a 700 billion dollar bill to the taxpayer to bail out some banks that got too fat and happy, and that should’ve known better. For most of my life I’ve been told numerous times that a free market will provide its own regulation . . . after all, no one wants to fail. Yet, in our country, we have no problem privatizing profits and socializing costs. (Remember my report a few weeks ago about the failure of Fannie and Freddie). Why am I told again and again that government is always the problem, except when it’s needed to do something only a government can do?

It begs the question, do free markets really correct themselves? In my lifetime I haven’t seen it, but it sounds good doesn’t it? A lot of people made a lot of money knowing that there wasn’t anyone to answer to… I suppose that they thought that they “were pulling themselves up by their boot straps” while taking advantage of the system.

For our 700 billion we will get not one guarantee, not one assurance that those issues that led to this crisis will be resolved, nor will there be any oversight on the deal that Paulson cuts with the banks.

Hmmm . . . no regulation. Have I seen this before?

Remember the junk bond idea and the S & L crisis 20 years ago. It looks awfully familiar to what’s going on right now and proves that we cannot regulate ourselves without government intervetion. Something needs to keep our greed in check: Greed cannot be regulated by the individuals who profit from it.

Here’s the point: If there’s no oversight by Congress or the courts for the buyout…how do we know that we are not overpaying? In fact, based on previous experience, I’m willing to bet whatever is left in my stock portfolio that we will overpay. After all, the guys that are leading this charge understood that corporations were gaming the system and undermining capitalism . . . but the money was too good to resist and doing anything would’ve reshaped the political and economic landscape. And they knew this in 2002!

So what’s the big deal?

We haven’t yet paid for a nearly trillion dollar war, and now this on top of 70 million Baby Boomers retiring (most without adequate retirement funds), rampant medical costs, an aging infrastructure, burgeoning energy needs, failing schools, collapsing fisheries, etc. It’s a terrible confluence of events that will take American ingenuity and money, lots of it, to get us where we need to go. Weren’t we told several years ago that we’d be getting a trillion dollar surplus? What happened?

Listen, as short sale investors we know how the banks work. We know that banks do nothing for anyone outside of their own interests. They’ve always fought regulation . . . and they have powerful lobbyist that in an election year will be spending money and calling in their chips to get what they want. The banks are going to want to sell as high as they possibly can as a way to avoid further write-offs; the taxpayer will want to buy as low as possible to get a good deal. There are lobbyist scurrying all over Capitol Hill as I write.

However, there’s a gleam on the horizon, and if the House and Senate can come to a sensible agreement –– one that the lobbyists are sure to dislike –– then we may see the goverment find a solution through the use of a REVERSE AUCTION.

Here’s how it will work: The government will say we have 150 billion to put in play this quarter and we are going to buy 150 billion dollars worth of bad debt. The banks are going to have to line up a say, “We have 500 million we want to unload.” The government will reply that, “Whomever will sell their bad debts for the lowest amount is the stuff we’ll buy.” The theory is that out of desperation the banks will scurry to sell their stuff off at the lowest amount possible, thereby giving the government (i.e. the tax payer) the best deal possible. The government can turn around and re-sell these bad debts (i.e. houses) for more because the government can hire professionals to liquidate the stuff they just bought and they can do it over time and not at a fire sale price.

From a taxpayer perspective this sounds like a reasonable strategy. The banks get CASH FAST. The government buys at reverse auction prices (the lowest prices) and then the government may actually make a profit by selling to the open market (to investors like us) who can make some money fixing these houses up and either renting or flipping them to a retail buyer. This may create an opportunity to buy government owned REOs at steep discounts which could create a good deal of business for those of us in real estate investing.

With deregulation, Wall Street has been calling the shots the past twenty years, and because of this the American capitalist system is being remade before our eyes. We’ll find out in the next few days what, if anything, has been learned.