From a practical standpoint it is not necessary to go over the details of the current bailout as there really is only one thing that matters: the condition of the banks. The US banking industry, in aggregate, is facing bankruptcy and the Fed has made large sums of money available to US banks so that they can meet their reserve requirements. Yet this is the least discussed bailout to date, perhaps precisely because it lies at the heart of the problem.

The current aggregate reserve requirement of all US banks is $40.75 billion and the banks are collectively borrowing $267.86 billion from the Fed, or 657% of the reserve requirement, to post those reserves. According to John Williams of shadowstats.com, when banks had to borrow 46% or their reserve requirements in March 1933 President Roosevelt declared a bank holiday and closed the banks. No wonder Henry Paulson literally went down on one knee last week to beg Democratic leaders not to derail the bailout plan he put on the table.

The banking system, and by extension the money it creates, is insolvent by design and only functions when the public has confidence and trust in banks. The importance of this concept cannot be over-stated. Please read the May 16th letter, Confidence and Trust, if you have not yet done so. Banks are insolvent by nature because they borrow short and lend long, and if the confidence in banks is shaken their fragile world can collapse very quickly. Several banks in the US and Europe have already gone under and it is precisely because confidence in US banks is in question that Paulson, Bernanke and Bush are begging, threatening, coercing, and doing whatever is necessary to instill some confidence in US banks again.

Over 70% of banks’ liabilities are depositors’ accounts. The other 30% is money that the banks borrowed. Their assets are mortgages, car loans, credit card debts, etc. The value of these assets declined but their liabilities did not, and when this happens shareholders’ equity has to decline by the same amount as their assets decline. But because shareholders equity is much smaller than the value of the assets, even a relatively small decline in asset values can wipe out their entire shareholders equity.

US banks have about $11 trillion in assets, of which approximately 11% is shareholders equity. So banks have roughly $1.2 trillion in equity. Their reserve requirements are only $41 billion, or 3.7% of their equity, and yet they cannot come up with the $41 billion in cash they need to deposit at the Fed for their required reserves. Instead, they have borrowed $267 billion from the Fed.

As Bernanke explained, the $700 billion that Henry Paulson is asking for is not a number plucked out of thin air. It represents the 5% estimated loss rate of the approximately $14 trillion of residential and commercial mortgage debt. The rub is that it implies that the Treasury is proposing to absorb the entire loss, which is in stark contrast to the plan they’re trying to sell Congress.

As a smart guy once remarked, “White man speaks with forked tongue.” Paulson, Bernanke and Bush are trying to make it sound as if they are going to buy up to $700 billion worth of mortgage assets, hold them to maturity, and recoup their invested capital. According to them, if there is a loss, it should be much less than $700 billion since they would still own the underlying assets. This might be true in the sense that there are real assets behind those mortgages. However, after factoring in the time value of money there is no way that tax payers are not going to take a loss.

Bernanke described the plan as “designed to avoid forcing banks to sell or value their mortgage assets at a ‘fire sale’ price.” It seems clear that they intend to buy the toxic waste at book and take the losses instead of letting the banks take those losses.

The Treasury has to do this because if the banks had to write off $700 billion, 58% of their aggregate shareholders equity would be wiped out. They are already borrowing $267 billion, or 22% of their equity, to meet their reserve requirements and therefore can hardly afford another big knock right now.

The draft proposal that was released early Sunday explicitly calls for protection of taxpayers’ money and for taxpayers to share in any potential profits realized. How exactly they are going to achieve these remains to be seen. It also limits the initial bailout to $350 billion with Congressional review for any additional funding.

If the funds are used to buy mortgages at their current market value, which is pennies on the dollar, it would force the banks and other financial institutions to recognize the losses immediately, which means their shareholders equity will evaporate and the bailout would have failed. So this is clearly not the plan.

If the funds are used to buy the debt at book, thereby removing the losses from banks’ balance sheets, it could go a long way to restore confidence in the banking system. That explicitly means that taxpayers are taking the current write-downs and the potential real losses if those mortgages don’t perform, and it’s unlikely that they will perform since roughly two million homeowners could face foreclosure over the next year.

The current plan also calls for possibly reducing the principal amount on some mortgages and changing the payments schedules for those facing foreclosure, at the expense of US taxpayers. To me this sounds like a bailout for both banks and reckless speculators who bought homes they couldn’t afford in the hope that they would be able to flip them in a few years and make a handsome profit. There is no more justification for bailing out reckless real estate speculators than there is for bailing out banks.

There is also no way the Treasury can bail out both the banks and speculators with taxpayers’ money without one of the three taking a hit. Regardless of what lawmakers agree to in the end, the bailout can only achieve its objective if the money is used to buy non-performing mortgage assets at close to book value, which implies taxpayers are left with the risk and the potential losses that banks otherwise would have had to accept.

If the bailout is adopted, the worst of the toxic waste will be removed from the banks’ balance sheets, thereby stemming the decline in bank equity. That would hopefully put the banks in a position to start raising new capital.

After the change in regulations allowing investment banks, like Goldman Sachs and J.P. Morgan to become bank holding companies, they were both able to raise additional capital. Warren Buffett’s Berkshire Hathaway invested $5 billion in Goldman Sachs and J.P. Morgan is selling $10 billion in new stock.

You can basically ignore everything that is happening in Washington, but keep an eye on whether the banks can raise new capital. If they continue to raise capital, as Goldman and J.P. have done, then the worst is behind us; but if they don’t, then there is much to fear in the financial sector.

The Fed has not stoked inflation with its bailouts so far; the current Treasury proposal is not inflationary per se. The most urgent problem is that banks need additional equity and if they can raise equity the markets will calm down. Then all we have to deal with is the inevitable slowdown in economic growth. On the other hand, if the banks cannot raise new equity, there will be real trouble ahead. Bernanke and Paulson know this very well, and they will do whatever it takes to make sure the banks survive.

We are witnessing history in the making, but it is not the end game for fiat money or fractional banking. I also don’t think the US dollar is going to collapse. Right now the US is under a microscope but we should not forget that Europe, the UK and Canada are all facing the same problems, and will have to deal with them eventually. The Fed announced that it increased the amount of swaps with foreign central banks to $290 billion, so I don’t think the cost of the US bailouts is ultimately going to be borne by the US dollar exchange rate. Instead, the prospect of hundreds of billions’ worth of new US Treasuries being issued and similar problems in other countries should weigh on interest rates, which is why I am still stubbornly short US 30-year Treasury Bonds.

Consider two recent deals: Berkshire Hathaway bought $5 billion worth of Goldman Sachs perpetual preferred shares that pay a 10% dividend. They also got warrants to buy $5 billion worth of common shares that must be worth at least a few percentage points to the original investment option value. It’s safe to say that the current value of Berkshire’s investment in Goldman Sachs carries a return of at least 12%, or more.

On the 16th the Fed agreed made a loan to AIG -- once the largest insurance company in the world -- of $85 billion bearing interest at LIBOR plus 8.5%. The 12-month LIBOR rate is currently 3.5% meaning the loan carries an interest rate of 12%, and the Fed is also getting 79.9% of AIG’s equity for no additional cost. Compared to the Fed, Buffett was a pushover.

The point to take away from these deals is that they were both structured to yield well in excess of 12%, which is an indication that capital is readily available at the right price. But the price is nowhere near the 4% yield on 30-year US Treasuries and an 800 basis point spread between private capital and government capital is not going to last. So either the rate on government issued debt will rise or the rate on private deals will fall. I am betting that it’s the former, not the latter.