This week Ben Bernanke suggested that the “temporary” Term Auction Facility might be extended into 2009. Let me suggest that it will be extended into at least 2010 before it is no longer needed. Banks are going to need to be able to take their illiquid paper and convert it into liquid Treasuries against which they can make loans and continue to function.

As I have written for a long time, it is all about buying time. In 1980, every major bank in the US was technically bankrupt, as they all had large amounts of Latin American bonds in their portfolios, at a size far larger than their capitalization. When the Latin American countries started to default, if the Fed had made the banks mark their portfolios to market, it would have been a disaster of biblical proportions. There would have been no American banks left standing. The US economy would have gone into a deep depression.

Instead, with a wink and nod, they let them keep the bad bonds on their books at face value, which they all did. Then in the latter part of the decade, starting with Citibank in 1986 (cue the irony), they began one by one to write off the bad loans, but only when they had enough capital to do so. It took six years (or more) of profits and capital raising to get to where they could deal with the problems without imploding themselves and the economy of the US at the same time.

Today is only different in the details. The Fed and central banks around the world are allowing banks to buy time to work through their problems. There really is no other option. That extra $1.1 trillion that the research by Bridgewater says will have to be written off? You can take it to the bank, pardon the pun, that it will not be written off this quarter. This is going to be an ongoing process that will take several years at a minimum. Just like in 1980, the regulators are going to allow banks to write down their losses as they can, except in the most egregious of circumstances, in which case those banks will be “absorbed,” a la Bear Stearns.

Treasury Secretary Paulson said Thursday that no bank is too big to fail. That is for public consumption. The fact is that there are any number of banks that are too big to fail, depending upon (and borrowing from my favorite linguist, Bill Clinton) what your definition of fail is. If by fail you mean that shareholders are wiped out, then he is correct, there is no institution too big to fail. If by fail you mean that the operations and debt obligations will be allowed to collapse, then there are institutions whose collapse would pose major systemic risk to the world markets. They cannot be allowed to collapse.

Take Freddie Mac. Please.

(Cue Henny Youngman) Take Freddie Mac (FRE). Please. Its shares are down almost 90%. “Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules. The fair value of Fannie Mae (FNM) [down 78%] assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, former St. Louis Federal Reserve President William Poole said.” (Bloomberg)

Poole asserted that these institutions are essentially on a short path to insolvency.

But in the same story, Senators Schumer and McCain both said Freddie and Fannie would not be allowed to fail. Even curmudgeonly former Fed Vice-Chairman Wayne Angell (someone whom I sincerely respect), said on CNBC yesterday that the government regulator of the GSEs (Government Sponsored Enterprises) ought to get some money from Congress to buy preferred stock and then get even larger amounts from the public through an offering of preferred stock. He said that Congress ought to learn about its responsibilities with regard to a GSE; and the public ought to realize that we are in for a long, tough fight. (He also expects the second half of 2008 to be no better than the first half, and he sees 1% growth in 2009.)

I wrote the above paragraph, and a few I deleted below, on Thursday, as I am on a plane to Las Vegas and need to finish the letter in order to attend a conference. I wrote with suggestions about how a collapse of the two Government Sponsored Enterprises might be handled. Last night, the New York Times broke a story that government officials are looking at how to go about taking over operations at Freddie and Fannie, should worse come to worst. Then this morning, the Wall Street Journal in its lead story elaborated on this theme.

The basic problem is that both Fannie and Freddie need more capital, and perhaps far more than their current market capitalization. Where to find it? What investor wants to try and catch this falling safe, without government guarantees? The Journal article quotes numerous people with various ideas about what to do. Most of their ideas will potentially cost US taxpayers.

And make no mistake: The problems with Fannie and Freddie have to be solved. They are now doing 80% of the mortgages in the US. Without them the housing market would grind to a halt quickly and housing prices would drop even beyond Gary Shilling’s pessimistic views.

Not to mention that the world has assumed the implicit backing of the government in buying the paper of Freddie and Fannie. How easy would it be to finance US debt if this paper was allowed to default? The implications are serious. I understand the arguments for allowing them to fail, and I think shareholders should bear the risk they take on when buying equity.

A very reasonable idea was broached by Steve Forbes on a BizRadio program this afternoon, which Dan Frishberg graciously allowed me to co-host. He suggests breaking Fannie and Freddie into eight smaller companies, giving them whatever backing they need in the form of public financing to start business, and then cut them off to sink or swim on their own, with much tighter capitalization controls. Remember, this is one of the more free-market conservative thinkers.

The authorities are slowly losing control. All they can do is crisis manage. There are no good solutions, only expedient ones. And we must all hope they choose the best among a handful of not particularly pleasing options. Allowing the system to devolve into chaos is not an option. The Fed and whatever administration comes in will do the same as the current group, which is to buy time so that the wounds can heal, and hopefully put in place rules to prevent another such occurrence.

(Sidebar: I will go into greater detail in a later letter, but regulators need to move NOW to create a Credit Default Swaps Exchange. A problem/crisis in that unregulated market is actually a far bigger problem than the current subprime crisis. Why do you think Bear Stearns was not allowed to go into bankruptcy? There are banks that are too big to fail, despite what Paulson says for public consumption.)

There are a lot of conflicting opinions, which you can read on Bloomberg, if you care. Some say Fannie and Freddie will have to lose $70 billion before the regulators step in. Poole says they are insolvent now, using fair market accounting methods. I don’t know, and neither do 99.9 % of the shareholders. At this point Fannie and Freddie are not an investment, they are a gamble. Sitting here at Caesar’s in Vegas, and reading the opinions, makes me think I have better odds at the tables below me.

I hope that when (not if!) taxpayer money is used, it is at market rates and means that shareholders are last in line, if at all, to recoup any money. For those of us who for years have called for tighter regulation and increased capitalization of the GSEs, as well as a clear removal of any government backing, implicit or explicit, being able to say “I told you so” does not feel all that good. Freddie and Fannie cannot be allowed to go out of existence. They are too tightly wound into the core and fiber of the US economy.

What can and should happen is that shareholders bear their losses, taxpayers pick up the bill, and when they are healthy again, as they will be at some point, another public offering should be done to hopefully recoup the losses to taxpayers. Or perhaps an auction with some guarantees to a potential buyer, but a complete removal of implicit government guarantees on future loans, and higher capitalization requirements. There are any numbers of ways to lessen the ultimate cost to the taxpayer.

What I fear is that politicians will use the opportunity to prop up the mortgage markets with taxpayer guarantees and create much larger losses, which could quickly mount into the hundreds of billions if not properly dealt with. A new populist-oriented administration could find this problem on their desk as they take office.

I would not want to own any stock in the financial sector. There is going to be a continual stream of write-offs over the coming year, at a minimum. Yes, some banks are better managed and will avoid the real life-threatening problems. Some will be like JP Morgan and end up with solid assets backed by government guarantees.

But which ones? Do you want to trust the analysts that have been telling you there is value in the financials at each step, all the way down? The management who insists they are in good shape, then raises capital at dilutive prices? The very people who did not see the problems to begin with, telling you that they are now solved?

The “value” that analysts optimistically see in various financial stocks is evaporating with each quarter, as they slowly write down ever more losses. With another potential $1 trillion to be written off or absorbed through earnings from profitable parts of the business, there is more pain to come. Investing in financials today is like trying to catch a falling safe.