How Financial Madness Overtook Wall Street

By Andy Serwer and Allan Sloan

If you're having a little trouble coping with what seems to be the complete unraveling of the world's financial system, you needn't feel bad about yourself. It's horribly confusing, not to say terrifying; even people like us, with a combined 65 years of writing about business, have never seen anything like what's going on. Some of the smartest, savviest people we know — like the folks running the U.S. Treasury and the Federal Reserve Board — find themselves reacting to problems rather than getting ahead of them. It's terra incognita, a place no one expected to visit.

Every day brings another financial horror show, as if Stephen King were channeling Alan Greenspan to produce scary stories full of negative numbers. One weekend, the Federal Government swallows two gigantic mortgage companies and dumps more than $5 trillion — yes, with a t — of the firms' debt onto taxpayers, nearly doubling the amount Uncle Sam owes to his lenders. While we're trying to get our heads around what amounts to the biggest debt transfer since money was created, Lehman Brothers goes broke, and Merrill Lynch feels compelled to shack up with Bank of America to avoid a similar fate. Then, having sworn off bailouts by letting Lehman fail and wiping out its shareholders, the Treasury and the Fed reverse course for an $85 billion rescue of creditors and policyholders of American International Group (AIG), a $1 trillion insurance company. Other once impregnable institutions may disappear or be gobbled up.

The scariest thing to average folk: one of the nation's biggest money-market mutual funds, the Reserve Primary, announced that it's going to give investors less than 100 cent on each dollar invested because it got stuck with Lehman securities it now considers worthless. If you can't trust your money fund, what can you trust? To use a technical term to describe this turmoil: yechhh!

There are two ways to look at this. There's Wall Street's way, which features theories and numbers and equations and gobbledygook and, ultimately, rationalization (as in, "How were we supposed to know that people who lied about their income and assets would walk away from mortgages on houses in which they had no equity? That wasn't in our computer model. It's not our fault"). Then there's the right way, which involves asking the questions that really matter: How did we get here? How do we get out of it? And what does all this mean for the average joe? So take a deep breath and bear with us as we try to explain how financial madness overtook not only Wall Street but also Main Street. And why, in the end, almost all of us, collectively, are going to pay for the consequences.

Going forward, there's one particularly creepy thing to keep in mind. In normal times, problems in the economy cause problems in the financial markets because hard-pressed consumers and businesses have trouble repaying their loans. But this time — for the first time since the Great Depression — problems in the financial markets are slowing the economy rather than the other way around. If the economy continues to spiral down, that could cause a second dip in the financial system — and we're having serious trouble dealing with the first one.

The Roots of the Problem
How did this happen, and why over the past 14 months have we suddenly seen so much to fear? Think of it as payback. Fear is so pervasive today because for years the financial markets — and many borrowers — showed no fear at all. Wall Streeters didn't have to worry about regulation, which was in disrepute, and they didn't worry about risk, which had supposedly been magically whisked away by all sorts of spiffy nouveau products — derivatives like credit-default swaps. (More on those later.) This lack of fear became a hothouse of greed and ignorance on Wall Street — and on Main Street as well. When greed exceeds fear, trouble follows. Wall Street has always been a greedy place and every decade or so it suffers a blow resulting in a bout of hand-wringing and regret, which always seems to be quickly forgotten.

This latest go-round featured hedge-fund operators, leveraged-buyout boys (who took to calling themselves "private-equity firms") and whiz-kid quants who devised and plugged in those new financial instruments, creating a financial Frankenstein the likes of which we had never seen. Great new fortunes were made, and with them came great new hubris. The newly minted masters of the universe even had the nerve to defend their ridiculous income tax break — much of the private-equity managers' piece of their investors' profits is taxed at the 15% capital-gains rate rather than at the normal top federal income tax rate of 35% — as being good for society. ("Hey, we're creating wealth — cut us some slack.")

The Root of the Problems
Warren Buffett, the nation's most successful investor, back in 2003 called these derivatives — which it turned out almost no one understood — "weapons of financial mass destruction." But what did he know? He was a 70-something alarmist fuddy-duddy who had cried wolf for years. No reason to worry about wolves until you hear them howling at your door, right?

Besides a few prescient financial sages, though, who could have seen this coming in the fall of 2006, when things were booming and the world was awash in cheap money? There was little fear of buying a house with nothing down, because housing prices, we were assured, only go up. And there was no fear of making mortgage loans, because what analysts call "house-price appreciation" would increase the value of the collateral if borrowers couldn't or wouldn't pay. The idea that we'd have house-price depreciation — average house prices in the top 20 markets are down 15%, according to the S&P Case-Shiller index — never entered into the equation.

As for businesses, there was money available to buy corporations or real estate or whatever an inspired dealmaker wanted to buy. It was safe too — or so Wall Street claimed — because investors worldwide were buying U.S. financial products, thus spreading risk around the globe.

Now, though, we're seeing the downside of this financial internationalization. Many of the mortgages and mortgage securities owned or guaranteed by Fannie Mae and Freddie Mac were bought by foreign central banks, which wanted to own dollar-based securities that carried slightly higher interest rates than boring old U.S. Treasury securities. A big reason the Fed and Treasury felt compelled to bail out Fannie and Freddie was the fear that if they didn't, foreigners wouldn't continue funding our trade and federal-budget deficits.

You've heard, of course, that subprime mortgages — subprime is Wall Street's euphemism for junk — are where the problems started. That's true, but the problems have now spread way beyond them. Those predicting that the housing hiccup wouldn't be a big deal — what's a few hundred billion in crummy mortgage loans compared with a $13 trillion U.S. economy or a $54 trillion world economy? — failed to grasp that possibility. It turned out that Wall Street's greed — and by Wall Street, we mean the world of money and investments, not a geographic area in downtown Manhattan — was supplemented by ignorance. Folks in the world of finance created, bought, sold and traded securities that were too complex for them to fully understand. (Try analyzing a CDO-squared sometime. Good luck.)

For an example in our backyard, consider Lehman Brothers. Lehman was so flush, or at least felt so flush, that in May 2007 it sublet 12 prime midtown-Manhattan floors of the Time & Life Building — across the street from Lehman headquarters — from Time Inc., which publishes this magazine. Lehman signed on for $350 million over 10 years. (It's not clear what kind of hit, if any, Time Inc. will now face.)

Lehman's fall shows the downside of using borrowed money. Even though Lehman has a 158-year-old name, it's actually a 14-year-old company that was spun off by American Express in 1994. AmEx had gobbled it up 10 years earlier, and it wasn't in prime shape when AmEx spat it out. To compensate for its relatively small size and skinny capital base, Lehman took risks that proved too large. To keep profits growing, Lehman borrowed huge sums relative to its size. Its debts were about 35 times its capital, far higher than its peer group's ratio. And it plunged heavily into real estate ventures that cratered.

Here's how leverage works in reverse. When things go well, as they did until last year, Lehman is immensely profitable. If you borrow 35 times your capital and those investments rise only 1%, you've made 35% on your money. If, however, things move against you — as they did with Lehman — a 1% or 2% drop in the value of your assets puts your future in doubt. The firm increasingly relied on investments in derivatives to produce profits, in essence creating a financial arms race with competitors like Goldman Sachs. Even though the Fed had set up a special borrowing program for Lehman and other investment banks after the forced sale of Bear Stearns to JPMorgan Chase in March, the market ultimately lost faith in Lehman. So out it went.

Uncle Sam Steps Back In
The market lost faith in AIG too, but the government was forced to save it. A major reason is that AIG is one of the creators of the aforementioned credit-default swaps. What are those, you ask? They're pixie-dust securities that supposedly offer insurance against a company defaulting on its obligations. If you buy $10 million of GM bonds, for instance, you might hedge your bet by buying a $10 million CDS from AIG. In return for that premium — which changes day to day — AIG agrees to give you $10 million should GM have an "event of default" on its obligations.

But as a way to make sure that swap meisters can make good on their obligations, they have to post collateral. If their credit is downgraded — as was the case with AIG — they have to post more collateral. What put AIG on the brink was that it had to post $14 billion overnight, which of course it didn't have lying around. Next week, the looming downgrades might have forced it to come up with $250 billion. (No, that's not a typographical mistake; it's a real number.) Hence the action. If AIG croaked, all the players who thought they had their bets hedged would suddenly have "unbalanced books." That could lead to firms other than AIG failing, which could lead to still more firms failing, which could lead to what economists call "systemic failure." Or, in plain terms, a financial death spiral in which firms suck one another into the abyss.

AIG, like Lehman, was ultimately done in by credit-rating agencies, of all things. The main credit raters — Moody's and Standard & Poor's — had blithely assigned top-drawer AAA and AA ratings to all sorts of hinky mortgage securities and other financial esoterica without understanding the risks involved. Would you know how to rate a collateralized loan obligation? Or commercial-mortgage-backed securities? Sophisticated investors took Moody's and S&P's word for it, and it turned out that the agencies didn't know what they were doing. Credit raters, who claim to offer only opinions, are party to Wall Street's cycles too. At the beginning, they're far too lenient with borrowers, who are the ones who pay their rating fees. Then, after a couple of embarrassments — remember Enron and WorldCom? — the raters tighten up, maybe too much. Then memory fades, and the cycle repeats.

What doomed AIG was the rating agencies' decision — they had suddenly awakened to AIG's problems — to sharply downgrade the firm's securities. That gave AIG no time to react, no time to raise more capital, no more time to do anything else but beg for help. Because AIG is in a much scarier situation than Lehman — the insurer has assets of $1 trillion, more than 70 million customers and intimate back-and-forth dealings with many of the world's biggest and most important financial firms — Uncle Sam felt that it had no choice but to intervene.

Right before the markets began to unravel last year, Lloyd Blankfein, chief executive of Goldman Sachs, presciently quipped that he hadn't "felt this good since 1998," referring to the Wall Street wipeout precipitated that year by Russia's defaulting on its ruble debt. Blankfein argued that confidence in global markets had built up to a dangerously giddy level and that investors weren't being compensated for assuming outsize risk in securities like esoteric bonds and Chinese stocks. Blankfein was right, of course, but even he wasn't paranoid enough. Though Goldman stands, along with Morgan Stanley, as one of the last two giant U.S. investment banks not to collapse (as Lehman and Bear Stearns have) or be sold (à la Merrill Lynch), Goldman too has been pummeled. The firm's quarterly profit plunged 70% — results considered to be relatively good. While analysts generally believe that Goldman and Morgan Stanley will survive the meltdown, that view is not unanimous. Says doomster New York University economics professor Nouriel Roubini: "They will be gone in a matter of months as well. It's better if Goldman or Morgan Stanley find a buyer, because their business model is fundamentally flawed." Both firms would beg to disagree, but their stock prices have been hammered.

All of us are now paying the price for Wall Street's excesses. Some of the cost is being paid by prudent people, like retirees who have saved all their life. They're now getting ridiculously low rates of 2% or so on their savings because the Federal Reserve has cut short-term rates in an attempt to goose the economy and reassure financial markets. Taxpayers are going to get stuck too. By the estimate of William Poole, former head of the St. Louis Fed, bailing out the creditors of the two big mortgage firms, Fannie Mae and Freddie Mac, could cost taxpayers $300 billion. Think of that as about a year and a half in Iraq.

Didn't the folks on Wall Street, who are nothing if not smart, know that someday the music would end? Sure. But they couldn't help behaving the way they did because of Wall Street's classic business model, which works like a dream for Wall Street employees (during good times) but can be a nightmare for the customers. Here's how it goes. You bet big with someone else's money. If you win, you get a huge bonus, based on the profits. If you lose, you lose someone else's money rather than your own, and you move on to the next job. If you're especially smart — like Lehman chief executive Dick Fuld — you take a lot of money off the table. During his tenure as CEO, Fuld made $490 million (before taxes) cashing in stock options and stock he received as compensation. A lot of employees, whose wealth was tied to the company's stock, were financially eviscerated when Lehman bombed. But Fuld is unlikely to show up applying for food stamps.

Fuld is done with the grueling job of trying to stave off financial crisis. Not so for regulators, of course. It's difficult to imagine the pressure and stress. Key players such as Treasury Secretary Hank Paulson and New York Fed chief Tim Geithner have been working around the clock for weeks now, putting out fire after fire. Besides having to comprehend and solve the mind-bending financial woes of some of the world's biggest companies, they are also briefing and seeking counsel from CEOs of the surviving companies, never mind President George W. Bush and the two presidential candidates, plus central bankers from around the globe.

Where Do We Go from Here?
There's no question that the crisis has gone so deep that it cannot be halted by one stroke. Banks and other financial companies around the globe are struggling to pull themselves out of this mess. Rebuilding will take time, vast amounts of money and constant attention. Sooner or later, the hundreds of billions (or trillions) of dollars that the Fed and other central bankers are throwing into the markets will stabilize things. Sooner or later, housing prices will stop falling because no financial trend continues forever.

Given that this is a political year and change is the buzzword, how do Barack Obama and John McCain intend to see us out of this mess? Good question. We don't know, and it's not at all clear that they've thought about it in greater than sound-bite depth.

Obama has called for increased regulation, which seems like a no-brainer, but he hasn't articulated many specifics. Meanwhile, McCain has talked about ending "wild speculation" and railed against Wall Street greed. Well, duh. Know anyone who is in favor of naked greed? Whoever wins will face a massive job of righting the financial ship and restoring confidence that has been badly shaken. The next President will have to cast away partisan predispositions and add the just-right measure of regulation and oversight to the mix. As Treasury Secretary (and former Goldman Sachs chief executive) Paulson recently said, "Raw capitalism is dead."

Whatever the politicians do, we as a society are going to be poorer than we were. We've lost credibility with foreigners; they will be less likely than before to lend us endless amounts of cheap money. Will that ultimately lead to higher borrowing costs? It's hard to see how it won't.

Coping in this new world will require adjustments by millions of Americans. We all will have to start living within our means — or preferably below them. If you don't overborrow or overspend, you're far less vulnerable to whatever problems the financial system may have. And remember one other thing: the four most dangerous words in the world for your financial health are "This time, it's different." It's never different. It's always the same, but with bigger numbers.

(Additional photo credits -- Paulson: AP; AIG Ticker: Andrew Harrer / Bloomberg / Landov; Lehman: Getty; Federal Reserve Bank of New York: AP; Foreclosure: AP; AIP sign: Getty; Dow Jones: AP)

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Where Did the Government Get $85 Billion?

By Noreen Malone

American International Group

On Tuesday the U.S. government agreed that the Federal Reserve would supply $85 billion to bail out American International Group, the world's largest insurance company. Does the government really have a spare $85 billion lying around just in case?

Yes. There's no stack of unused money gathering dust in the federal coffers, but the Federal Reserve can always raise cash by selling off some of the securities it keeps in reserve. The Fed maintains a massive balance sheet that shows exactly what its assets are; right now, its reserves are estimated to be less than $200 billion, down from $800 billion at the beginning of this year. These reserves take the form of securities, often purchased from the U.S. Treasury. The securities function as a kind of "under the mattress" stash that can easily be converted into cash on the open market.

In fact, the government didn't actually hand over any cash to AIG today. Rather, the bailout deal represents an assurance from the Fed that an $85 billion loan will be available to AIG at any point during the next 24 months. If and when the company decides it wants the money, it will supply the Federal Reserve with the routing number of its clearing bank—an institution that specializes in transferring securities from one institution to another—and an electronic transfer of funds would be made.

The Fed padded its reserves on Monday with the help of "repurchase agreements": It bought $70 billion in securities that it will sell back to the issuing banks at an agreed-upon date. (This is also how the government "injected" money into the market.) And on Wednesday, the Treasury Department announced it was creating a "Supplementary Financing Program" to auction off $40 billion of Treasury bills, with the profits going to the Fed. (This is an unprecedented step; normally, money from Treasury bill auctions goes back into the Treasury coffers.)

The AIG deal may not end up being for the full $85 billion. It is what's known as a "bridge loan," meaning that the Federal Reserve is offering to lend the money for the short term, at a fairly steep interest rate. AIG doesn't have to take it all, which is precisely the point—the lousy terms of the loan give the company an incentive to find other sources of cash.

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Worst Crisis Since '30s, With No End Yet in Sight

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.

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The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.

Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.

"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."

Spreading Disease

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.

In the wake of this past week's market meltdown, WSJ's economics editor David Wessel looks at the shakeup and sees one of two outcomes: the crisis as catharsis or a drawn-out mess.

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.

Not Enough

Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.

But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.

"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.

Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.

In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.

Taking Out the Playbook

Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."

Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.

But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.

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Traders on the floor of the New York Stock Exchange Wednesday. Expectations for a quick end to the crisis are fading fast.

This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.

Swaps Game

The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.

One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.

As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.

Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.

Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.

But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.

Resolution Trust Scenario

In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.

But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.

One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.

"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"

The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.

In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.

The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.

Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.

Pleasant Mystery

One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."

At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.

In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.

In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.

But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.

—Aaron Lucchetti, Mark Whitehouse, Gregory Zuckerman and Sudeep Reddy contributed to this article.

Write to Jon Hilsenrath at jon.hilsenrath@wsj.com, Serena Ng at serena.ng@wsj.com and Damian Paletta at damian.paletta@wsj.com

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Morgan Stanley in Talks with China's CITIC

Morgan Stanley is in talks to possibly be acquired by China's CITIC, sources in the U.S. and China have told CNBC.

No deal is certain at this time, however, and sources said that none was likely to be finalized Wednesday.

Word of the talks follows an earlier report in the New York Times that Morgan Stanley—one of the two last independent, U.S.-based investment banks—is considering a merger with Wachovia or another bank.

The Federal Reserve has been active in encouraging the Chinese to invest in U.S. financial institutions and has even made it clear that it would look favorably upon a Chinese acquisition of a U.S.-based financial institution, sources said.

Though Chinese financial institutions do not have a great deal of experience in running large investment banks, Citic does own the largest brokerage in China. Sources both in the U.S. and in China says discussions are ongoing. China’s sovereign wealth fund, China Investment Corporation (CIC), owns 9.9 percent of Morgan.

Morgan Stanley's senior management has been in talks with a number of potential buyers, and a deal becomes more likely as the investment bank's stock—which plunged [MS 22.55 0.80 (+3.68%) ] more than 24 percent Wednesday—declines further. London-bsaed HSBC has also been cited as a possible suitor for Morgan Stanley.

Morgan Stanley's chief executive, John J. Mack, received a telephone call on Wednesday from Wachovia [WB 14.50 5.38 (+58.99%) ] expressing interest in the Wall Street bank, the Times said.

The talks are preliminary and no deal may emerge.

Ongoing Turmoil for Big U.S. Banks

Meanwhile, Washington Mutual [WM 2.99 0.98 (+48.76%) ] has put itself up for auction, people briefed on the matter also told the Times.

Reports of both possible deals came after the market closed.

Earlier, anxious investors continued to hack away at Morgan Stanley and Goldman Sachs Group [GS 108.00 -6.50 (-5.68%) ], sending the two largest investment banks' shares lower.

Morgan Stanley's shares sank 40 percent below the depths reached during the Asia debt crisis and collapse of Long Term Capital Management a decade ago. Goldman stock plummeted 22 percent to a three-year low. This year, Goldman shares have fallen 45 percent and Morgan's are down 57 percent.

Investors also bid up the price of protecting against a default in debt issued by the banks, indicating growing concern that Wall Street's biggest firms are in jeopardy.

"The credit crunch and credit contraction is intensifying," said Peter Boockvar, an equity strategist at Miller Tabak in New York. "The action in Morgan Stanley in light of what was better-than-expected numbers last night is disconcerting."

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Fed Asks Treasury Dept. for Funds to Backstop Intervention Efforts

By David Cho

Washington Post Staff Writer

The Federal Reserve has requested that the Treasury Department deposit $40 billion with the central bank in an effort to help the Fed continue to stabilize the financial markets and address concerns about whether it is overstretched.

The Fed's extraordinary series of efforts to pump extra funds into the financial system and bail out such firms as American International Group and Bear Stearns with mammoth loans has depleted its store of Treasury bonds. The central bank will use the funds to offset the amount of money it has injected into the markets in its rescue efforts.

"By over-funding itself and placing those funds at the Fed, the Treasury is expanding the Fed's balance sheet in a way that will give the Fed the ability to conduct further operations to support the financial market functioning, should the need arise," said Michael Feroli, an economist with J.P. Morgan Chase.

The department is raising the $40 billion by auctioning bills, known as Treasurys.

Central banks around the world are taking dramatic actions to contain the crisis in the credit markets, pumping more than $280 billion this week into the financial markets, including $70 billion from the Federal Reserve.

Many banks are now charging very high rates to lend to each other, and some institutions have closed their windows altogether -- a sign of how tight borrowing has become. The benchmark overnight lending rate for these banks, called the London interbank offered rate, or Libor, nearly doubled to 6.4 percent, the highest jump on record.

The loss of confidence in the credit markets pushed interest rates on Treasuries lower as investors looked for safe places for their money. This happens because the more investors demand Treasuries, the lower the rates sink. Rates on the three-month Treasury bill, for instance, fell at one point this morning to 0.23 percent, the lowest since at least the 1950s.

Meanwhile, Russia halted trading on its two stock exchanges and injected billions into three former state-owned banks as questions were raised about whether these institutions would remain viable. These banks had accepted a wide range of collateral for loans, including stocks that have fallen more than 50 percent over the past several months.

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The 10 Biggest Chapter 11 Bankruptcies In US History

CNBC has put together a quick slideshow list of the top 10 largest Chapter 11 bankruptcy filings in US history based on the pre-bankruptcy assets of the companies in question. It really gives you a sense of the incredible scale of the Lehman Brothers filing — the next closest bankruptcy was Worldcom, which had $103.9 billion in assets before the filing — 535.1 BILLION DOLLARS less than Lehman Brothers. Damn.

10. United Airlines
Assets: $25.2 billion
Date Filed: Dec. 9, 2002

9. Pacific Gas and Electric
Assets: $29.8 billion
Date Filed: April 6, 2001

8. Global Crossing
Assets: $30.2 billion
Date Filed: Jan. 28, 2002

7. Refco
Assets: $33.3 billion
Date Filed: Oct. 17, 2005

6. Financial Corp. of America
Assets: $33.9 billion
Date Filed: Sept. 9, 1988

5. Texaco
Assets: $35.9 billion
Date Filed: April 12, 1987

4. Conseco
Assets: $61.4 billion
Date Filed: Dec. 18, 2002

3. Enron
Assets: $63.4 billion
Date Filed: Dec. 2, 2001

2. Worldcom
Assets: $103.9 billion
Date Filed: July 21, 2002

1. Lehman Brothers
Pre-Bankruptcy Assets: $639 billion
Date Filed: Sept. 15, 2008

Biggest Chapter 11 Cases [CNBC]
(Photo: epak )

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AP Refuses To Comply With Secret Service Request On Sarah Palin's Hacked E-Mails

WASHINGTON -- Hackers broke into the Yahoo! e-mail account that Republican vice presidential candidate Sarah Palin used for official business as Alaska's governor, revealing as evidence a few inconsequential personal messages she has received since John McCain selected her as his running mate.

"This is a shocking invasion of the governor's privacy and a violation of law. The matter has been turned over to the appropriate authorities and we hope that anyone in possession of these e-mails will destroy them," the McCain campaign said in a statement.

The Secret Service contacted The Associated Press on Wednesday and asked for copies of the leaked e-mails, which circulated widely on the Internet. The AP did not comply.

The disclosure Wednesday raises new questions about the propriety of the Palin administration's use of nongovernment e-mail accounts to conduct state business. The practice was revealed months ago _ prior to Palin's selection as a vice presidential candidate _ after political critics obtained internal e-mails documenting the practice by some aides.

One person whose e-mail to Palin apparently was among those disclosed, Amy B. McCorkell, declined to discuss her correspondence. "I do not know anything about it," McCorkell said. "I'm not giving you any comment." Wired.com said McCorkell later confirmed that she did send the e-mail to Palin.

Another of the e-mails apparently revealed Wednesday was an exchange in July with Alaska Lt. Gov. Sean Parnell discussing a talk show host who had been critical of Parnell. Parnell declined to discuss the matter.

Palin herself used "gov.sarah" in one of her e-mail addresses, but the hackers targeted her "gov.palin" account. Her husband used "fek9wnr" in his address. "Fe" is the representation for iron, and "k9" is an abbreviation for canine. Todd Palin was the winner of the grueling Iron Dog snowmobile race, and "fek9wnr" also is Todd Palin's vehicle license tag in Alaska.

It wasn't immediately clear how hackers broke into Palin's Yahoo! account, but it would have been possible to trick the service into revealing her password knowing personal details about Palin that include her birthdate and ZIP code. A hacker also might have sent a forged e-mail to her account tricking her into revealing her own password.

McCorkell was appointed by Palin to an advisory board on issues involving alcohol and drug abuse. One of the leaked e-mails suggested McCorkell wrote to Palin on Sunday to say she was praying for Palin. "Don't let the negative press get you down!" the message said.

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Fed takes heat on AIG from both sides of Congress

By Emily Kaiser

WASHINGTON (Reuters) - The U.S. Federal Reserve took some bipartisan bashing on Wednesday from members of Congress who criticized the central bank's $85 billion loan to troubled insurer American International Group.

In what may be a foreshadowing of the sort of questions Fed Chairman Ben Bernanke can expect when he testifies before congressional committees next week, Republicans and Democrats alike expressed concern over the size of the bailout and perceptions that it put Wall Street ahead of Main Street.

House Speaker Nancy Pelosi, a California Democrat, told reporters at a news conference that lawmakers had a number of questions, particularly after they were told by Fed officials that the AIG bailout was urgent in part because of foreign central banks' worries about fallout to their own economies.

"It raises certain questions. Why aren't these foreign institutions participating in this bailout? Where is this money coming from? What is its impact on our budget?" Pelosi said.

Leveling harsh criticism against the Bush administration's oversight of the financial industry over the past eight years, Pelosi also said hearings will look at potential industry fraud and mismanagement.

House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, questioned whether Federal Reserve Chairman Ben Bernanke should have so much power to act unilaterally.

"No one in a democracy, unelected, should have $800 billion to dispense with as he sees fit," Frank said, referring to a pool of money the Fed has had at its disposal to deal with financial crises.

Rep. Henry Waxman, the California Democrat who heads the House Oversight and Government Reform Committee that also will hold hearings, said any legislation will likely be left to the next president and next Congress to be seated in January.

"But this Congress still has to find out what happened, why it happened, who is responsible and how we ought to go forward in the future," Waxman said.

Republicans in Congress also criticized the bailouts.

"Americans should be very concerned by the size and frequency of these government bailouts," South Carolina Republican Sen. Jim DeMint said. "The easy money, cheap credit policy of the Fed and the guarantees provided by Congress for Fannie and Freddie created a bubble that is now bursting."

Fed officials said they needed to step in to steady AIG late on Tuesday because a bankruptcy could have caused chaos in credit markets and dealt a serious blow to an already shaky global economy. It was the third time in six months that the government acted to prevent the collapse of a major financial firm.

Sen. Christopher Dodd, the Connecticut Democrat who chairs the Senate Banking Committee, said the Fed ought to be doing more to help people struggling to pay their mortgages. Bernanke is scheduled to testify before Dodd's committee next Tuesday.

"If the Federal Reserve bank is going to be using bad debt to provide collateral to extend loans or resources to financial institutions, how about doing the same for homeowners?" Dodd told reporters at a briefing.

"Allow them to have new mortgages to stay in their homes ... If it's good enough for Wall Street it ought to be good enough for people ... running the risk of losing their home."

Republican Sen. Jim Bunning of Kentucky said he was introducing legislation to strip the Fed of the authority to use taxpayer dollars on bailouts.

"Once again the Fed has put the taxpayers on the hook for billions of dollars to bail out an institution that put greed ahead of responsibility and used their good name to take risky bets that did not pay off," he said. "The only difference between what the Fed did and what Hugo Chavez is doing in Venezuela is Chavez doesn't put taxpayer dollars at risk when he takes over companies - he just takes them."

Senate Majority Leader Harry Reid said he was doing his best to be supportive of Bernanke and Treasury Secretary Henry Paulson, but no one seemed to have any answers to the credit crisis that has raged for more than a year.

"We are in new territory. We're not out there playing soccer, basketball or football. It's a whole new game," the Nevada Democrat said. "You could ask Bernanke, you could ask Paulson, they don't know what to do (on regulatory reform) but they are trying to come up with ideas."

(Additional reporting by Richard Cowan, Donna Smith and Kevin Drawbaugh; Editing by Diane Craft)

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Vatican: Guess what, Darwin? Evolution is OK

By Philip Pullella

VATICAN CITY - The Vatican said on Tuesday the theory of evolution was compatible with the Bible but planned no posthumous apology to Charles Darwin for the cold reception it gave him 150 years ago.

Archbishop Gianfranco Ravasi, the Vatican's culture minister, was speaking at the announcement of a Rome conference of scientists, theologians and philosophers to be held next March marking the 150th anniversary of the publication of Darwin's "The Origin of Species."

Christian churches were long hostile to Darwin because his theory conflicted with the literal biblical account of creation.

Earlier this week, a leading Anglican churchman, Rev. Malcolm Brown, said the Church of England owed Darwin an apology for the way his ideas were received by Anglicans in Britain.

Pope Pius XII described evolution as a valid scientific approach to the development of humans in 1950 and Pope John Paul reiterated that in 1996. But Ravasi said the Vatican had no intention of apologizing for earlier negative views.

"Maybe we should abandon the idea of issuing apologies as if history was a court eternally in session," he said, adding that Darwin's theories were "never condemned by the Catholic Church nor was his book ever banned."

Creationism is the belief that God created the world in six days as described in the Bible. The Catholic Church does not read the Genesis account of creation literally, saying it is an allegory for the way God created the world.

Some other Christians, mostly conservative Protestants in the United States, read Genesis literally and object to evolution being taught in biology class in public high schools.

Sarah Palin, the Republican candidate for the U.S. vice presidency, said in 2006 that she supported teaching both creationism and evolution in schools but has subsequently said creationism does not have to be part of curriculum.

The Catholic Church teaches "theistic evolution," a stand that accepts evolution as a scientific theory and sees no reason why God could not have used a natural evolutionary process in the forming of the human species.

It objects to using evolution as the basis for an atheist philosophy that denies God's existence or any divine role in creation. It also objects to using Genesis as a scientific text.

As Ravasi put it, creationism belongs to the "strictly theological sphere" and could not be used "ideologically in science."

Professor Philip Sloan of Notre Dame University, which is jointly holding next year's conference with Rome's Pontifical Gregorian University, said the gathering would be an important contribution to explaining the Catholic stand on evolution.

"In the United States, and now elsewhere, we have an ongoing public debate over evolution that has social, political and religious dimensions," he said.

"Most of this debate has been taking place without a strong Catholic theological presence, and the discussion has suffered accordingly," he said.

Pope Benedict discussed these issues with his former doctoral students at their annual meeting in 2006. In a speech in Paris last week, he spoke out against biblical literalism.

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Verizon Refuses To Help Locate Body Of Missing Woman For Four Days

Verizon, which has no problem helping the government spy on its customers, suddenly turned stupid in June when a police department asked them for help finding the body of a woman who had been abducted on camera. Despite pleas from the woman's parents, the police, and the FBI, it was four days before a technician was sent out to the appropriate cell tower. When that technician gave the police the location info, they found Kelsey Smith's body within 45 minutes. Verizon won't respond to requests for an explanation of why they couldn't help sooner.

The Johnson County District Attorney, Phill Kline, told Fox News that Verizon not only seemed unhelpful, but possibly incompetent:

We did have a problem with Verizon. We're talking about 3 hours afterwards, they [the police] were already pushing for this information, with the sergeant speaking to Verizon directly at 2:30 a.m., demanding that this information be provided and it wasn't.

There was a lack of understanding on their end of what they were incapable of doing. I was on the conference call with Verizon, and we had three technicians telling us different things and using different terms, and we can't guess their mind. We've got a girl that's missing. We have a girl that's missing, we have a likely abduction, we need to find her.

Everyone involved in the search has made it clear that Verizon's incompetence had nothing to do with Kelsey's death, but it could have made the search a lot shorter, and saved a lot of people unnecessary grief. Unfortunately, when Verizon's president met with Kline and Kelsey's parents two months later, he brought three lawyers with him for protection.

Kelsey's mom told Fox, "If [Verizon] brought them because you think we're here to sue you, that's not what this is about." Says Kline, "They didn't realize that they have an opportunity... to establish a course that leads the way that is right and responsible, and instead they chose a different posture, and that's unfortunate."

Kelsey's mom:

We almost didn't get to say to goodbye to Kelsey, because of her body decomposition from being out there so long.

Kelsey's dad:

We never did get a why, that was the thing that was so frustrating, why can't you do this. That question was never answered.

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16 killed in attack on US embassy in Yemen

SANAA (AFP) — Islamist militants attacked the US embassy in the Yemeni capital Sanaa with a car bomb and rockets on Wednesday, leaving 16 people dead, in the second strike on the high-security compound in six months.

The dead were six Yemeni soldiers, four civilians including an Indian and six attackers -- one wearing an explosives belt, the interior ministry said, while a US official in Washington said there were no American casualties.

A group calling itself Islamic Jihad in Yemen claimed responsibility for the attack and threatened similar strikes against the British, Saudi and United Arab Emirates missions in the Yemeni capital.

Witnesses said a fierce firefight erupted after gunmen raked Yemeni police guarding the heavily fortified embassy compound, before a suicide bomber blew up a car at the entrance, setting off a fireball.

A series of explosions followed as the compound came under rocket and small arms fire, they said, adding that the force of the bomb blast sent pieces of flesh a hundred metres (yards) away.

In March, a schoolgirl and a policeman were killed and 19 people wounded in a hail of mortar fire that US diplomats said targeted the embassy in Yemen, which has been battling a wave of attacks by Al-Qaeda militants for years.

After a rocket attack against a residential compound used by US oilmen in April, the US State Department ordered the evacuation of non-essential diplomatic staff, but the order was lifted last month.

In a statement, the embassy in Sanaa condemned what it described as a "heinous" attack and vowed to work with the Yemen authorities to bring the perpetators to justice.

It also said both its chancery and consular sections would remain closed until further notice.

"Today's events demonstrate that terrorist criminals will not hesitate to kill innocent citizens and those charged with protecting them in pursuit of their agenda of terror.

Briton Trev Mason told CNN he heard at least three big explosions around the embassy from his nearby residential compound.

"We heard the sounds of a heavy gunbattle going on. I looked out of my window and we saw the first explosion going off, a massive fireball very close to the US embassy," he said.

In April, the embassy told its employees they were not authorised to travel outside Sanaa and to avoid public places and urged Americans in the country to take "prudent security measures" and keep a low profile.

The statement from Islamic Jihad, which could not be authenticated, claimed it was behind the "martyr operation."

"We will continue the explosions and target other embassies," it said, referring to a previous statement in which it said it would "blow up" the British, Emirati, Saudi and US embassies if its "brothers were not freed from prison."

In recent years, militants have carried out a string of attacks in Yemen, the ancestral homeland of Al-Qaeda chief Osama bin Laden and one of the poorest countries on the planet.

In October 2000, Al-Qaeda attacked American warship the USS Cole off the southern port of Aden, using a small boat packed with explosives to blow a hole in the side of the vessel, killing 17 American sailors.

Al-Qaeda's local wing Jund Al-Yemen Brigades has also claimed responsibility for deadly attacks on Belgian and Spanish tourists in Yemen in the past two years.

A group calling itself Jihad -- which is not connected to Al-Qaeda -- has carried out a series of attacks against security forces and oil installations in the south of Yemen since 2003.

One of its leaders, Khaled Abdel Nabi, was captured after an exchange of fire with police in the town of Jaar late last month. He had been on the run for five years.

Yemen is awash with weapons, with roughly three firearms for every citizen, and has become a major focus of the US "war against terror".

Last month, Yemeni security forces announced the arrest of 30 suspected Al-Qaeda members in a crackdown on the jihadist network in the east of the country.

On August 12, the defence ministry announced the death of a local chief and four others belonging to Al-Qaeda in clashes with police.

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Rising Deficits -- Don't Blame the Economy

The first rule of holes is this: If you're in one, stop digging. New government estimates released last week show that the federal government will be in a big hole in fiscal 2009: a $546 billion deficit. They also help show how we got into this hole -- and the answer may surprise you.

In January 2001, the month President Bush took office, the Congressional Budget Office released budget estimates for each of the next ten years (2002-2011). CBO predicted that the 2009 budget would show a $710 billion surplus. So the $546 billion deficit now predicted for 2009 is actually $1.3 trillion worse than CBO predicted nearly eight years ago. What caused this trillion-dollar decline?

Some people point to the economy. CBO's 2001 projections came out before the 2001 recession and the 9/11 attacks, which further slowed the economy. A weaker economy means less tax revenue, which in turn means smaller surpluses or bigger deficits. Since the 2001 projections couldn't factor these events in, it's not surprising that they proved too optimistic.

But, in fact, the economy's weaker-than-expected performance, along with other "technical" factors that are beyond policymakers' control, account for less than a fourth of the $1.3 trillion deterioration in the budget. The other three-fourths -- $1 trillion's worth -- is due to actions by the White House and Congress since 2001 -- specifically, the tax cuts and spending increases they enacted.

Put another way, even though the economy has performed less well since 2001 than CBO expected, the federal budget would still be running a projected $465 billion surplus in 2009 if policymakers had enacted no tax cuts or program increases.

Does this mean increased domestic spending is mostly to blame? That's a common claim by those seeking to shrink domestic programs, but the numbers don't support it.

It's true that Congress has expanded several entitlement programs since 2001 -- most notably by adding prescription drug coverage to Medicare. Yet these cost increases amount to only 12 percent of the $1 trillion deterioration.

And funding increases for domestic "discretionary" programs -- the programs Congress funds each year through the appropriations process, such as education, medical and scientific research, and law enforcement -- account for just 6 percent of the deterioration. Over the past six years, funding for this part of the budget has hardly grown at all in real per-capita terms.

In reality, the two main reasons why the 2009 budget will be so much worse than CBO had predicted are tax cuts and increases in military and other security-related spending.

Tax cuts alone account for 42 percent of the budgetary deterioration for 2009 that stems from policymakers' actions since 2001. Increases in military and other security programs account for another 39 percent. Combined, these two factors account for 82 percent of the budget decline that is due to policy actions.

The tax cuts -- the largest of which by far was the giant 2001 Bush tax cut -- will cost $295 billion in 2009 alone. While nearly all taxpayers will receive some tax cut, the distribution of the tax cut benefits is highly skewed. In 2009, a typical household in the $40,000-to-$50,000 income range will receive a tax cut of about $950; households with incomes over $1 million will receive tax cuts averaging $135,000.

Regarding the military and other security-related increases, it's worth noting that these reflect more than the wars in Iraq and Afghanistan. The underlying budgets of the Defense, State, and Homeland Security Departments have also gone up significantly, for reasons not directly related to operations in Iraq and Afghanistan.

The picture these new CBO figures present -- an enormous deterioration in the budget over the past eight years, caused mostly by tax cuts and security-related spending increases -- is much the same if we look not just at 2009 but at the entire ten-year period that CBO's January 2001 projections cover. In 2001, CBO predicted the federal government would amass surpluses totaling $5.6 trillion over the 2002-2011 period. Now, CBO data show a cumulative deficit of $3.8 trillion over that same period. That's a $9.4 trillion deterioration, $7.2 trillion of which was caused by policy actions. Tax cuts and security-related spending increases caused 83 percent of that.

These facts carry several important messages for the next President and Congress as they try to restore fiscal responsibility, one of which is that domestic discretionary programs shouldn't be made the scapegoat for the emergence of large deficits.

As noted, increases in domestic discretionary programs account for just 6 percent of the budgetary deterioration for 2009 caused by policymakers' actions. Moreover, some of these programs have been cut significantly in recent years (child care funding, for example, has fallen almost 17 percent since 2002, after adjusting for inflation), and some will require additional investments over the next several years to address unmet needs in areas ranging from veterans' health care to job training to the environment.

Another important message is that tax cuts cost money -- and extending all of the 2001 tax cuts past their scheduled expiration in 2010, as many conservatives favor, would cost a lot of money. Consider this: extending the tax cuts just for the top 1 percent of households, a group that today makes more than $450,000 a year, would cost more over the next 75 years than the entire Social Security shortfall.

Thus, one of the most critical domestic policy debates over the next two years will be about which of the tax cuts to extend.

And a critical part of the tax-cut debate will be to ensure that policymakers understand that tax cuts really do cost money. Some people argue, despite clear evidence to the contrary, that tax cuts pay for themselves. If we fall for that claim, we're likely to end up digging the deficit hole even deeper.

Robert Greenstein is Executive Director of the Center on Budget and Policy Priorities.

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Smithsonian to put its 137 million-object collection online

WASHINGTON (AP) -- The Smithsonian Institution will work to digitize its collections to make science, history and cultural artifacts accessible online and dramatically expand its outreach to schools, the museum complex's new chief said Monday.

The Smithsonian Institution's new chief wants to bring in Web gurus to find creative ways to present artifacts online.

"I worry about museums becoming less relevant to society," said Secretary G. Wayne Clough in his first interviews since taking the Smithsonian's helm in July.

Clough, 66, who was president of the Georgia Institute of Technology for 14 years, says he's working to bring in video gaming experts and Web gurus to collaborate with curators on creative ways to present artifacts online and make them appealing to kids.

"I think we need to take a major step," Clough said in an earlier interview. "Can we work with outside entities to create a place, for example, where we might demonstrate cutting-edge technologies to use to reach out to school systems all over the country? I think we can do that."

Smithsonian officials do not know how long it will take or how much it will cost to digitize the full 137 million-object collection and will do it as money becomes available. A team will prioritize which artifacts are digitized first.

Clough told reporters and editors of The Associated Press that the Smithsonian will need a reorganized, central department that would become an authority on K-12 curriculum development.

The biggest advantage for the museums, including the American history and air and space, is that many of their visitors are younger. Longtime Smithsonian leaders acknowledge, though, that the academic side could do more to relate to youngsters.

"Wayne's coming from a place, Georgia Tech, where he spent a lot of time with 19-year-olds, which is a demographic that the Smithsonian doesn't relate to all that much," said Richard Kurin, the acting under secretary for history, art and culture. "That's where the future is."

It's also a new way for the Smithsonian to generate cash from private educational foundations or the U.S. Department of Education at a time when funding from Congress is flat and could decline, Clough said.

The Georgia native replaced a Smithsonian chief who was criticized for pursuing questionable commercial ventures, including a television deal with Showtime, and spending lavishly on corporate travel and expenses while trying to boost moneymaking operations.

The push to connect with schools comes as some museums across the country are seeing declines in student field trips, said Ford Bell, president of the American Association of Museums.

The federal No Child Left Behind law with its "focus on math and reading, and the high prices of gasoline is a double whammy," Bell said.

Some museums are going out of their way to prove their programs tie in with state education standards, Bell said. Museum leaders also are increasingly focused on digitizing their online collections, despite its expense, he said.

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