Everyone should read this article because it explains why the Treasury is busy bailing out Ma and Pa Banker exactly the way they are bailing out Ma and Pa Banker:

Freight Trains and Steep Curves

The U.S. financial system’s big gamble on perpetually low short-term interest rates

© 2003 John P. Hussman, Ph.D.

Geithner is a well- polished and arrogant idiot but he is constrained by the system he allowed (as chief of the New York Fed) to flourish. John Hussman briefly instructs all how the currency and interest rate swaps work. Believe it or not, there are trillions and trillion of dollars worth of these things out there!

Transforming risky debt into government backed paper

First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and too big to fail at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

In a nutshell, this is why the Treasury dudes are acting like felonious assholes. They have no real choice. Because of swap strategies, the US is a counterparty to a large percentage of interbank lending ‘action’.

This article was written in 2003 and is … prescient. Nothing about Peak Oil or freight trains, however. Quite mysterious.