We are Jerome Kerviel

It turns out that one newly unemployed guy wasn’t doing so bad earlier in the month. Jerome Kerviel had ‘1.4 billion in profits on his book earlier in January 2008. (WSJ.)

I keep wanting to sketch out how Kerviel –speculating wildly, way beyond his limits, hiding his speculation from everyone with a series of offsetting paper trades — is a near perfect metaphor for our entire economy. Everyone is in on it and nobody wants to look too closely at how rotten the whole scheme is.

Consider that US banks are getting ready, with the collusion of bank regulators, to try to bail out the bond insurance agencies who are supposed to cover bond defaults. Why? Because if the bond agencies get downgraded from their current AAA rating, then all the bonds they’ve insured are worth less. And if those bonds are worth less, then the banks’ portfolios will have to go through another round of brutal markdowns.

Does nobody notice that this circle of risk-washing is fictitious — the banks are basically just stepping in as guarantors of the bonds already on their own books? You could call it fraud, except regulators are right there at the table too.

You have to read the NYT article to see how perverse the scheme is (bolds are mine):

Eight major banks are in talks to bolster the Ambac Financial Group, the troubled bond insurance company, as part of an industrywide rescue being orchestrated by state regulators, people briefed on the negotiations said Friday.

The banks, which include Citigroup and UBS, are considering injecting capital into Ambac and assuming some of the risks associated with guarantees written by the company, these people said.

The plan is still in flux, and it is unclear how much money the banks might commit to the effort, either by extending credit to Ambac or by buying a stake in it. It is also uncertain if such moves would be enough to restore confidence in the insurer and safeguard its triple-A credit ratings from Standard & Poor’s and Moody’s.

A spokesman for Ambac declined to comment, but people briefed on the talks said Ambac’s management is involved in the negotiations. The group is planning to reach a deal in ‘days, rather than months,’ one person involved in the talks said. Once the parties have reached a deal they will present it to the ratings agencies to make sure the plan meets their requirements for a triple-A rating.

Regulators are hoping to arrange similar rescues for other guarantors like MBIA and the Financial Guaranty Insurance Company, which have been hit hard by declining values in mortgage securities they insured, but are moving one company at a time. Ambac is in more dire financial straits than its larger rival, MBIA, which has raised $1.5 billion in recent weeks.

The New York insurance superintendent, Eric Dinallo, has hired Perella Weinberg Partners, the investment bank, to advise him and bring the parties together. Mr. Dinallo is not attending the negotiations but is receiving frequent updates and is keeping Gov. Eliot Spitzer abreast of the developments.

Speed is crucial, according to people involved in the talks. On Friday, Moody’s warned that it might downgrade the bond guarantors by late February if the companies did not raise capital and pursue a ‘viable business plan.’

Investors fear a chain reaction of losses might rock the financial industry if even one big bond insurer were to lose its top credit rating. The concern is that Ambac and MBIA, which have guaranteed more than $1 trillion in municipal, corporate and mortgage debt, will not have the capital they will need to pay claims as defaults rise.

Many big banks and investors that hold mortgage securities guaranteed by the companies would have to write down the value of those investments if the insurers were to lose their top ratings. Those losses could total tens of billions of dollars for some banks.

The banks participating in the Ambac talks are said to be those that have the most direct exposure to that company, people briefed on the talks said. Likewise, other banks that have heavier involvements with MBIA and Financial Guaranty are working on plans to help those companies.

“Speed is crucial.” That’s the give-away that this is a flimflam, a shell game. If we don’t hyperfast stuff this dreadful panther back in the bag of denial, we’ll have to admit how wildly unstable our banking system really is… and then it’s gonna shred of us.

The whole banks-underwriting-insurers-of-bonds-in-bank’s-portfolios scheme is just as fictitious as Jerome Kerviel’s paper-trading to cover up his massive profits and losses. Banking is based on faith — I give you money today based on my faith that you’ll give it back to me tomorrow — and bad faith banking is suicidal.

But we can’t throw 10,000 upright Wall Street folks — rating agency staff, bond insurance executives and bond-addicted-bankers — in jail, can we? (Or can we?)

The real solution is morally rotten, but might keep the economy from cratering. We should skip the charade of having the bankers guarantee their own bonds with the collusion of ratings agencies and regulators; to avoid a banking cataclysm, the government will probably have to bail out the rotten bond insurance agencies, thus bailing out the rotten bankers. (Just as the 3% discount rate is padding their profit margins right now.) Then we’ll all pretend the whole thing never happened. Except we’ll have to live with the higher taxes and the inflation.

First, though, the government should expropriate 10 years worth of banker, bond insurer and ratings agency executive bonuses and the Porsches, Greenwich swimming pools and Winged Foot memberships they bought.