WASHINGTON — There's a memorable scene in The Wizard of Oz when an outraged Dorothy learns the mighty wizard is just an old man behind a curtain, blowing smoke out of a machine.

“If you were really great and powerful, you'd keep your promises,” Dorothy chastises after the wizard balks at taking her home to Kansas. “… You're a bad man."

It's a little like that as regulators and investors pull back the veil on the Wizards of Wall Street, only to discover a disturbingly large pile of bad debts, toxic assets and a whole lot of smoke. Lehman Brothers, Merrill Lynch, American International Group, Washington Mutual, Fannie Mae, Freddie Mac, Bear Stearns, IndyMac. The list of insolvent and hobbled financial institutions grows longer by the week.

For a generation, Wall Street was held up as a model for the rest of the world of strength, efficiency and transparency. But now, the country's vaunted banking system lies on the brink of ruin. Only the U.S. Treasury and Federal Reserve Board stand in the way of a total collapse with a $1-trillion (U.S.) bailout.

That price is so steep it could wreck the country's finances. At $1-trillion, the rescue would easily eclipse the savings-and-loan workout of the 1980s and 1990s. It would add roughly 10 per cent to the overall public debt of the U.S. government, punting the cost to the future.

“This financial crisis signals the beginning of the decline of the American empire,” said economist Nouriel Roubini of New York University, who has long warned that banks and regulators have hidden the severity of the crisis from investors.

“Over time, the relative economic, financial, military, geo-strategic power of the U.S., and the reserve role of the dollar will significantly decline,” Mr. Roubini said.

Obituaries have been penned for the American empire before, and they have proved to be premature. But the trillion-dollar burden is without precedent.

At its core, the credit crisis is about the unwinding of too much leverage and excessive borrowing on risky bets in the home mortgage market. The trigger, of course, was a slump in home prices. But as the saga unfolds, it's now apparent that the financial system itself was built on shaky foundations, hidden deep below ground.

Now, the task – and the risk – of restructuring the banking sector has fallen to the U.S. government, and future generations of taxpayers. The price could be paid in the form of higher interest rates down the road, as the government takes on new debt, and potentially limits its ability to devote resources to other priorities, such as health care, social security or the military.

Banking on a rescue plan

If the Treasury and the Fed were not propping it up, the U.S. financial system would be bankrupt. The Treasury now owns or guarantees nearly half the country's mortgages through its seizure of Fannie Mae and Freddie Mac. The Fed owns most of AIG, once the world's largest insurer based on market value. The central bank has also lent billions more dollars directly to banks and brokers in exchange for increasingly dubious collateral to ease the burden on banks.

And that's just beginning. Key Fed and Treasury officials are huddling this weekend to work out the details of a proposed superfund to buy up much of the bad debts that have paralyzed the banking system, while attempting to salvage the institutions that own them.

That's what Washington did in the 1980s to end the savings-and-loan crisis. But this fund is potentially much more costly and complex, perhaps a staggering $1-trillion. The S&L workout took more than a decade and cost taxpayers $124-billion.

The prospect of a mega mortgage bailout raises the question of what's the price, and more importantly, can the U.S. afford it?

The Fed, which flooded financial markets with nearly $200-billion this week, is already stretched. After the $85-billion loan to AIG, the central bank had just $200-billion of unpledged assets left on its roughly $900-billion balance sheet. So it will expand its balance sheet and create money, which it can do virtually at will, by buying securities from commercial banks.

The final cost to taxpayers of the bailout is unknown because no one really knows how much of these assets the government will have to buy, nor what it might recoup when the workout is complete several years from now, pointed out Robert Litan, a former top budget official in the Clinton administration who is now director of economic studies at the Brookings Institution in Washington.

“We don't know what all this stuff is worth, and neither does the government,” Mr. Litan said. “But it's safe to say people will be paying for this for a long time.”

Just as banks binged on debt, so too can governments. The United States is on track to post a deficit this year of $425-billion, or 2.8 per cent of gross domestic product, swelling the national debt to more than $5.4-trillion, according to a recent Goldman Sachs estimate. That's more than double the 2007 deficit of $161-billion, or 1.2 per cent of GDP.

For the moment, at least, a $1-trillion bailout would have no impact on the budget deficit. It would, however, add significantly to the overall public debt. The government will presumably create a separate entity, equipped with its own borrowing authority to acquire toxic assets. The plan is to hold these assets – mainly mortgage securities – until housing prices recover, and then sell them at a better price.

“Nobody has any idea if there will be losses,” said National Bank Financial chief economist Clément Gignac, who lived through Canada's own debt crisis of the mid-1980s.

“Debt is always a concern,” Mr. Gignac said. “But debt to avoid a depression – I have no problem with that.”

For perspective, the United States is still in much better fiscal shape than Canada was during the depth of its debt mess. Canada's annual budget shortfall peaked at nearly 9 per cent of GDP in 1984-85. And the country survived, thrived even.

Triple-A, for now

For now, the U.S. enjoys a gold-plated Triple-A bond rating.

But this week, Standard & Poor's raised the unthinkable – that the U.S. could eventually lose its good credit record unless it gets its finances under control.

Remarked S&P's John Chambers: “There's no God-given gift of a triple-A rating, and the U.S. has to earn it like everyone else.”

The ability of the U.S. government to raise cash depends on the appetite of global investors, particularly the Chinese, for American debt.

Fortunately for Washington, China does not seem likely dump its holdings in U.S. Treasury bills and other government bonds. China invests in those securities not just to make money or park its funds in a safe place but to help support the U.S. dollar. A falling dollar would make it harder for American consumers to buy Chinese exports, the engine of the Chinese economy.

And despite the massive financial obligations that the U.S. government has assumed by bailing out Wall Street, U.S. government-backed securities still look good to investors compared with the alternatives.

“What are they going to do, invest in Italian government bonds?” said William Cline, a senior fellow at the Peterson Institute for International Economics in Washington.

The irony is that even as Washington has assumed hundreds of billions of dollars in new commitments by backing up failed and failing financial firms, its own securities are still considered safer than private securities – shares in banks and other big companies that are exposed to the winds of the shaky markets.

“It's going to take some time to see if international investors think the U.S. government is piling up so much debt with all these bailouts that it is no longer quite the blue chip it has been in the past,” Mr. Cline said.

The engine that makes all of the borrowing possible is the U.S. economy, which is huge, and still expanding. But the demands on Uncle Sam are growing at an even faster clip: 13 per cent a year on George W. Bush's watch, or roughly four times economic growth.

Even before the current crisis, U.S. debt levels were unsustainable, without much higher taxes or drastic cuts in social security and Medicare benefits. A recession would compound the problem, swelling expenditures and eroding tax revenue.

One thing is clear: The country can't go on living beyond its means. Too many Americans bought homes and cars with loans they couldn't afford. Banks made risky bets they were never prepared to lose.

Now that all that leverage is coming unwound, all eyes have turned to Washington.

Coming home to roost

As with many crises, U.S. financial authorities are cleaning up a mess that stems in part from their efforts to address the last corporate disaster. This time, new U.S. accounting rules designed to end the abuses of the Enron era made the current crisis worse.

Since the credit crisis began more than a year ago, investors have been exposed to a murky world of synthetic securities, credit default swaps and structured investment vehicles, convoluted financial tools that even the savviest bankers don't fully understand. The extent of the problem was invisible.

Ever heard of Level 3 assets? Last November, regulators began requiring banks to categorize their assets based on current market value in a three-class liquidity rating system, with Level 3 at the bottom of the heap. These are the assets for which there is no ready market, and therefore are virtually impossible to price, such as soured mortgage-backed securities.

In recent months, regulators turned a blind eye as the major investment and commercial banks stuffed their balance sheets with Level 3 junk. They allowed banks to put their own inflated prices on often dubious investments – some now probably worthless – instead of insisting on more realistic valuations. Banks, in turn, succeeded in avoiding larger writedowns, while presenting healthier books to the world.

The Federal Reserve and the U.S. Treasury, some economists say, missed their chance to head off the disaster by failing to blow the whistle on the banks' Level 3 junk.

Goldman Sachs, for example, reported this week that 6 per cent of its assets – $68-billion worth – are of the Level 3 variety. All of them could be worthless as far as outsiders can tell. Before its bankruptcy filing, the much smaller Lehman had $42-billion in Level 3 assets. But even that figure may understate the full extent of the firm's dodgy real estate investments.

As the mortgage market imploded, investment banks refused to acknowledge the full extent of their losses.

“A massive amount of creative accounting and other forms of balance sheet window dressing is occurring to prevent banks from recognizing their true losses,” Mr. Roubini explained. “Most of these earnings reports are not worth the paper they're written on.”

Now, investors assume it's all junk, exposing banks to attacks by short sellers. Think of the demise of Enron, but on a grand scale.

One of the key reasons the Fed agreed to buy AIG is because the company is a major player in credit default swaps (CDS), a form of insurance against potential losses on an array of debt instruments.

With the help of swaps, risk is bought and sold like a commodity by often invisible actors, in a global market with scant regulatory oversight. A decade ago, CDOs didn't even exist. Today, the market is colossal, worth roughly $50-trillion. For a sense of scale, that's five times the size of the U.S. mortgage market that is the epicentre of the credit crisis. Risk has been shuffled around like the pea in a shell game so that no one really knows where it ends up.

“It's a pyramid-like situation,” explained Erik Benrud, a finance professor at Drexel University.

If there is a silver lining, it is that while financial institutions play an important role in the economy, they represent a relatively small part of the $14-trillion U.S. economy, Prof. Benrud pointed out.

“There will be a shakeout, but the good banks will survive this,” he insisted.

The root of the problem

There will be lasting consequences of this bailout. As the word implies, the government is coming to the rescue, as it has in the past.

Many will argue, as Treasury Secretary Henry Paulson did when he outlined the superfund plan Friday morning, that the government had little choice. Without such a bailout, he argued in stark terms, the country would face “a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.”

If the bailout succeeds, the crisis will pass. But will the seeds of the next bubble be sown in the process? As the government steps in, banks and homeowners will make the assumption that Uncle Sam will step in again the next time they're in trouble. It's the old problem of moral hazard.

“The inevitable result," said Bank of America economist Peter Kretzmer, "is to encourage excessive risk-taking and future losses.”

With files from Marcus Gee

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