Henry Paulson’s Frankenstein

The government purchases 79.9 percent of the company in question. It can’t be more than that, because if it goes over the magical number of 80 percent, the company’s debts are then required to be consolidated onto the federal government’s balance sheet. Keeping it at 79.9 percent allows the government to maintain the fiction that it is still not responsible for the company’s solvency.

The purchase isn’t even a purchase of the stock of the company. Rather, it is a purchase of warrants giving the federal government the right to buy some number of shares. This permits the federal government to further claim that it doesn’t even have an ownership interest.

Meanwhile, the necessary debt funding is placed at a politically appropriate level. The debt can’t go too high in the capital structure of the company being rescued, because that might cause more turmoil or tick off foreign buyers.

Rather, the debt must go in just right, like porridge — enough to knock out the security holders it is politically acceptable to dilute (usually preferred and common stock holders) but to keep other interests happy.

Then you probably want to replace management; after all, they are the ones who got you into this mess. (It will be even better if the government actually takes a stab at fighting moral hazard by stripping the executives of their pay packages.)

The details of the bailout of American International Group are still emerging, but it is already clear that it follows these lines — similar to the rescues of Fannie Mae and Freddie Mac.

There will be an $85 billion revolver loan, and the government will have a 79.9 percent interest. It is unclear if these are warrants or an actual interest, but I suspect warrants. The loan will be for two years and have a yield of three-month Libor plus 8.5 percent (about 11.3 percent these days).

To be honest, I hope they do bring back Hank Greenberg to run it. It is time to forgive him of his sins for the sake of the country. Sorry, Eliot Spitzer.

I’m hard pressed to say how we got into this mess yet again so quickly. It is certainly a lesson in the need for trust in the market to survive, the dangers of precipitous share-price falls and the weird role the ratings agencies still play.

Jim Cramer, the host of “Mad Money,” said last night it was the fault of the short-sellers, and while I usually hesitate to agree with him, I do think that we should put limits on naked shorting of financial institutions. Now.

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