When you’re in the middle of a maelstrom, it’s hard to step back for a teaching moment.

The prospect of Fannie Mae and Freddie Mac failing is almost too unsettling to contemplate. As one investor told the New York Times, “If people lose faith in Fannie and Freddie, then the whole system freezes up, and nobody can buy a house, and the entire housing market can crash.”

We’re talking about a pair of institutions that hold or guarantee more than half of the nation’s mortgages.

In other words, they’re TBTF (too big to fail) and it’s a sure bet that we won’t let them go under. Treasury Secretary Henry Paulson apparently asserted today that the government is not planning an imminent bailout , by which he means that the government is busy planning an imminent bailout.

If you’re like me, you could use a short break from sweating bullets about all this. First, read Steve Pearlstein’s sage, measured take on this in today’s Washington Post. It’s easy for us to overreact at times like this and dig ourselves in deeper by being too heavy-handed with short-term fixes, like requiring all the banks with large write-offs to replenish their capital stocks right away. He concludes, “In the end, what matters most is that we get through it as quickly as possible with an economy and a financial system intact.”

I’d amend this point. What matters most is that we learn a lot more about what went wrong and implement some fixes. Not necessarily today, as Pearlstein stresses, but soon. When it comes to financial markets, our modus operandi is starting to look like shampoo instructions: bubble, bust, repeat.

So here are a few random observations that came to my mind when contemplating the Fannie/Freddie potential meltdown in the context of the bigger picture.

-- Bubbles are much worse than we like to think, and we should work much harder to identify and prevent them. By “we” I mean, among others, the Federal Reserve, who, under Greenspan, had a fairly explicitly stated policy of waiting by the sidelines as the bubbles inflated, mops at the ready.

-- Overleveraging means undercapitalizing. See Fannie/Freddie/Bear Stearns and pretty much every hedge fund and investment bank that borrows short and lends long. I don’t really care if big banks play with fire, until I’m called upon to put the fire out. If you’re TBTF, then we must provide you with the necessary oversight to avoid charging a costly bailout to US taxpayers.

-- When derivatives are worth multiples more than the underlying value of the equity or bond from which their value is derived, that’s not a hedge. It’s a big, speculative bet and a recipe for greater volatility and risk ... risk which will typically be under-priced. I’m still working out the arithmetic on this one, but I pretty sure I’m right.

-- Speaking of pricing risk, yes, moral hazard is a big problem that contributes to the underpricing of risk (which, at some level, is the one factor behind all the bad stuff that’s happening now). But the time to worry about moral hazard is not the weekend when the big bank is failing. It’s years before, when you’re setting up the regulations under which the financial system can flourish without going off the rails.

BTW, on these points, I haven’t found a better set of ideas than those of Michael Lewitt, expressed here.

I could go on, but I’ve got to get back to biting my fingernails.

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Everyone’s been so busy searching for the alleged Bush recession that they’ve missed what the markets are trying to tell us about next year. As the attached chart shows \(courtesy of Professor Mark Perry’s Carpe Diem blog \), the current bear market corresponds fairly well with the drop in the probability of a McCain victory.

Intrade’s presidential future’s market \(where investors buy and sell futures based on their estimate of the probability of a particular candidate’s victory\) has been tracking the falling prospects of McCain and the rising expectations of an Obama victory. As of this writing, Obama futures are trading at more than a 30 point premium over McCain futures. This doesn’t, of course, mean that the market thinks Obama will win by 30 points. It means that the markets think that he is about 34% more likely to win than McCain. In other words, it’s not a margin of victory; it’s a margin of the probability of a victory.

I don’t think that the current Dow bear market was caused by last August’s credit crunch. Nor do I believe it’s being caused by a recession that is allegedly starting right now (having failed to appear in the first or second quarter). Stocks are forward looking; when they drop now, it means investors are worried about things that are coming later – 6 to 9 months later. In other words, they’re worried about Obama.

And why shouldn’t they be. He’s promised to erase Bush’s investor tax cuts. That means a hike in the tax rates for dividends and capital gains. This means very large additional levies directly on investors. Of course this affects stock prices. It is ludicrous to suggest that adding a tax directly on an asset class would have no effect on the value assigned to that asset. Add to that harrowing scenario our already high levels of inflation, which the tax code treats as a gain, even though it isn’t one, and we’re getting to some very high tax rates on capital. This is happening just as most of the developed world has been cutting its cost of capital.

The political class is shifting left. We’re likely to get Obama and Nancy and Harry running the most advanced economy in the world next year. The investor class doesn’t like what it sees coming. That’s why it is scaling back. Capital is going on strike, and we won’t come back to the table until we see that we have a chance to a fair deal.

What are other CNBC.com guest commentators saying?

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The market enjoyed a good day yesterday and at first blush you could attribute rising stock prices to falling oil prices (crude oil was off over $5 on the day.) Jerry Bowyer and David Malpass both had an interesting view on Larry Kudlow's show as to why oil prices slumped.

Earlier in the day, Fed Chairman Ben Bernanke left open the likelihood that the Federal Reserve Discount window will stay open to investment banks for the foreseeable future. I think that is exactly the right thing to do. There is little borrowing going on as investment banks don't want to appear desperate by going to the Fed, but if one of them indeed becomes desperate, then the window will be open and another Bear Stearns could be avoided.

I need to pass along the beginnings of a note from JP Morgan strategist Michael Cembalest. In his latest commentary, he writes,

"'I have come to the conclusion that one useless man is a Disgrace, two are a law firm, and three are called a Congress.' So said John Adams.

"The same applies to energy independence in 2008. As the US endures an energy crisis and imports 60 percent of its energy needs, the House and Senate decided to take action: they overwhelmingly voted to allow OPEC to be sued in US courts for running a cartel. The mind reels.

"Over the past 30 years, elected officials blocked nuclear build-out and spent-fuel storage construction, impeded construction of oil refineries, refrained from passing meaningful alternative energy legislation, imposed a tax on cheaper Brazilian ethanol, prevented offshore drilling in Alaska, California, and Florida, blocked the construction of LNG ports, killed wind farms in their own backyards (or back bays) .......They got it wrong; Congress should sue itself."

Amen!

On "The Call" today Bob Pisani made the excellent point that in a bear market all the sectors usually get shot. So it is today, as the materials and energy names, especially the natural gas names, are being sold. Byron Wein, a deservedly famous strategist, feels that the market is bottoming and will do better later this year. (See Market Insider blog post: "Market Strategist Wien: Stocks Are Bottoming ")

Joe Belestrino of Federated Investors hasn't yet seen capitulation on the part of individual investors, as there haven't been large redemptions of funds by the private investor.

All of the above opinions can co-exist with one another. I'm thinking that by the time the markets are off the 20 percent needed to declare it a bear market, two-thirds of the damage has been inflicted and I'm more inclined to look for opportunities. A couple of names offered today on the show by different money managers were Monster Worldwide, Boeing, and Philip Morris International. I happen to own Boeing, but the quick case made for the other two names was intriguing enough to make me want to look at them.

Oil is off sharply, and I'm hoping this will continue as the inflationary implications of high oil prices are severe.

The highest marginal cost of production of a barrel of oil anywhere in the world is close to $75 and I'm probably much too high. Add to that some sort of geopolitical risk premium and my target for oil is towards $100. I think that oil will be only more expensive as time goes on, but this super-spike we are in should correct back to where demand won't be destroyed. I'm figuring that is around $100.

I'm not negative on the oil equities, as they haven't gone up with the price of crude. If I didn't own any I would try to wait a bit and then buy Chevron (which I own.) Lehman just issued a report and said if oil were to average $115 a barrel next year, CVX would earn over $13. With the stock around $98, the P/E multiple is less than 8 times.

Ben Bernanke also indicated in a speech that the Fed will keep the Primary Dealer Credit Facility (PDCF) open for investment banks. This is, in my opinion, necessary to allow the system time to heal.

Since there is a stigma attached to going to the Fed, the investment banks are avoiding this avenue of liquidity, but it's necessary to have the vehicle. If it were to become permanent, different regulations would be needed to put commercial banks and investment banks on the same page. But that can be worked out.

I will be on Larry Kudlow's show tonight (Tuesday) at 7pm NY time. Financials looking okay at this hour, so maybe I won't have the dotted line around my neck cut too much tonight.

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If Barrack Obama wins the presidency, the price of oil could fall by $40 per barrel. The financial markets will discount the possibility before hand, at least partially. There are three ways in which this could happen:

1) As was the case during the Clinton administration, Obama might be more inclined to intervene in the foreign exchange market to support the value of the dollar. The U.S. has not intervened in the FX market since Treasury Secretary Robert Rubin did so in September 2000 when the Treasury sought to support the Euro, then costing about 80 cents per dollar (yes, the cost has almost doubled since then). Intervention or the threat of intervention could shave $20 off the price, based on the divergence in price between oil quoted in dollars versus that of other currencies.

2) Obama will speak in a more concilatory tone toward nations in the Middle East. If he does, some of the risk premium would likely be extracted from the oil price.

3) Energy conservation and investment in energy infrastructure are likely to increase if Obama wins, as it will be part of his mandate. Announcements of a nationwide effort to both decrease consumption and increase the supply of energy would have an announcement effect on the energy markets, lowering energy prices and burning speculators.

Points 2 and 3 are probably the most bankable ideas, but the mere threat of point 1 is still enough to impact the markets.

More: Click for Latest Economic coverage ...

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The commodity sector appears to have taken a roman candle shot to the head over the Fourth of July Holiday weekend. The spikes in crude oil, gasoline, heating oil, corn, copper, cocoa, too name several, have been largely erased.

The malaise being exhibited by the equity markets and the deteriorating economic outlook appear to have affected the psyche of market participants. A major component of the macro commodity bull run has centered on unyielding demand. So far, we have only seen energy demand destruction of any significance in the United States.

As I write this, I sit here in Western Pennsylvania, atop the Marcellus Oil Shale Deposit, which may become one of the largest sources of natural gas in the world.

The CEO of its development company recently told Larry Kudlow that things were going pretty quickly for him because most of the land above the deposit is privately owned. Negotiating with private owners, he said, who have an incentive to negotiate mineral rights, works a lot better than negotiating with governments. (See the video)

Some western states are almost all government owned, and the resources of those states remains buried in the ground. Not so with Pennsylvania, which is historically a farming state. That’s why the world’s first commercial oil well was sunk not far from here, in Titusville, on what previously been a farm.

Energy prices continue their rise, and why not? They continue to get support from every quarter that determines their calculus. The round robin of factors is familiar to anyone that has paid attention to the rise: global security issues, unrelenting demand strength from Asian nations, and the weakness of the US dollar, among the financial levers.

The extensive speculation over a possible Israeli attack on Iran’s nuclear facilities set off a renewed speculative fervor over what a post-attack crude oil supply landscape would look like. It’s not pretty. Iran’s Foreign Minister, Manouchehr Mottaki spoke of a line of fire from Lebanon to Tehran, across the Middle East, in an attack’s aftermath. The shutting the Strait of Hormuz by Iran, disrupting one-fifth of world supplies, is a given, in the scenario analysis.

In a disappointment for the hopes of consumers, the energy market failed to take some obvious clues from Washington and the very same Iranian official. Diplomacy was clearly emphasized in all the various commentary of President Bush and others.

Lies and Mendacity seem to be spreading thickly through thefinancial markets today as we watch the Dow Transports dropsharply as energy continues to rally and gasoline demand in theUnited States drops.

With both President Bush and US Treasury Secretary Paulsongiving speeches today, you wonder how important it is to seethem engaging reporters ahead of the G8 meeting. Isn't thisjust a bit unusual for the President to talk about a financialsummit almost a week before it occurs?

I'm watching Paulson get grilled on his speech from Europeanreporters and stating the obvious: the financial regulatoryinstitutions we have are far from optimal.

Life with Kudlow is always interesting. Last night's lively discussion/debate centered in part on John Mauldin's (newsletter writer par excellence) bearish view of the earnings outlook. He feels that the price level of the S&P is too high relative to what will be disappointing earnings.

I'm not sure what earnings are going to be so let's plagiarize some of Jason Trennert's work from Strategas. Jason looked at all the recessions since WW II and calculated that on average earnings fell 17% from whatever the peak had been. I don't see a recession on our table yet, but let's declare one for the sake of argument. The recent peak in earnings was the four-quarter period ending June, 2007 when the S&P earned $91.50. If we take 17% off that, and remember, those that don't study history are condemned to repeat it, then the trough in earnings will be $76. That number is far below any estimate I have seen, so that might be bearish enough.