This post first appeared on Minyanville and our sister site Dawn Patrol.

The bailout is done! Time to breathe a sigh of relief.

Or is it?

As details emerge about the financial bailout package that was jammed through Congress over 10 days of political theater at its most nauseating, there’s still a striking omission from the plan to right American’s economic ship.

The failure of bureaucrats and regulators to propose a realistic solution for the foreclosure problem is emblematic of their inability to treat the root cause of an issue, focusing instead on simply applying band-aids to the visible symptoms.

The bailouts of Bear Stearns, Fannie Mae (FNM) and Freddie Mac (FRE), and AIG (AIG) all claimed to remove the cancer - but all they did was hasten the patient’s demise.

Treasury’s plan will deliver money into the banking system to sop up toxic assets sitting on the balance sheets of our financial institutions. This is a necessary — albeit unfortunate — step, but it still doesn’t address the root of the rot: Milions of homes are worth less than the outstanding balance of the owner’s mortgage.

Billions of dollars in negative equity are destroying Main Street’s balance sheet even as it devours Wall Street, eroding the value of the very securities Taxpayers are about to start buying.

As long as Washington tries to fight foreclosures with ineffective loan modification programs that simply prolong the problems, foreclosures will continue to set records. Modifying a mortgage for someone who is barely scraping by is sort of like rescuing him from the side of a cliff, only to leave him on the edge, dangling by one arm.

Foreclosures are often blamed for spiraling home prices and the resulting collapse in value of securities tied to the mortgages used to buy those houses. According to Bloomberg, the government’s aid package is designed to support “financial companies reeling from the record number of home foreclosures.”

Foreclosures don’t cause houses to lose their value. Foreclosures happen when a home loses value such that it’s worth less than the mortgage used to buy it, and the homeowner can’t sell or refinance if his interest payments become overwhelming.

Defaults become delinquencies, which become foreclosures, which become evictions, which become repossessions, which flood the market, depressing prices as supply outstrips demand.

Back in what seems like ancient history, when home prices only went up, banks weren’t too concerned with defaults, since homeowners could almost always sell themselves out of a problem. Foreclosures stayed low because the liquid, appreciating housing market bailed out troubled homeowners on its own. That’s part of the reason the industry is so ill-equipped to handle the scope of the current problem: it never had to before.

But now, with so many borrowers underwater — owing more on their house than it’s worth — defaults result in not only eventual liquidation of the property, but profound distress in the homeowner’s life and real losses for investors. Furthermore, delinquent borrowers are less inclined to pay for upkeep or security, and many foreclosed homes are seriously damaged by the time a bank is able to take possession of it.

Being underwater is debilitating. To sell, not only does a homeowner have to pay a Realtor 6% whether he gets a raw deal or not, but he has to pay the bank the difference between where his home sells and the outstanding balance of his loan.

For many who have seen the value of their homes fall hundreds of thousands of dollars, this is an impossibility. Most homeowners, once they’re upside down, just want to stay in their homes.

A more effective plan to curb foreclosures would require an independent reviewer to evaluate each delinquent mortgage, determine the borrower’s ability to pay going forward and the amount, if any, of negative equity that needs to be destroyed to bring the loan amount back under the home’s value.

Since the notion that buying Wall Street’s toxic assets will result in windfall profits is a willfully distributed fallacy aimed at getting the public on board for the bailout, Taxpayers would be well-served dumping money into a blender that’s at least in their own backyard.

British Prime Minister Gordon Brown recently proposed a similar plan, where the government will buy delinquent mortgages from banks for the outstanding balance of the loan. The home is then rented to the existing tenant or a new one and managed by a local housing association.

The government would absorb the difference between the loan amount and the resale value, which would hasten increase sales activity, clearing out the glut of homes listed too high for the simple reason that the owner can’t afford to sell at a lower price.

This type of personalized bailout, unfortunately, reeks of moral hazard. Many individuals who made bad financial decisions will get to keep their homes, albeit without actual ownership. But the current socialization of our free markets is simply moral hazard be design, so if Congress is so hell-bent on bailing out Wall Street, why not share the spoils with Main Street.

If Congress wants this bailout to help the American people and keep the financial system in tact, a sizable portion of the funds should be directed at fixing the asset that’s at the center of this turmoil: the residential property.

Home prices need to come down further. They will come down further. It’s only a matter of time. We can either let home prices bleed down, slowly eroding the value of the securities they support and violently uprooting families, or the government can plug the hole.

Washington Mutual (WM) is already off the field, as JP Morgan (JPM) continues to play widowmaker for the financial system. Wachovia (WB) isn’t likely to remain independent for long. The sooner the rebuilding process begins, the better.

This crisis, and the resulting ebb and flow of what remains of the free market has already tipped the scales, started us sliding down a path of deflation in everything from stock prices, to cereal boxes, soda bottles, not to mention homes.

This is a good development. The hardest lesson Americans will learn from this crisis, should learn from this crisis, is that sometimes it’s necessary to live within our means. There is virtue in simplicity. More is not always better. Bigger is not always better. Sometimes, amazingly enough, less is often better.

This progress is the only true way we’ll make it out of this mess.

This post first appeared on Minyanville.

When Bank of America (BAC) agreed to buy Countrywide, it didn’t just take on a mountain of questionably valued mortgage-related assets. It also took on huge legal liability.

San Diego City Attorney Mike Aguirre, who has a penchant for punitive lawsuits that rarely result in much more than a media frenzy, is accusing Countrywide of defrauding thousands of San Diego homeowners. A lawsuit has already been brought at the state level by California Attorney General Jerry Brown, as well as in several other states, including Washington and Illinois.

San Diego’s suit takes aim at Countrywide’s alleged practice of coercing borrowers into risky adjustable rate mortgages (ARMs). Aguirre hopes to make San Diego a “foreclosure sanctuary” by preventing foreclosure proceedings on any property secured by a subprime ARM where the borrower owes more than the home is worth. (For more on what the glut of upside-down homeowners means for the future of the housing market, please read Finding the Bottom in Housing.)

The litigious City Attorney isn’t satisfied with just taking aim at Countrywide (and, by extension, Bank of America). Aguirre said he’s planning similar suits against Washington Mutual (WM), Wells Fargo (WFC) and Wachovia (WB).

While Aguirre’s heart may be in the right place, foreclosure moratoriums aren’t part of the road to recovery for the housing market. Opportunistic mortgage market participants are buying delinquent mortgages on the cheap, forgiving some part of the debt and giving borrowers a fresh start. Government intervention in this process will simply scare off lenders, since they’ll have limited recourse if the loan goes sour.

At best, such suits will simply drive up the cost of new mortgages. At worst, they’ll bring the recovery process to a standstill.

Foreclosures are nasty, painful and tragic. They are, however, a necessary part of the mortgage process, enabling lenders to recoup losses on bad loans.

Mandating an end to foreclosures is like telling the IRS it can’t go after tax evaders or preventing cops from chasing down burglars. This is not to say victims of foreclosures are criminals or necessarily deserve to be thrown out on the street, but living in a law-abiding society means that contracts must be enforced.

The moment we waive one group’s obligation to honor their collective word, the floodgates are open.

This certainly isn’t the last lawsuit we’ll see following the collapse of the mortgage market. In fact, it’s just the tip of the iceberg. A couple years from now, when Option ARMs begin to reset, class action lawsuits will bear down on lenders like a rumbling avalanche rolling down a steep slope.

Banks would be wise to get long some lawyers.

This post first appeared on Minyanville and our sister site Dawn Patrol.

After leading the banking sector to its largest ever one-day drop yesterday, Washington Mutual (WM), in an effort to assuage concerns that it’s facing a cash crunch, released a statement claiming that the bank is “well-capitalized.”

Though the stock bucked the trend this morning as the broader financial complex continued its unrelenting sell-off, shareholders aren’t likely to be comforted by the WaMu’s pleas for calm.

The largest savings-and-loan in the country has seen share prices fall below $4 following the seizure of IndyMac (IMB) by benevolent federal banking regulators; investors fear WaMu could be next.

IndyMac was reopened on Monday to handle endless lines of depositors hoping to recover their pennies from the bank’s coffers.

In a stark reminder of just how dicey bottom-picking can be, Bloomberg reminded us that private-equity firm TPG led a consortium of investors in providing the bank with $7 billion in much-needed cash in April, when the stock traded at $13. Those daring saviors have seen most of their investment wiped out.

TPG did, however, slip a protective clause into the deal: If the stock drops below $8.75 — which it clearly has — TPG is owed the difference, effectively putting the bank on the hook for its own equity losses. While protecting TPG’s investment, this feature also makes it considerably more costly, if not impossible, for the bank to raise more capital, which would further dilute shares.

As more details emerge about these and other onerous terms with which banks have been forced to agree in their efforts to raise capital, it’s becoming clear just how misguidedly optimistic investors were when such deals were first announced. Banking expert Minyan Peter wrote of the WaMu deal:

“I think the problem for most market participants right now is the assumption [that] what we’re experiencing looks something like ‘their prior experiences in banking crises.’ And to me, that’s why we have seen such a big rally over the past two weeks — because, based on prior experience, a rally feels very right, right about now.

But for all the reasons I shared before, this one is different.”

We’re now seeing just how different this one is.

Professor Depew explained Friday how the Fannie Mae (FNM) and Freddie Mac (FRE) crisis is different from the Long-Term Capital Management failure in 1998: In this case, massive losses by financial institutions around the world are a symptom, not the cause.

A few misplaced bets aren’t to blame for the market turmoil; neither is rumor-mongering. The financial system’s problems, and by extension the economy’s, are rooted in years of mispriced risk and excessive leverage. Markets are now witnessing the destruction of that debt at a rate that’s stomach-churning to the traditional buy-and-hold investor.

The process, though painful, is necessary. The debt will be destroyed, firms will go out of business and the economy will slow, if not contract. All this is healthy. Agonizing, to be sure, but healthy.

As Toddo wrote yesterday on the Buzz and Banter, “The big picture blues will lead to an unfortunate destination, but that’s necessary to rebuild the foundation for sustainable economic growth. Once we get there, those with capital will be in a fantastic position to prosper.”