Today’s guest blogger is Daniel Alpert, a managing director at Westwood Capital, whom I’ve quoted quite a bit in my column the last few months. Why? Because he has been dead spot on in anticipating virtually every iteration of this crisis. Last night he sent me (and others) this note about the testimony of Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Chairman Ben S. Bernanke. It aptly sums the current the state of play. I asked him if I could reprint his note here at Executive Suite. Happily, he agreed.

Secretary Paulson has told us since last week that he’s late, he’s late for a very important date and has no time for a reasonable legislative debate (although willing to indulge in the “hello/goodbyes” of Congressional testimony, provided it doesn’t take too long). But instead of following him through the looking glass, like naïve and curious Alice, let’s pause and take a peek though the glass before taking the leap of faith the Treasury and Fed are asking of us.

As with Alice’s Wonderland, a lot of what Bazooka Hank and Helicopter Ben are saying is lacking in detail or simply doesn’t make much sense:

1. We were told today in the testimony, among other things, that private risk capital had withdrawn to the sidelines throughout global markets, on the very same day (albeit later in the day) that Warren Buffett signed up to a brilliant and opportunistic $5 billion investment in the newly chartered Bank of Goldman (the secretary’s former firm) at essentially a discount to market (a combination of preferred shares and warrants for common shares). Furthermore, Goldman apparently feels comfortable enough with market liquidity to announce an additional $2.5 billion offering of its common shares.

2. Chairman Bernanke is using the argument that there is a meaningful valuation differential between hold to maturity values and market values of troubled securities. When management of Fannie Mae and Freddie Mac tried to advance that very same logic to the government a few short weeks ago, the government said “no sale” and within days they were under conservatorship. There is no objective way to compute so-called “hold to maturity value” in an environment where ultimate cash flows from such securities are in serious doubt.

3. We are being told that the purpose of the $700 billion request is to recapitalize distressed institutions that so desperately need to sell us their sludge, in order that that the system may survive. But we are also told that those same institutions will back away from participating if we dare to ask for equity participation. We are essentially being asked to believe that if we throw a lifeline to a drowning man, he will refuse it because we want to be paid for the rescue (as the boards of AIG, FNM, FRE, and BSE proved, right? — um, not).

4. On the other side of the looking glass is a world in which taxpayers recover their handout (or maybe even profit handsomely) after buying impaired securities at higher than the values they have been marked to by financial institutions to date (which, in some cases may not even be adequate markdowns, as the government found out when teams from the Fed and Treasury went into other institutions and ultimately recommended that the government take them over or shut them down). This scenario can be based only on the recovery of the assets underlying those securities – American homes – to levels approaching their bubble-era value. Note that the secretary never uses the word “bubble” — always preferring the milder description of the decline in value as a “correction.” Well, on our side of the looking glass we still see a bubble having burst — no different from that of the property bubble in Japan 18 years ago (although mercifully to a lesser degree, we will see declines of about 30% from peak, whereas the Japanese experienced nearly an 80% decline) – and no reason why values should “recover” to anywhere remotely near the debt-driven bubble levels during the lifetimes of our Treasury secretary and Fed chairman (and we wish them a long and happy life for all the suffering they have endured these past months).

5. A number of comments by the secretary and the chairman, during today’s hearings, hinted that ownership of the impaired securities might result in the ability to restructure underlying mortgages. While wholesale takeovers of actual mortgages and securities in certain classes, such a subprime mortgages, may result in the Treasury having some potential ability to restructure underlying debt, the fact is that with regard to C.D.O.’s, C.D.S.’s and subordinate tranches of Alt-A and prime mortgage securitizations, there would normally be zero access by the Treasury to the underlying mortgage collateral. Such toxic paper, where the bulk of the write-downs have been experienced to date, is specifically designed to grant control of the mortgages to the senior-most classes of the securitizations, many of which senior tranches are still performing. The securitizations were designed to pass risk to the subordinate tranches for precisely this reason. The fact is that much of the subordinate M.B.S. classes, C.D.O.’s and C.D.S.’s were never really “money good” because existence of a bubble that everyone chose to ignore given the quick profits to be made by flipping out of that paper.

The Treasury is asking us to step into a distorted world that makes little sense, based on trust and fear. We endorse the authorization of financing to enable the government to save any institution that it judges is systemically critical (and on that judgment, we actually WOULD trust the secretary and chairman, although we think there should be some sensible minimum institutional size limit). That alone is enough — it tells the market that the world will not be coming to an end, that the banking establishment (now, just banking, no I.B.’s anymore) will survive intact (albeit with, hopefully, better regulation), and that it will be sufficiently well capitalized to do what it is supposed to do.

The notion of doing all of that without taking over whatever portion of the equity of the troubled institutions that is commensurate with the aid being given (and, as Senator Dodd has suggested perhaps a bit more for safety’s sake) is indefensible….and, in fact, the testimony given today couldn’t defend it. What would Warren Buffett have said to Lloyd Blankfein if we were asked to take the preferred shares he bought today without the equity warrants he received? He would have said “no deal!” And that is what Congress must say as well in defense of the American people.

Don’t worry about what the administration asked for, just pass a bill that works along the lines suggested by Dodd (although we really think some of the help to homeowner protection measures suggested are ineffective – for something we think really works, see the second half of our report from Friday, Sept. 19. It’s even possible that our two exhausted leaders are secretly hoping Congress does the right thing to give them the political cover they need to be able to explain to the financial establishment that they simply hadn’t any choice but to take equity. The world won’t come even remotely crashing down if the Dodd proposal, or something like it, is passed….and the president will surely sign it.

Note, we said nothing so far here about executive pay. While we appreciate the outrage and certainly believe that, merely as a business matter, management of institutions should refrain from drawing anything other than very reasonable base salaries if they are rescued, that is really a matter between management and their boards/shareholders. If shareholders are heavily diluted by a rescue, we imagine that there will be an outcry heard all the way to the “C-suite” that will sufficiently influence that issue. In any case, the matter is of far lesser import than the key issues above.