Something quite major happened in finance this morning. All week, officials like Ben Bernanke and Tim Geithner have been hinting that nationalization is not the way to save the banking system.

So today they only nationalized Citigroup halfway.

As part of the TARP plan, and also in a supplemental purchase, you the taxpayer have purchased about $45 billion worth of convertible preferred stock in Citigroup. Today, the government has made a deal with Citi to swap about $27 bn of that preferred for common.

Since the entire market value of Citigroup’s common stock was slightly below $27 bn as of yesterday’s close, the deal amounts to creating about as much new stock as existed beforehand. So each existing share is now worth about half as much.

And in pre-market trading, they’re down just about… half. See, financial modeling works after all. The massive dilution and the fear of more to come (possibly affecting other banks) is weighing heavily on stocks this morning, and they will open sharply lower.

I don’t have time now for a fuller explanation, but you’re probably wondering why they did this after a week of saying nationalizations are bad. I would say it’s because of the unique character of Citigroup.

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Things have been very fitful over the last several trading days, but there are several emerging themes that are operative over the short term.

1) Interest rates are on the rise. We’re now in the era of trillion-dollar deficits as far as the eye can see. Next week is going to be a quiet week, but the month so far has seen tremendous amounts of new issuance of government debt across the yield curve. (They’re scheduling their issuances basically from left to right on the curve.)

The thing that has tended to keep rates subdued has been the “safe-haven bid”: the feeling among the world’s investors that you have to own risk-free government paper just in case the world should end. Credit and capital markets have been stabilizing of late. This doesn’t mean they’re functioning normally, it just means they appear less likely to suffer massive new disruptions. This tends to reduce demand for Treasury paper (which is why rates have had room to rise in the face of the stepped-up issuance). It also reduces the demand for Japanese governments (which is why the yen has been falling like a rock lately).

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So it appears that Obama has floated a deficit reduction “plan,” and it seems like much deeper voodoo than anything we could have come up with. I use the scare quotes because, as always with this President, there’s no actual plan with details we could evaluate (and maybe criticize). All he did was float some ideas out to the Washington Post.

Call it Economic Management by Press Release.™

Peter Orszag, a capable guy that you wouldn’t make for a liar or a political hack, said that they’re going to cut the federal deficit in half by the end of Obama’s first term. That’s the political spin you’re supposed to take away from this: Fiscal discipline is something Republicans promise but Democrats achieve.

Except that Bush’s highest deficit was last year’s, at about $450 bn, or 3% of GDP. Obama’s first year in office will feature a deficit of $1.2 TRILLION, 8% of GDP, a post-WWII high.

WaPo says that cutting this deficit in half by 2013 would mean a deficit in that year of over $500 bn. The cut-in-half deficit we’re supposed to be all streamy about will be higher than that of any of the Bush years.

And they’re not even counting the stimulus plan and the increased debt-service payments from it! They could easily run a trillion dollar deficit in 2013 and say they kept their promise.

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There’s a remarkable story being reported in the New York Times. It’s remarkable in itself, and also because as far as I can tell, it’s only being reported in the Times.

It’s a proposal by the Treasury for a radical way of restarting private participation in credit markets. I’m only going to give you the barest outlines of this with minimal analysis, because I can’t be sure the Treasury really means it.

For many months now, “securitizations” have come to a near-standstill. That’s the much-maligned process through which whole mortgages get “sliced and diced” into mortgage-backed securities and sold to the world’s investors.

Through a different but analogous process, other kinds of consumer loans are also securitized: car loans, credit cards, and student loans. (The goal is always to give an investor a piece of paper with a credit rating, a semi-annual coupon payment, and a maturity date. Mortgage analytics and risk management are more complicated, but beyond that, the process is the same.)

Securitization matters because banks can’t provide credit now that most of them are so far undercapitalized. Securitization is an alternate process through which investor funds are channeled into the consumer credit markets.

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Today could turn out to be an important day in the ongoing financial and economic crises. Stock markets overseas are riding declines of about 3%. European trading suggests that US stocks may decline even more today, perhaps as many as 300 Dow points.

The moves are significant because we’ve now decisively broken below the “technical support” level provided by the multiyear low reached in 2002. And we’re falling from a higher peak this time.

Stock markets are clearly discounting the fact that the Obama team are fighting the crisis with good intentions and not a whole lot more.

They’re also discounting an outlook for corporate earnings that could hardly be worse. I think that Q1 earnings will be very spotty, but on the whole will surprise on the upside, possibly setting up a rally in early April. But between now and then, the weakness may trigger waves of margin calls and panic selling, as in November. There’s no discernible bottom from here if that happens.

There’s not much more to say other than, let’s hope for the best.

He only announced it a few minutes ago in Mesa, Arizona, but let’s look at how the markets are reacting to Obama’s mortgage-relief plan.

The idea is to spend about $275 billion to give more money to Fannie Mae and Freddie Mac, and to facilitate refinancings of distressed mortgages.

It’s still too early to give you an actual analysis of the plan, but I did notice one very interesting thing. Obama’s warmup act was FDIC head Sheila Bair, who was been screaming about preventing foreclosures for a long time now. In her remarks, she said that voluntary mortgage relief hasn’t worked, and now it’s time to try something else. What that “something else” turns out to be, is of a course a matter of intense interest.

What did Mr. Market have to say about this? Prices for high-coupon mortgage-backed securities immediately tumbled. That makes sense if you assume that a lot of people who couldn’t refinance at lower rates before, will be able to now.

Yes, this raises interest rates. Yes, it makes the banking crisis worse by cutting the value of “toxic assets” still farther. Unintended consequences don’t always take so little time to appear.

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I’m indebted to reader Olivier Strauch, who wrote to us at RedState to express some reservations he has about the admittedly radical tax-holiday proposal that I made here.

Mr. Strauch’s pithy but resonant rhetorical style defies summarization, so I’ll quote him literally (with one minor redaction; I changed a crude sexual reference to a crude gastronomic one):

“Seriously.  Your answer to the devastation caused by the dogma of rightwing deregulation of everything  is.. to cut 100% of federal taxes?

So how do we pay for your favorite President Bush’s most brilliant achievement - the war in Iraq?  Shall our troops eat dust and drink happy thoughts, and shoot magic bullets filled with your pee and propelled by wingnut farts?   How about Afghanistan?  How about border guards, customs, INS, the FBI, the CIA, Guantanamo, federal prisons, airport security, and all the other things even disphits as braindead s you agree government needs to do?

Seriously - you are a [overeating] over the top, blue-ribbon winning, one in a million tool.

Please never, ever reproduce.”

Thus Olivier Strauch. His points are thoughtful and well taken, but I feel that they don’t go nearly far enough as regards the spending priorities of the Federal government. More critically, Mr. Strauch appears not to appreciate one of the finer points of Federal taxation, that actually is key to my argument.

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Yesterday was his boss’s turn. Today’s it’s Tim Geithner’s.

There are two crises going on, a financial one and an economic one. Yesterday, Obama went to Indiana (a red state that he flipped and needs to suck up to, so they’ll keep going blue), and then to national television, to talk about the economic situation. His message was that the only way to make the economy better is to spend a lot of borrowed money, right now, and it almost doesn’t matter what we spend it on.

The economic crisis is actually rather easy for the President to deal with, on the terms in which he has framed it. He’s not actually interested in returning the US economy to stable, sustainable growth, while repairing the global macro-imbalances which are part of what caused the crisis.

All the President wants to do is to “create or save” 4 million jobs. He already has a disingenuous economic report in hand, published on January 9, which presents a spreadsheet version of an economics-101 case that $800 billion or so in government spending produces 1.5 times that much additional GDP, which by Okun’s law will create or save 4 million jobs. QED.

Whatever happens in the economy, even a return to Great Depression-level unemployment rates, Obama will always be able to say that the situation would have been 4 million jobs worse than it is. His job is all done, except for the PR.

Geithner’s job is just beginning. He has to stabilize the financial system. Success for him is being defined as a return to reasonably-normal levels of private credit formation. He’s going to announce today that he really has no clue how to make that happen.

In a nutshell, Geithner’s problem is that America’s biggest banks aren’t actually dead, they’re just on life support. That constrains his options. Let me explain.

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We take for granted that the government of the United States will act with probity and restraint. Uniquely among nations, we have a government that is overshadowed by powerful ideas about the sources of its legitimacy. These are encoded in the Declaration of Independence, the Bill of Rights, key passages of the Gettysburg Address (“dedicated to the proposition…”, “of the people, by the people, for the people”) and elsewhere.

Examining the history of our government’s involvement in political economy bears out that it has always been very reluctant to intervene in private arrangements. Every nation must find a critical balance between the rights of men and the rights of society, and every nation must provide for its material well-being in the context of that balance. As Americans, we have always sought to err on the side of human dignity and private rights, even in times of war and crisis.

We’re now deeply enmeshed in crisis. Moments of crisis often bring change. But now we now have a President who is pleased to tell us that we must look to the future with fear, rather than welcome it with hope as Americans have always done.

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I live in New York City. I talk to a lot of businesspeople, investors, and Wall Streeters. I don’t talk to all that many ordinary people.

But I enjoy being interviewed on live radio in other parts of the country. And when I do that, I get the chance to hear what local callers think about the economy, and more importantly, what they want.

They want to save a lot more money. This answer comes up automatically, without qualification, and without exception when you talk to ordinary folks.

When did this desire to save materialize? It was pretty sudden. If you look at official statistics (both the Commerce Department and the St. Louis Fed publish relevant ones), the personal saving rate suddenly ticked up to between 2 and 3 percent about four months ago. Remember, it had been running nearly zero before the financial crisis started. We had one month when personal savings jumped over 5%.

Curious? Sure enough, it was May 2008. That’s when the tax rebate checks went out.

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Ok, so Mitch McConnell, of all people, is talking about a new Federal program to offer 4% mortgages to anyone “credit-worthy.” (If something like this happens while Barney Frank is in power, “credit-worthy” will be defined as “has a pulse,” so Sen. McConnell probably ought to be careful what he wishes for.)

What will happen if we do this? It’s basically the opposite of the things being discussed to fix the banking system. Wouldn’t you assume that everyone in America will dash to refinance at 4%? This obviously wouldn’t do anything to improve housing values per se, because of the overcapacity that still exists in those markets. But it would certainly make mortgages more affordable.

I’m not entirely sure yet, but my gut is that this wouldn’t necessarily slaughter the banks and other holders of toxic MBS.

Those securities are toxic for a long chain of reasons, but the head of the chain is default risk. If every mortgage in America becomes issued and guaranteed by the government (well, more likely issued through the nationalized banking system, so we can feed some of the profits back to the Saudis and Chinese who own our banks), then the default risk becomes replaced by market (interest rate) risk.

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Global stock markets are soft across the board as we swing into the first trading day of February. At first glance, this appears to be responsive to the constant drumbeat of terrible economic news, as economies and trade shrink in unison.

The action in the bond markets appears to be somewhat healthier. For several weeks, the theme underneath the surface noise in corporate debt markets has been gradual stabilization. Things are far from normal, but they’re inching along in the right direction. Spreads between corporate debt and government debt have been compressing, and the tone shows that risk tolerance is making a comeback in some sectors.

Here, and in the slightly-improving tenor of the short-term capital markets, you can see the positive impact of the Treasury and the Fed’s heroic stabilization efforts, including the much-maligned TARP.

The government debt market is where the real action is. The yield curve has been neurotically steepening and flattening as participants weigh the broadly offsetting influences on prices for governments: the steadily worsening economic news tends to support prices, and the gargantuan amounts of new issuance push the other way.

I think the friction and noise being generated as markets absorb new supply is the surface phenomenon, and the continuing strong demand for risk-free debt is the deep structure.