We are the monolines now

Before the market in collateralised debt obligations (CDOs) started to implode in 2007, many of these securities constructed out of low-quality subprime loans were sold as AAA investments - the highest quality investments, up there with the sovereign debt of the richest nations - partly because some of these bonds were insured against default by so-called monoline insurers.

However, the insurance turned out to be more or less worthless, because these specialist insurers didn't have sufficient capital to absorb the mind-boggling losses on lending to US home owners with poor credit histories.

So the value of CDOs collapsed, generating about $1tn of losses for banks around the world - and hobbling the likes of Merrill Lynch, UBS, Citigroup, Royal Bank of Scotland, and so on.

This subprime/CDO debacle also led to the almost complete disappearance of important wholesale sources of funds for banks.

And the rest, as they say, is financial market meltdown, credit crunch and global recession.

The provision of credit by banks and other financial institutions was squeezed all over the world, prompting a collapse of consumer spending, business investment and trade from which no economy has been insulated.

Which is why so much of the effort of governments - especially ours and that of the US - has been directed towards shoring up the banks and reinvigorating the supply of credit.

There'll be another initiative with that aim today, when the US Treasury Secretary Timothy Geithner announces a so-called Public-Private Investment Program to purchase between $500bn and $1tn of impaired assets - toxic investments such as CDOs and loans - from America's battered banks.

The US authorities - the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation - will provide finance to hedge funds and pension funds for the purchase of these assets.

Some of the details can be found in an article by Mr Geithner in this morning's Wall Street Journal, and the minutiae will be disclosed later today.

The aim is to remove as many of these bad assets as possible from banks' balance sheets, so that the banks become less anxious about future write-offs and become more confident that they have the capital resources to restart lending.

It's an alternative approach to that taken by the British Treasury, which has used the public sector's balance sheet to insure Royal Bank of Scotland and Lloyds Banking Group against future losses on some £600bn of poor loans and investments.

But both the UK and the US are trying to avoid more conventional, full nationalisation of the banks.

In the US case, taxpayers will be both providing some of the loan finance to buy the toxic assets and will sharing in the risks of owning them - both losses and profits.

As a public-private solution, it has a snake-eating-its-tail, paradoxical quality to it - since at least some of the finance for the purchase of the impaired assets will presumably come from the very banks that are supposed to be cleansed by the exercise.

It's also important to note - as I've been pointing out for more than a year - that both the US and the UK authorities are simultaneously providing the funds to banks that the banks can no longer obtain in a purely commercial way from wholesale markets.

In America, for example, the Term Asset-Backed Securities Loan Facility (TALF) will lend up to $1tn (£695bn) to private-sector investors to purchase securities manufactured out of new loans to consumers, car buyers, students and small businesses.

Here in the UK, our Treasury is providing hundreds of billions of pounds in guarantees for securities made out of bank debt, mortgage debt, consumer debt and corporate debt. It's providing separating guarantees for bank lending to small business. And, in partnership with the Bank of England, it's purchasing various forms of loans to companies.

The way to see all this is as the public sector - especially in the US and the UK - taking on the risks of lending to the private sector.

And it may have struck you that this is what the monoline insurers were doing on sub-prime lending to US homebuyers with poor credit histories, via their insurance of the securities created out of sub-prime.

Like the monolines, the US and UK authorities are exploiting their AAA ratings.

They are turning risky private-sector loans into the equivalent of sovereign debt, so that private-sector investors will buy these loans.

And the US and UK authorities are also raising money directly from private-sector investors by selling them government bonds which is then recycled into the banking system.

In a classic sense, the British and American governments are exploiting the perceived strength of the public sector to correct the failure of markets to channel finance to where it's needed.

As a strategy, it works for as long as there's a widespread confidence that we as taxpayers have the capacity to make good any potential losses on all this lending.

Or to put it another way, the productive potential of the British and American economies is being mortgaged to prop up the banking system. The banks are being kept alive by our promise to provide an indeterminate proportion of our future economic output to make good the banks' future losses.

How big could the banks' call on us as taxpayers turn out to be?

Support for the UK's banks and for private sector lending in the form of loans, guarantees, insurance and investments is equivalent to just under 100% of GDP, or a bit more than £1.3tn.

And based on out-of-date IMF figures, the equivalent figure for the US is more than 70% of GDP - or not far off $10tn (£6.95tn).

Those are not small numbers. Unfortunately, they don't tell us anything very useful about how much is at risk of being lost, how much could in theory be written off.

That said, even on worst-case projections of the impact of the recession on the ability of borrowers to repay, losses for taxpayers will only be a proportion of the gross sum.

And, everything else being equal, that sum would of course be affordable, even if paying it would be painful for us (in the form of higher taxes or fewer resources for public services).

But everything else is not equal.

The US and UK public finances are in a dreadful state, because of recession-induced collapses in tax revenues and the cost of measures to stimulate our economies.

Which is why there are some economists and analysts who fear that the AAA credit ratings of the US and the UK are not wholly unimpeachable.

It's probably worth remembering that three years ago, no regulator or central bank expressed serious concerns that the monolines could lose their AAA ratings.

What would happen if the AAA rating were lost?

Well, the virtuous interplay of bank bailouts and fiscal stimulus in limiting the severity of the recession could become a vicious simultaneous squeeze on the ability of both the public sector and private sector to obtain credit.

To state the obvious, the US and UK governments have a very delicate balance to strike between supporting the banks and overstretching the public-sector balance sheet.

There's another important implication of the extent to which we've mortgaged our futures to save the banks.

It rationalises the acute anger felt by millions at any bonuses or pay rises going to bankers.

Their argument is that we're all in this together - and that if all taxpayers are making potentially serious financial risks and sacrifices to save the banks, the quid pro quo should probably be profound gratitude on the part of bankers and a joyful willingness to defer any incremental earnings until the foundations of the financial system and the economy have been rebuilt.