Consequently, it’s rare today to see someone rise to national government from the farm. So even though Paulson has a fancy big city MBA from Harvard Business School and a personal fortune in the hundreds of millions from a sterling stint at the helm of Goldman Sachs (GS), we expect him to plainly possess the honesty, industriousness, and salt of the earth common sense that we romantically assign to farmers. Goldman by the way received a huge investment from Warren Buffett’s Berkshire Hathaway (BRK-A). Buffett is widely recognized for possessing those qualities in ample quantity.

So we eagerly wanted to believe Paulson and pal Ben Bernanke from the Federal Reserve when they promised to be transparent and subject to oversight in the Congressional hearings for the $700 billion Troubled Asset Relief Program (TARP).

In late October, I wrote about Paulson’s statement, “The program right now is for banks and thrifts.” I was alarmed to see his qualifier “right now.” It indicated to me that he was already thinking of a future where other types of institutions might dip into the bailout coffers.

I speculated that the precedent set by Long Term Capital Management’s bailout in 1998 would rear its ugly head again as hedge funds “too large to fail” will line up right behind Citigroup (C), American International Group (AIG), Bank of America (BAC), and Morgan Stanley (MS) for the Wall Street version of the bread line. In this case, the “dough” is taxpayer money. Anything to stave off a recession and a painful bear market right?

Turns out that Bernanke and Paulson have been less than forthcoming. Bloomberg News has sued the Federal Reserve citing the Freedom of Information Act to obtain records regarding the implementation of TARP. The Federal Reserve and the Treasury have been collaborating on a surprisingly leak-proof information embargo.

As a result, the public possesses only sketchy information about where the $700 billion is going. Only a few recipients of the relief funds have been disclosed. Even more troubling, we don’t know what kind of securities the banks or other recipients have pledged as collateral. What kind of deals are being made? What is there to hide?

Some say that the loans have to be made in confidentiality so as to shield troubled financial institutions from more panic selling of their stock, especially from rapacious short sellers. I say rubbish, this smells like the stuff Paulson used to spread around on his farm. The government has already imposed temporary bans on short selling of financial institutions stock (which I think was unconstitutional or at least inconvenient as I regularly hedge my investments with shorts); it could extend those bans to protect vulnerable banks.

My guess is that improper loans to hedge funds have been made. I hope I’m wrong, but the “too big to fail” rationale can be temptingly applied to gigantic hedge funds with trades and derivatives positions so heavily leveraged and so intertwined with mainstream financial institutions that failure would be too catastrophic for our overall economy. Bernanke and Paulson may have no choice.

The secret fear on Wall Street lies with impending but unknown hedge fund redemptions. This could happen if poor hedge fund performance compel already fearful investors to pull their money. In early November, I pointed to the distinct possibility that we could fall deeper in this bear market from heavy hedge fund redemptions. Paulson and Bernanke have already shown a reluctance to suffer pain and a willingness to do whatever it takes to avoid pain. They are merely compliant doctors we’ve ordered to keep the painkillers coming regardless of the risks of addiction or decreased efficacy.

There is some evidence surfacing that hedge funds are indeed struggling in this environment. Theoretically, hedge funds should do well or at least less poorly during market downturns. Whatever happened to hedging?

Hedge funds are the private domain of the ultra-wealthy. The average American taxpayer should not be getting into that business. Unfortunately, like Bernanke and Paulson, the average American taxpayer may have no choice.

That qualifier, “right now,” is what has me worried that our well-intentioned public servants will find it difficult to ignore the inevitable cries for mercy and help from their hedge fund brethren. Paulson is leaving himself the option of opening the program up to hedgies sometime in the future, when the most leveraged hedge funds with an intricate web of derivatives trades come calling for help are “too big to fail.” The average American taxpayer, while deemed unsophisticated enough to make direct investments in hedge funds will finally be able to own some of these exotic bad boys through our government proxies.

In the 1990s, a hedge fund called Long Term Capital Management promised to generate excess returns with minimal risk through the use of sophisticated financial models and formulae devised by a team full of PhDs and Nobel Prize laureates. Sounds seductive doesn’t it? It certainly was seductive enough that investors put in over $1 billion before the fund started trading in 1994, a huge starting coffer even by today’s standards. The short story of LTCM is that it made extremely leveraged trades with an intricate web of trading partners that, while highly profitable in the beginning, turned out horribly wrong. The fund suffered tremendous losses and teetered on the edge of outright failure. The Federal Reserve orchestrated a bailout in 1998 of over $3.5 billion. LTCM’s highly leveraged derivatives trades were made with so many counter-parties in the financial world that a Darwinian approach would have had much wider repercussions. The risk of a more widespread collapse of the financial markets loomed as a distinct possibility. LTCM was simply too big to ignore and not bail out.

So the precedent was set exactly 10 years ago. Today, the scary prospect of hedge fund failures acting as catalyst for another leg of decline in the markets is very real. We are collectively hyper-focused on the credit crunch, falling real estate prices, and Main Street’s inability to pay the mortgage. Few can see around the corner when imminent hedge fund failures will send shock waves through the system and drive us deeper into this bear market. There are now at least a dozen LTCMs out there, all crossing their fingers that their limited partners won’t request withdrawals. If the LPs bail en masse, Mr. Paulson as the taxpayer’s agent will bail out his hedge fund buddies.

Interestingly, Warren Buffett’s Berkshire Hathaway (BRK-A) teamed with Goldman Sachs (GS) to offer an alternative plan to the principals of LTCM. Ultimately, LTCM went with the government sponsored rescue. I wish it went down differently. If we’re going to spend taxpayer money to bail out hedge funds, and I’m betting we will, we should find private partners who can share the risk with the public taxpayer. We could give incentives for large private players like Buffett, who have the talent and financial heft to collaborate on a bailout, to help us carry the load. So what if a few fat cats get a little wealthier, I’d like to see the public taxpayer not have to foot the entire bill.

Even the mighty are falling. The last two major independent investment banks on Wall Street, Goldman Sachs (GS) and Morgan Stanley (MS), have received permission from the Federal Reserve to convert from traditional investment banks into commercial banks or bank holding companies. Plenty of ink, digital or otherwise, has been spilled about the disappearance of investment banks so I won’t dwell much on that. We’ve seen the collapse of Lehman Brothers (LEH) and Bear Stearns. Still somehow, I’m sure there were some who sentimentally held out hope that the two shiniest of white shoe firms in investment banking would survive relatively unchanged. Disappointingly, Goldman Sachs and Morgan Stanley will now join the ranks of Bank of America (BAC) and Wachovia (WB) as large commercial money center banks serving the retail masses.

It remains to be seen what will happen to the investment banking businesses of Goldman and Morgan. Other commercial money center banks like Bank of America and Citigroup (C) have been able to operate smaller investment banking divisions within the corporate umbrella. While the market is caught up in short-term financial myopia (worthwhile because some fear a total meltdown), I’m more interested in the long term strategic implications.

Survival – It is clear that the decision to convert to a commercial bank was spurred in part by a need to raise capital and survive. Becoming commercial banks allows Goldman and Morgan to tap the emergency funds that the Fed has made available. Goldman has also reached an agreement to secure private funding as well from Warren Buffett, the head honcho at Berkshire Hathaway (BRK-A). Morgan has agreed to sell a piece of itself to Mitsubishi UFJ Financial Group (MTU), in a move reminiscent of the Japanese shopping spree of the 1980s. In the panicked rush to shore up our faltering financial system and institutions, have we given enough thought to these combinations and their future implications?

Initial Public Offerings – Goldman Sachs and Morgan Stanley consistently topped the league tables as the best bulge bracket firms with the power and reach to handle large IPOs. No one is thinking of going public in this market environment but there will come a time when all is right again and innovative businesses will want to go public. Who will be there to sell the hype and coordinate the logistics?

Pure Investment Banks – Will there be a changing of the guard? The investment banking divisions within commercial bank holding companies have never been able to win more business than the Goldmans and Morgans and Lehmans that focused deeply on investment banking and merchant banking. Is it reasonable to assume that Goldman and Morgan will maintain their dominance of investment banking while converting into commercial banks? I think there is merit in the focus of pure investment banking. It will be interesting to watch if other players like Jefferies Group (JEF), Greenhill & Company (GHL), and Stifel Financial (SF) can aggressively move to fill the void. I think these stocks will perform well over the long term as they jockey to become the next white shoe firm (so long as they haven’t gotten involved with all the toxic financial instruments floating out there).

Talent Exodus – Look to the Yahoo! (YHOO) saga to see that Talent (with a capital T) goes where the opportunity is best and where it can operate with the least restraint. Goldman and Morgan will see their cream of the crop flee to hedge funds or the remaining smaller, albeit pure play, investment banks to ply their trade. Goldman’s proprietary traders generated a majority of the firm’s profits so I expect those guys will find happy homes at hedge funds. Why would any truly good trader want to be a part of Goldman Sachs now? On the other hand, I’ve rarely seen a guy from the sell side of investment banking be able to withstand the ruthless performance pressures of the buy side though so I expect there will be a ton of unemployed investment bankers. My how MBA programs will be flooded with applications. Brush up on those GMATs cause you’re going to be competing against a horde of former ibankers. Why would any truly good trader want to be a part of Goldman Sachs now?

There is a lot of knee-jerk anger and many hyperventilating voices calling for change and placing blame on government, government officials, greedy business executives, mindless consumers, etc. I’m over that already, in fact, I’ve never been there in the first place. I’m only interested in profiting from what the future will bring and what we can learn from history. In that light, let me end by quoting one of the great Founding Fathers.

“All human situations have their inconveniences. We feel those of the present but neither see nor feel those of the future; and hence we often make troublesome changes without amendment, and frequently for the worse.” – Benjamin Franklin (1706 – 1790)

These recent events highlight the lucrative nature of infrastructure investments and the persistent and controversial trend of foreign companies and sovereign wealth funds acquiring huge infrastructure assets in the United States. The political environment grows increasingly hostile as national and local politicians, including the presidential candidates, look to explain Americans’ economic struggles with a cornucopia of reasons including free trade agreements like NAFTA, a “corrupt sitting president,” and globalization generally.

This issue of foreign investment in public infrastructure has been on my radar since late 2006. Below is an essay I wrote for an investment newsletter published in January 2007 distributed to high net worth clients.

Public Infrastructure Sales: Samurais, Jihadists, and Masters of the Universe

“The Japanese are coming!” Remember when modern-day Paul Reveres shouted this refrain in the 1980s? Honda (HMC), and Toyota (TM) earnestly began their conquest of the American driver and, resultantly, Detroit’s mammoth metal benders. Would-be samurais from a nation of diminutive conformists threatened our towering sense of American exceptionalism by snatching up national treasures from our private sector like Pebble Beach, Columbia Pictures, Universal Studios, and Rockefeller Center. Although the apocalyptic visions of Japanese dominance and American indentureship have faded, the “buying of America” continues today.

Only now, the purchasers hail from different shores and their acquisition targets are of a more public flavor. In January 2006, a plan to privatize the Indiana Toll Road came to fruition when the State of Indiana entered into an agreement with Cintra (a Spanish construction firm) and Macquarie Bank (an Australian bank). The Spanish-Australian partnership paid the Indiana State Government $3.85 billion for a 75-year lease to operate and maintain the toll road. The same consortium recently entered into a $1.83 billion lease to operate the Chicago Skyway Toll Bridge. As these foreign entities begin to exact payments from beleaguered commuters, resistance to foreign ownership of public infrastructure grows.

Free trade and free markets be damned. Early this year, public sentiment derailed the proposed Dubai Ports World acquisition of U.S. ports facilities in New York, New Jersey, Philadelphia, Baltimore, New Orleans, and Miami. In a cacophonic display of bipartisan zealousness, Republican and Democratic members of Congress questioned the wisdom of selling strategic infrastructure assets to not only a foreign country, but one which two members of the 9/11 hijackers called home. The overall tone could be summed up by the mordant one-sentence letter Representative Sue Myrick (R-NC) sent to President Bush that read, “Dear Mr. President: In regards to selling American ports to the United Arab Emirates, not just NO – but HELL NO!”

Being neither knee-jerk nationalists nor adherents to Ricardian economic orthodoxy, the editors of this publication acknowledge the merits of both the free market argument and the argument for excluding strategic infrastructure from the free market. One of the tenets of free trade asserts that private industry is more efficient at delivering services than government, and experience has confirmed that theory. But, when does that precious efficiency bump up against national sovereignty and security? Pragmatic protectionists should point out that ports and roads are different species in the genus of public infrastructure; that roads are strategic but ports are more strategic.

Do we as a nation make distinctions between domestic private players and foreign entities? How do we respond to foreign companies that are not entirely private, being controlled by foreign governments? In the case of Dubai Ports World, the United Arab Emirates government owns a stake in the port operator. How do our reactions at home affect the ability of our own private companies to venture abroad and invest in and own foreign assets?

Through all this brouhaha, the editors of this publication see an opportunity for the many domestic leveraged buyout firms within our own borders. With over $175 billion raised in 2006 alone, the industry is flush with liquidity. At the risk of sounding cliché, we echo the industry’s mantra that there is “too much capital chasing too few deals.” With all the largest funds finding themselves in highly contested auction environments for companies suitable for buyouts, even the most sanguine investors admit that future returns will lag past performance. Public infrastructure as an asset class represents a potential opportunity to deploy some of that excess liquidity and to diversify LBO or private equity portfolios.Some questions beg consideration. This asset class will no doubt offer lower returns than traditional private equity investments; does the stability of returns compensate for that shortfall? What are the reasonable exit opportunities? What consequences might arise from shifting concepts of private and public property? How can the public be safeguarded from the specter of crony capitalism?

Questions notwithstanding, infrastructure investments with their super-stable revenue and profit streams offer the possibility of smoothing out the volatility of returns in portfolios otherwise dependent on the ever shifting environment for initial public offerings, mergers, and acquisitions. The promise of stable returns is causing some financial masters-of-the-universe to contemplate establishing investment pools to capture this opportunity. Goldman Sachs (GS), the Carlyle Group and other top institutions are all rumored to be pitching this idea to limited investors. We’re quite sure that hedge funds will want to get into this game too.We suspect there might even be an inefficiency here for domestic buyout firms to exploit. Public sentiment against encroachment by foreign firms might allow for lowball bids by domestic buyout firms. This compromise between public and private could placate the citizenry. The Golden Gate Bridge anyone?

A few days ago, I remarked how precariously positioned the investment banks had become. Today, we witnessed something spectacular as these once proud institutions accelerated their fall. Bear Stearns (BSC) will be taken over in a fire sale for approximately $2 per share by JPMorgan Chase & Co. (JPM) with backing from the Federal Reserve. Lehman Brothers (LEH), which has a similar business model to Bear, saw its stock take a dive on fear that it too faces liquidity problems.

Yesterday, Fed chair Ben Bernanke took the unusual step of lowering rates and extending loans to investment banks only two days ahead of the regularly scheduled Fed meeting. The high priests of the central banking system are in full panic mode now and I suspect them to lower a key interest rate by at least 75 basis points and probably by 100 basis points. If Bernanke & Company are going to try and avert financial disaster, they may as well take bold steps. The market will most certainly react very negatively to an interest rate cut of less than 75 basis points.

Does the Bear Stearns buyout make it an interesting speculative short, even this late in the game? JPM’s acquisition price of $2 per share is much less than today’s closing price of $4.81 per share in BSC. Large shareholders of BSC will no doubt revolt at the $2 liquidation price tag but there aren’t many options left on the table. Without a buyer, BSC will likely declare bankruptcy and there aren’t many other banks around with the support of the Fed underwriting the first $30 billion in risk on the BSC balance sheet.

In the aftermath of this debacle (whenever that may be), many value investors will attempt to pick the good apples off the ground while leaving the bruised ones to rot by the tree. Mostly prudently run ibanks like Goldman Sachs (GS) will need a good dusting off, but will be relative bargains worthy of inclusion in a value portfolio. Note, even the mighty Goldman is rumored to be gearing for a $3 billion writedown when it reports earnings Tuesday. I suspect that Merrill Lynch (MER), whose business model is most unlike the Bears and Lehmans of the world, will weather this storm and come out much weaker but capable of recovery.

The really big question: Does Mr. Bernanke have enough firepower and “influence capital” left to avert another disaster if Lehman becomes the next casualty? At the very least, he has proven himself unafraid to take drastic measures.

Bear Stearns plunges amid trade risk worries – Bear Stearns (BSC) was a pathfinder in the securitization of mortgages, but its over-reliance on mortgage-backed securities led to big losses in a couple of its hedge funds. Now external hedge funds, clients of its prime brokerage, are fleeing in droves for fear the bank lacks sufficient cash or liquidity. Oh how our mighty investment banks have fallen. Funny how the top in these stocks coincided with record numbers of MBAs coming out of our business schools to join the likes of Goldman Sachs (GS), Merrill Lynch (MER), Morgan Stanley (MS), and Lehman Brothers (LEH).

DCP Midstream Prices Public Offering – Not all is well in the energy sector. DCP Midstream Partners (DPM), a producer and marketer of natural gas, is selling shares in the company at a time when the stock price is hitting new lows. Management is in a quandary because operational results have been poor but cash is running low while debt remains high.

Sigma Designs Q4 earns miss market view; shares fall – Anyone want to tell me that the shorts are wrong? They’re practically skipping to the bank. Sigma Designs (SIGM) makes chips that control television set-top boxes and Blu-ray players. The company reported strong earnings but missed estimates; check the earnings call transcript here. Since Blu-ray has essentially won its war against HD-DVD, Sigma should be a turnaround candidate.

Air Methods 4Q net earnings beat Street expectations – The world’s largest air medical transportation company in the world is expanding its fleet and beating the Street’s estimates. Air Methods (AIRM) stock has taken a hit lately and has a sizable short contingent.

S&P: Write-downs may be halfway done – This little tidbit has coincided with a big turnaround in the stock market. What started out as a huge down day has reversed and the markets are in positive territory. The more important question is how reliable is Standard & Poor’s Ratings Services (MHP) given that it did not see the subprime meltdown in the first place? What are the fatal flaws in their analysis? Has any consideration been given to the possibility that prime mortgages could fail if real estate prices continue to fall nationwide?