We have come to a major crossroads in the history of our nation, a time when you must understand all the relevant events in far greater depth, and see the likely future with far greater clarity.

Indeed, I feel this need is so critical and urgent, I am providing you this morning with the most elaborate gala issue in the history of Money and Markets.

Let’s begin by assuming that, despite all the government bailouts, many of America’s largest corporations still go bankrupt, U.S. unemployment continues to surge, and a new, larger wave of home foreclosures sweeps the nation.

How will our leaders respond?

I have no pretense of knowing the answers. Nor can anyone forecast what individuals in power will decide under the stress of pending doom. But following up on a similar fictional scenario that I drew for you many months ago, here’s what I see ahead …

The Final Bailout

The time is sometime in the future; the venue, a hastily assembled meeting at the White House.

The President’s Chief of Staff invites the Treasury Secretary, the Federal Reserve Chairman, the CEOs of bankrupt or at-risk corporations, and former Federal Reserve Chairman Paul Volcker. The Treasury Secretary obtains unanimous vows of confidentiality and opens the discussion.

Treasury Secretary: Gentlemen, I know the events swirling around us seem like Armageddon. But let’s begin by stressing the positive: Not all banks have failed. Not all big companies have gone down. The financial markets, even after their great decline, are still alive.

The grave challenge we face is that — despite the trillions we’ve spent, lent, invested or guaranteed — we have not yet been able to restore confidence. So our goal is to come up with a revolutionary new set of actions that meet the challenge.

But first, I want to get everyone’s views and stress the importance of coordinated communication. In normal times, I wouldn’t presume to tell you what to say or how to say it. But in this unsettling climate, the last thing we need is dissenting voices from the administration, from former government officials or even from industry. We must present a united message that resonates, that’s credible, that can inspire consumers to consume, investors to invest, lenders to lend.

Chief of Staff: First, I want to apologize for the President’s absence; he is dealing with another financial emergency that we will also have to address, at least briefly, before the end of this meeting. It was too late to combine that meeting with this one.

Treasury Secretary: I’m joining them as soon as we’re finished here.

Chief of Staff: Yes, I am also. Second, although many of us are already familiar with it, let me remind everyone of the President’s strategy regarding messaging: Get the bad news out into the open right up front. Don’t sugarcoat it. Then segue very quickly to the positive — what steps we’re taking, what we believe the outcome will be.

What he wanted me to ask you is: What economic pressures are driving this phase of the crisis? What’s at its core?

Fed Chairman: At the core of the crisis are two forces feeding on each other — (a) debt liquidation and (b) price deflation. Although we saw them coming and although we had contingency plans in place to deal with them, what caught us flatfooted was their volume and, above all, their speed.

The debt liquidations — in every credit sector — have struck so quickly, they have overwhelmed our efforts to restore credit creation. The price deflation — impacting a gamut of goods and services — has been so dramatic, it has neutralized our rate cuts, money infusions and other stimulus measures.

Let me refer you to Chairman Greenspan’s memorable comments regarding this crisis.

Chief of Staff: His testimony before the last Congress.

Fed Chairman: Yes. About the tsunami; about the once-in-a-century crisis we were facing. Well, let me tell you what I’m hearing now — from some of my staff and from other hushed voices. What I’m hearing is that, with the events that have unfolded since then, this is not a 100-year storm for the American economy; it’s a millennial rite of passage for all mankind.

Treasury Secretary: Millennial?

Fed Chairman: I didn’t say I agree with that. I merely said that’s what’s being said.

Treasury Secretary: I accept the 100-year storm concept. But let’s not get carried away by the public mood of gloom. Yes, I know debt liquidation and price deflation continue to be at the heart of our economic challenges and remain our most significant downside risk. I know real estate prices are down as much as 50% in some sectors and stock market barometers are down nearly 70% from their former peaks. And I know all about the tsunami of home foreclosures.

But let’s also give people hope, damn it! Let’s not do like some people — I won’t mention names — who talk about the housing market as a “bottomless pit” … or the automotive industry as a “black hole” … or Wall Street like “ground zero of a neutron bomb.” Let’s not talk about a run on bank deposits or insurance policy loans. And for God’s sake, let’s not name names of banks on the verge of insolvency!

Fed Chairman: None of those statements were mine. But from everything I can see, they may not be that far from the truth. So I’m pleased that Citigroup and JPMorgan have accepted our invitation to join us today.

I’d like to take this opportunity to ask Citigroup about its credit card and consumer loan portfolios. Is it true that, if you value them properly, the bank is, in effect, insolvent? And I’d like to ask JPMorgan a similar question: If you value your derivatives based on actual, current market conditions, is there truth to the view that Morgan is also de-facto insolvent?

Before you answer, let me stress that the Federal Reserve, in coordination with central banks globally, has done everything in its power to avert this situation, and with some success. We were able to revive the short-term interbank lending market. We were able to stave off a calamity in the commercial paper market. We were even able to restore some sectors of the consumer credit market.

But it was — and still is — obviously impossible to maintain adequate activity levels in all credit sectors on a continuing basis, due simply to the confidence factor the Secretary stressed at the outset. If borrowers are reluctant to borrow and lenders are afraid to lend, there’s only so much we can do. How do we twist the arms of millions of consumers and thousands of banks? We can’t. That’s why, ultimately, in the final reckoning, every credit stimulus we’ve tried has failed its primary objective — the restoration of confidence.

Citigroup: If this is the day of reckoning, and this is the time to start confessing, I will be the first to volunteer. I can no longer stand here before you and refute the fact that Citigroup is effectively insolvent.

Treasury Secretary: I, ah, I … I find that hard to believe.

Citigroup: At our peak, we had 185.1 million in credit card accounts, with 147 million of those in North America. Peak value: $200.7 billion. Now, more than a quarter of that entire portfolio is impaired — over 90 days past due or in default. God knows we’ve tried everything in our power to hold back that tide. But we could not act fast enough. And where we erred, I believe, is actually doing too much to ease the crisis.

Fed Chairman: In what sense?

Citigroup: Under pressure from the administration, we gave slow credit card payers more time. With subsidies from Congress, we then reduced their liabilities. But what message did that send? It merely sent the message to all nondelinquent accounts that the only way to qualify for aid was to become delinquent. It rewarded bad financial behavior. It promoted delinquency. In the end, nearly all of the steps we took to ease the burden for consumers inadvertently increased their burden.

Treasury Secretary: But what other choice did we have?

Citigroup: Tough love. Instead of a haphazard pattern of government-induced laxity here and industry-enforced toughness there; instead of giving some debtors a break, while forcing others into personal bankruptcy; instead of a mixed message that created confusion, we should have all been on the same page together — even-handedly tough across the board.

Treasury Secretary: That would have been totally inconsistent with the goals of this administration.

Citigroup: Let’s be honest here; let’s face up to the truth. Debts are debts; charity is charity. Instead of pouring good taxpayer money after bad into delinquent credit cards, why don’t we just set aside a fraction of that money for organizations dedicated to recovering debt addicts? I can’t guarantee it will work. But I can guarantee it will be a heck of a lot cheaper, without the boomerang effect.

Treasury Secretary: Which was …

Citigroup: The fact that we made it easier for more people to fall behind on their credit card payments. So guess what! More people fell behind — far more than they would have done otherwise, according to our surveys.

Fannie Mae: I must confess this was the same message we gave to the indebted homeowners of America: “To qualify for government debt relief,” we said, “you have to be delinquent. If you’re cutting your food budget, if you’re pawning your wedding rings, and if you’re doing all that to stay current with your mortgage payments, you don’t qualify. Sorry, no mortgage relief for you!” And that was supposed to be our way of cleaning up this mess?!

Now, look at the numbers that just came out! You’ve got a new, larger wave of Americans walking away from their mortgages and abandoning their homes with little sign of remorse.

Treasury Secretary: I know. It’s very ugly.

Fannie Mae: Yes. But what has us truly dismayed is the fact that, in the vanguard of that trend, there are some of the very same groups which, in an earlier stage of their payment history, were identified as the categories most qualified for mortgage relief. Instead of lightening their debt burdens, we merely prolonged them; instead of countering the culture of default, we merely enhanced it.

Treasury Secretary: Can we get back to the situation at Citi?

Citigroup: Yes. The tie-in to our consumer loan division is that the housing disaster feeds on the credit card disaster. We saw this coming. That’s why, quite some time ago, we warned investors that credit-related losses, such as payouts on loans we guarantee, were going to rise for the foreseeable future. But then the market crumbled far faster than anyone dreamed possible. Even the Jeremiahs and Cassandras inside Citigroup — and believe me, there are more of them coming out of the woodwork every day — even they underestimated how fast the consumer credit market could come unglued; how fast credit cards, auto loans, and student loans would go sour. That’s why some Wall Street analysts are saying, rightfully so, that we may not have enough capital to offset those losses.

Treasury Secretary: Why, then, do your statements show that you have adequate capital? Even the Comptroller of the Currency has testified before Congress that you have adequate capital. What are they looking at?

Citigroup: Outdated data. Even we are looking at outdated data. Things are happening so fast, by the time we get credit card and other consumer delinquency data compiled, it’s as if a whole year has gone by, compared to what would have been the typical data lag in more stable times. So we have to estimate what’s actually happening in real time. But even without taking those projections into consideration, we’re still coming up short on most capital measures. The big picture is simple: Asset values are plunging all over the country. Consequently, our asset values are plunging in tandem. That’s it in a nutshell.

Fannie Mae: Our situation is similar. We get reports from 5,000 real estate brokers all over the country handling our foreclosure sales. And out of those reports, we pulled one for a case study — in Flint, Michigan. The broker was trying to sell a particular home for a price that will shock you.

Citigroup: Under $30,000 or so?

Fannie Mae: Way less than that! He first tried to sell it for $6,900, but had no takers. Then he cut the price to $5,000, and still no buyers. This was a three-bedroom home in a residential neighborhood we’re talking about — not a two-door Chevy on a used car lot!

My point is that we were not picking up this type of thing in our databases, due to the same kind of data lag Citigroup is experiencing.

Meanwhile, new foreclosures are off the charts. Just last quarter, we got saddled with four times the number of homes through foreclosure than we could sell. We’ve tried to get rid of them quickly. But we keep falling further and further behind.

General Motors: You talk about home price deflation. But auto price deflation is equally severe. At the end of a two-year lease, one of our most popular SUVs was supposed to be worth $22,000. As it turns out, the best price we can get for it in the used car market is less than $4,000. And we’re not the only ones. I had my staff give me a list of other auto products and services that have suffered the worst declines — it’s a mile long.

Treasury Secretary: What about wages?

General Motors: The minimum wage is a joke. I haven’t seen this at GM particularly. But nearly everywhere else, workers and their employers are finding ways to get around the minimum wage. They’re working double time or clocking in for half-time hours. They’re busting labor laws and union rules, and the authorities are looking the other way. In other words, deflation is destroying our country. The Fed must inflate us out of this — with rate cuts and more.

Fed Chairman: I appreciate that. But I’d like to keep this focused on the GSEs for now. How much do Fannie and Freddie have in foreclosed homes on their books?

Fannie Mae: I don’t have exact Freddie Mac figures.