Fed Chairman: That’s a lot, but in proportion to the $5 trillion-plus in mortgages that you and Freddie own or guarantee, it doesn’t sound like that much to me.

Fannie Mae: The $40 billion is just the foreclosed properties we currently have in inventory, which are just a small fraction of the properties we’ve already cleared out … and, unfortunately, which are an even smaller fraction of the foreclosed homes we see coming down the pike.

We’re at the center of this mess. Right now, there are 8,500 banks and thrifts in this country holding about $60 billion in foreclosed homes. But between Fannie and Freddie — just two companies — we’re stuck with at least $40 billion. So if you look at all the money tied up in foreclosed homes in the United States, you’ll see that more than $4 of every $10 is our burden.

Fed Chairman: What are you doing about it?

Fannie Mae: Until last year, our stated goal has been to always seek the highest possible price for our foreclosed properties, even if that meant hanging on to them longer. But with the huge backlog we now have, that approach is no longer viable. Now, we’re pricing our foreclosed properties a lot more aggressively.

Trouble is, once we sent a directive to our 5,000 brokers across the country — to broaden some auction parameters and remove certain restrictions — there was no way we could keep that directive under wraps. Everyone in the local markets heard about it, and since we’re such a big player, nearly everyone is following our lead, dumping properties virtually regardless of price.

Treasury Secretary: Could it be that you are overstating the price declines and the losses that they have caused? Take that house in Michigan, for example. It must have been a dump to begin with. Do you know how much it sold for originally?

Fannie Mae: It’s a dump all right. It needs a new roof. It needs new carpeting. The plumbing has been ripped out. But back during the peak of the housing boom, it was not a dump. Back then, it sold for $110,000. So even assuming we can find a buyer for $5,000, its price has fallen by over 95%. Naturally, most of our foreclosed homes for sale haven’t fallen that far, that fast. But this gives you an anecdotal illustration of what we’re up against. And it gives you a sneak preview of the much deeper home price declines that are possible in the future, especially when entire neighborhoods are blighted, which is now becoming far more common, even in some higher end communities.

Treasury Secretary: But how widespread is this, really?

Fannie Mae: What definition are we using for “widespread”? If I told you that among the supposedly “AAA” rated subprime mortgage securities issued in 2006, the default rate is now about 98%, would that qualify as widespread?

Treasury Secretary: Ninety-eight percent?

Fannie Mae: You shouldn’t be so surprised. In 2008, it was already not far from current levels — 86%. And I’m not referring to a small, little subset of our portfolio. At our peak, we had about $70 billion in subprime and Alt-A securities in our portfolio. Freddie Mac was even more at risk, with nearly $150 billion. And that’s not even our primary concern any more. As you well know, our primary concern is the surging foreclosure rate in prime, supposedly high-quality mortgages, which represent the bulk of the paper we hold or guarantee.

Treasury Secretary: What is your outlook for nonperformance of prime mortgages going forward?

Fannie Mae: We used to say this crisis was “contained” to one sector or another. But that idea fell by the wayside in 2008. More recently, our view has been that it’s so bad, it can’t get any worse. But we can’t maintain that fiction much longer either. The fact is, we have no way of estimating how high delinquency rates can go on prime mortgages. Just a few years ago, who would have dreamed that the subprime delinquency rate could ever exceed 20%? Now look! Nearing 100%!

What we have to do now is learn from that mistake: To make no more promises. To tell the public what’s going on. As bluntly and clearly as we can.

Treasury Secretary: Why now and why so bluntly?

Fannie Mae: One reason is that, until recently, the rating agencies were playing along with us on this, postponing downgrades, keeping the fantasy alive. But now they’re downgrading all of this mortgage paper to deep junk levels in one fell swoop. They’re forcing everyone — including all of us here around this table — to face reality. Wall Street is telling us that, until we face reality, this crisis is going to be an endless soap opera. Another reason is that we’re soon going to run out of the $100 billion federal bailout money that Congress committed to Fannie Mae, and we’re going to have to explain to Congress why we need more.

General Motors: I think it will add value if I can contribute our experience to this discussion. Like Fannie Mae, we’ve also been through the ringer on this already — along a different path perhaps, but with a similar end game. At yearend 2008, as you will recall, the debate was whether or not to bail out GM with taxpayer money or let us file for Chapter 11.

Treasury Secretary: During the transition between administrations.

General Motors: Right. Looking back, however, we can see that the debate was splitting hairs. With a federal bailout, the conditions were to make massive cuts to turn the company around. And with a Chapter 11 filing, the mandate was also to make massive cuts to turn the company around. Six of one; half a dozen of the other. The only aspects that seemed to differentiate those two scenarios were the timing — a bit sooner or a bit later — plus the name on the door. It was going to be either someone appointed by the bankruptcy court if we filed for bankruptcy or a Treasury-chosen auto czar if we got the bailout.

At the time we wanted the bailout, of course. But looking back, I can see we would have wound up essentially in the same place we’re at right now — a shell of our former self, the epicenter of a jobless nightmare.

Treasury Secretary: From what I recall, though, there was heightened concern about a bankruptcy’s impact on shareholder value and on customer loyalty.

General Motors: That was our argument, yes. But in retrospect, we can see that was a classic case of shutting the barn door after the horse is gone. Shareholders were already practically wiped out, with only pennies left on the dollar. Customer loyalty and sales were already shot to hell, due to the bankruptcy chatter on the Internet and in the media. This is not like the old days when public messaging was about “divide and conquer,” telling one group one thing and another group something else.

Paul Volcker: Gentlemen, I’ve been listening to this discussion patiently, and I think the time has finally come for me to stop pulling punches and to put all my cards on the table.

First, although we started this meeting focusing on how to control messaging, the actual discussion which has evolved has been driving us to confessional. I heard Citigroup use that word. I heard Fannie Mae do it as well. And there was mention of the same refrain coming from Wall Street sources. So this meeting, under the cloak of confidentiality, is already a collective confessional. Now it’s time to shed the cloak and make it a public event.

Don’t be overly concerned with the impact on markets. As was also said, and correctly so, they are already in a state of chronic panic. Taking the lead on that front will help restore trust in our leadership and, later, in the economy.

Chief of Staff: You want the administration to be the leading source of any new bad news. You want us, in effect, to regain control of the news cycle. Is that it? If so, I see the wisdom in that. But …

Treasury Secretary: But what is the reaction going to be in the markets?

Volcker: It’s going to be cathartic. It could trigger a final, climactic wave of selling. They call it “capitulation” — when investors dump whatever they’ve been planning to sell all along; when they sell out with little regard to price.

Fannie Mae: Much like I was saying earlier regarding the recent trends in foreclosure sales.

Volcker: Yes. Not just in real estate and stocks, but also commercial paper and corporate bonds; not just marketable assets but also business inventories and receivables, consumer collectibles and valuables. It’s already happening. So we must be prepared for the possibility that, once we take the action I’m going to propose, a lot of that material still in the hands of nervous sellers is going to be flushed out.

Treasury Secretary: I’m having great difficulty buying into this.

Volcker: I suspected you would be, and when you hear the other side of my proposal, the more substantive side, I expect you’re going to be even more opposed. But if we don’t do it, I fear you’ll be forever …

Chief of Staff: … playing whack-a-mole.

Volcker: What?

Chief of Staff: Putting out brush fires.

Volcker: Right. Let’s review, one last time, what has happened and what we have done. For many decades, we have progressively built up a massive pool of private and public debts; and we did so while continually diminishing the savings that typically are required by modern economies to underpin such debts. After World War II, that’s the situation each successive administration has inherited, greatly enlarged, and then passed on to the next administration. And that’s why each administration has sought to build — with government guarantees, bailouts and backstops — a larger and larger dike to guard against any debt collapse.

In 2008, however, we came to the end of the line. The debt quality was so poor and the quantity so large that toxic paper began to spill over into the real economy. The dike sprang larger and larger leaks. And in response, all we thought of doing was to plug them with taxpayer money. First, subprime mortgages; then prime mortgages … the interbank market … commercial paper … consumer credit. First, Bear Stearns; then Lehman and AIG … Fannie Mae and Freddie Mac … Washington Mutual and Wachovia … GM and Ford … and now even Citi and Morgan. Each bigger than the previous, each taking us closer to the threshold of the absurd.

We dare not cross that threshold; we must change course. Now, rather than plugging the leaks reactively, we must guide and divert the flood waters proactively.

Treasury Secretary: Can you translate these metaphors into policy?

Volcker: It’s precisely what Citigroup was saying for credit cards, but writ large: Tough love — for debtors and lenders.

I’ve dug up some old, rarely-cited sources about the banking crisis during the 1930s, and having devoted many a sleepless night to their study, I now see things quite differently from virtually everyone in this group. We used to believe that, after the Crash of ‘29, the Fed’s hands-off approach either played a pivotal role in causing the Great Depression or at least made it a lot worse than it would have been otherwise. From that, we not only concluded that the Great Depression could have been prevented, but we also derived the theory that all depressions — present and future — were preventable.

You’ve heard this quote from Mark Twain, I’m sure, but let me recite it for you anyway. “When I was a boy of 14, my father was so ignorant I could hardly stand to have the old man around. But when I got to be 21, I was astonished at how much the old man had learned in seven years." Similarly, over the past months, the more we have floundered from bailout to bailout, the more I have realized how we underestimated the intelligence of our Fed forefathers. Men like Roy A. Young, Eugene I. Meyer, Eugene R. Black and others who presided over the worst of times in the 1930s.

Back then, there was also an attempt to patch banks up and sweep bad assets under the rug — not nearly as much as today, of course, but in the context of those times, a very significant effort nonetheless. Then, they too changed course, much like we will have to sooner or later.

Instead of propping up bad banks, they proactively shut them down. Instead of shotgun mergers to move toxic paper from weak banks to strong banks, they segregated the good assets and quarantined the bad ones. When that wasn’t enough, they shut the banks down in statewide holidays. And when that still wasn’t enough, Roosevelt shut them all down in a national holiday.

It wasn’t planned ahead of time; they also had to react to unexpected events, especially bank runs. But they eventually responded with an army of tough bank examiners. Unless banks could pass a tough exam, they were not allowed to reopen. It was banking triage en masse. Bad banks — shut down forever. Good banks — reopened promptly. On-the-fence banks — not for many months.

Treasury Secretary: Didn’t that deepen the Depression?

Volcker: Yes, it probably did. But the deepening effect would have happened anyhow, albeit in a more haphazard fashion. Moreover, without the bank closings and debt liquidations of those years, the subsequent recovery — including possibly the 60-year growth between 1946 and 2006 — could have been anemic. Indeed, depending on the vagaries of history and the rise of competing powers, much of that growth may never even have happened.

Treasury Secretary: So is that what you’re advocating? Proactively shutting down major banks that don’t meet your elevated standards?

Volcker: That’s what they did. What we must do is adapt that experience to the current realities.

Treasury Secretary: Such as?

Volcker: Such as the big risk areas that did not exist then. We need immediate data on derivatives portfolios and their true valuation. We need detail-level intelligence on the current credit exposure of derivatives players and the true risk of counterparty default. We need higher standards for risk-based capital to back it and efficient enforcement of those standards.

Treasury Secretary: I see the problem.