But the LTCM near-collapse and rescue set in motion Wall Street’s unchecked rush to risk during the decade by signaling to the market that the government would ultimately come to the rescue.

Wall Street is a kids’ game, so let’s refresh our memories. Everyone born before 1990 can skip ahead a couple of paragraphs.

LTCM was a hedge fund run by former Salomon Brothers bond whiz John Meriwether and a half dozen other traders. They raised $1.01 billion in 1994 and ended up with derivative positions of about $1.25 trillion, built on leverage, when the bets turned bad and lenders started asking for their money in the summer of 1998.

LTCM was strapped for cash. So, rather than unwind its positions and send the market into turmoil, the Federal Reserve Board of New York organized a $3.75 billion bailout paid for by Wall Street banks. The cash allowed LTCM to meet its obligations as it unwound its trades.

Maybe it’s because the numbers seem small by today’s standards, but LTCM caused a lot of anxiety at the time. The day after the bailout was announced, the Dow Jones Industrial Average fell 2%, mostly because investors feared the banks would lose their investment. The fall was followed by another 3% drop two trading days later when investors worried the Fed didn’t do enough.

Flash forward to 2008. On Monday the government pledged $200 billion to prop up Fannie/Freddie, two companies whose main investments were considered among the safest on Wall Street: American home mortgages.

The Treasury Department’s move followed one by the Fed in March. In a desperate attempt to help Bear Stearns Cos. avoid bankruptcy, New York Fed Chairman Timothy Geithner brokered a buyout with J.P. Morgan Chase & Co. The Fed backed $30 billion in assets with taxpayer money as part of the deal.
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Since the start of the year, 11 U.S. commercial banks have failed. In July, regulators shut down IndyMac Bank, a move that will cost the Federal Deposit Insurance Corp. — and, by extension, anyone who keeps his or her money in a bank — $10 billion.

That’s reasonable, at least compared to what the auto industry wants: a $50 billion bailout in the form of loans to help the companies retool lines and become competitive. The airlines will be next, of course.

You can’t blame Rick Wagoner at General Motors for passing the hat to Uncle Sam. These CEOs have seen what a little government intervention can do, whether it be banning naked short selling for a few bank stocks or propping up the entire mortgage banking industry with billions in backing.

The taboo against bailouts has been broken. Now the problem is that everyone is rushing the government at the same time. Wall Street firms ran up risk for a decade after the LTCM bailout precisely because there was a bailout.

The unwritten message, what the bankers call moral hazard, was simple: come a crisis, the government will do everything it can to avoid a collapse. The leverage at Wall Street banks remains high. At Lehman, the ratio of debt to equity is 10.6, and this is after the bank spent nine months reducing its leverage. At the time of the LTCM meltdown the ratio at Lehman was 6.2.

Rising leverage is a familiar story across Wall Street. That these firms are all imploding at the same time should not come as any surprise to the government. Brokerages, banks, mortgage banks, airlines and automakers at the door in a classic run on the bank, but this time it’s the Central Bank.

The good news is that there was a happy ending to the LTCM scandal. The bailout banks eventually made a profit on the investment by the time the fund actually was closed in 1994.

It’s a 33-point move by way of a 1000-point swing. The exhausting roller-coaster of the last five days would have traders happy to see the weekend arrive were it not for the anticipation of more activity from federal regulators and Wall Street bankers over the weekend. It will be difficult to surpass the sinking feeling investors had this past Monday, however, when several large financial companies were teetering on the brink all at once.

Just five days and a bankruptcy, a government takeover and a shotgun merger later, the American financial system has been completely reordered, and more changes in the regulatory framework and on Wall Street are likely to come in the next few years.

“I’ve been trading 23 years, and I can finally say this has eclipsed what I saw the week before and the day of the 1987 market crash,” says Tom Alexander, president of Alexander Trading. “I didn’t think I’d ever say that. So many things have changed so quickly, maybe even more so than 1987.”

The two-day, 800-point rally on the Dow industrials has most assuredly left traders with a sense of renewal after the crushing losses earlier in the week, but the cost is likely to be great. A temporary ban on short-selling of 799 financial issues goosed that sector, which led the way, but left Mr. Alexander wary of what’s next to come, as he judges most of this rally to be short-covering.

The last few weeks have progressed with an air of foreboding. Large fund managers weeks ago were warning that American International Group Inc. needed $15 billion to $25 billion in capital, with one saying that “they’re the one that scares me the most.” In the end, they’re the one that received the most in the way of government help — but at the highest cost, interest rates north of 11% as it currently stands.

Through the 13 months of this winding credit crisis, the prevailing hope among investors, banks and traders was that the next development, be it major write-downs from an investment bank, unloading of terrible assets, another interest-rate cut, or the announcement of a new lending facility, would be the definitive one that would “get us past all of this.” It was the slump in subprime, the Bear Stearns fiasco, and then the TSLF, and then the Fannie/Freddie bailout.

This past week that scenario played out at the speed of light, with traders digesting the news of the Lehman Brothers bankruptcy and responding not with relief, but by moving on to the AIG feeding frenzy.

The financial death spiral produced memorable hair-trigger decisions that may, in hindsight (following the Treasury’s “enough is enough” moment Thursday afternoon), look hasty, such as John Thain’s decision to partner the vaunted Merrill Lynch firm with Bank of America.

That short-selling ban may have been enough to save Merrill, but as the saying goes, you can’t unring that bell. Then again, what’s happened at the end of this week may only be a postponement of the execution, with Hank Paulson’s hand on the lever, deciding the fate of money-market fundholders, short-sellers, and the nation’s largest financial institutions.

“It creates stability, but long-term, the fundamentals remain the same,” says Keith Springer, president of Capital Financial Advisory Services in Sacramento, Calif.

Some of that uncertainty will be resolved this weekend with the potential formation of some kind of “bad bank” structure that would buy up the underperforming, hard-to-sell assets sucking all the air out of Wall Street’s firms. It may prove ephemeral, because it will force those firms to sell these assets at bargain-basement prices to the U.S. Garbage Barge Trust, or whatever it will be named, and already there is talk that some are unhappy with that.
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In the annals of history last week will be remembered as the implosion. But the market heads into next week treading on a landscape where short-selling is prohibited, the government is engineering some kind of Golem-like structure to cleanse balance sheets, and investors cannot be sure if the two-day rally was for real or a mirage.

The SKF (proshares ultrashort financials) has been halted down 22%. It’ll be real interesting to see how they’re gonna mop that one up. They can’t simply pretend it’s not there and make it disappear. Oh wait, they can. I forgot–they can do whatever they want.