By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter

Last Updated: September 30, 2008: 12:28 PM ET

(Fortune Magazine) -- As Congress wrestles with another bailout bill to try to contain the financial contagion, there's a potential killer bug out there whose next movement can't be predicted: the Credit Default Swap.

In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG (AIG, Fortune 500), whose calamitous descent itself was triggered by losses on its CDS contracts (see "Hank's Last Stand").

And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation.

"The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe."

***

AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.

Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract.

And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)

You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.

Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.

The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.

***

ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.

"It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."

***

THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."

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By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter

Last Updated: September 30, 2008: 12:28 PM ET

This is not an academic concern. Wachovia (WB, Fortune 500) and Citigroup (C, Fortune 500) are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some CDOs. The specifics of the spat aren't important. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?

That's one element of what's known as "counterparty risk." Here's another: In many cases, you don't even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties. Investment firms assert that transfers are well documented (a claim that, like most in the world of CDS, is impossible to verify). But even if that's true, you're still left with the fact that a given company's risks are being dispersed in ways that they may not know about and can't control.

It doesn't help that CDS trading is a haphazard process. Most contracts are bought and sold over the phone or by instant message and settled manually. Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks. Pushed by New York Fed president Timothy Geithner, the players have been improving the process. But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that "there were $1 trillion worth of swaps that were unsettled among counterparties."

Trade settlement is not the only anachronistic aspect of CDS trading. Consider what will happen with CDS contracts relating to Fannie Mae and Freddie Mac. The two were placed in conservatorship on Sept. 7. But the value of many contracts won't be determined till Oct. 6, when an auction will set a cash price for Fannie and Freddie bonds. We'll spare you the technical reasons, but suffice it to ask: Can you imagine any other major market that would need a month to resolve something like this?

***

WITH WASHINGTON SUDDENLY in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. "The market is here to stay," asserts Cawley. The question is simply: What sorts of changes are in store? As this article was going to press, SEC chairman Christopher Cox asked the Senate to allow his agency to begin regulating CDS - mostly, it should be said, to rein in short-selling. And the SEC separately announced that it was expanding its investigation of market manipulation, which initially targeted the short-sellers, to CDS investors.

Under other circumstances, Cox's request might have been met with polite silence. But the convulsions over the mortgage bailout are so dramatic that they are reminiscent of the moment, soon after the Enron scandal, when Congress drafted the Sarbanes-Oxley legislation. The desire to blame short-sellers may actually result in powers for Cox that, until very recently, he showed no signs of wanting. Should legislators wade into this issue, the measures most widely seen as necessary are straightforward: some form of centralized trading or clearing and some form of capital or reserve requirements. Meanwhile, New York State's insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some (but not all) CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law - requirements that would probably drive many participants from the market. Whether CDS players will find a way to challenge the rules remains to be seen. (ISDA, the industry's trade group, has already gone on record in opposition to Cox's proposal.) If nothing else, the New York law may provide additional impetus for the feds to take action.

For now, the biggest impact could come from the Financial Accounting Standards Board. It is implementing a new rule in November that will require sellers of CDS and other credit derivatives to report detailed information, including their maximum payouts and reasons for entering the contracts, as well as assets that might allow them to offset any payouts. Anybody who has tried to parse CEO compensation in recent years knows that more disclosure doesn't guarantee clarity, but any increase in information in the CDS realm will be a benefit. Perhaps that would limit the baleful effect of CDS on (must we consider it?) the next disaster - or even help us prevent it.  

How/why is this situation different from investors simply losing their money because of bad judgment about what to invest in? Can I get bailed out when my portfolio tanks?

It's a variant on the old saw (often attributed to J. Paul Getty, although I'm sure somebody must have said something like it before him): "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Leveraged financial institutions (banks, investment banks, hedge funds) make investments with lots of borrowed money, so when their portfolios tank they can quickly get into a situation where they can no longer make good on their debts. When that happens to a single institution, it's no big deal to let it fail. But if it's happening to a lot of them at once, you get the paradox of deleveraging: a downward spiral in which failure begets more failure and retrenchment begets more retrenchment.

Why should Wall Street be bailed out? Won't it just make them all the more eager to engage in risky practices in the future? Are we bailing out the very people who created the problem?

A lot of the people who created the problem have already lost their jobs, but yes, any bailout risks rewarding the profligate and the foolish. But we're getting to the point where financial sector problems are starting to hurt people who didn't profit from the boom. And you can design a bailout that's not so much a bailout as a new start--such as the Swedish solution outlined above.

There's also the approach favored by the late MIT economist Charles Kindleberger, who thought it was the job of governments and central banks to step in and halt panics, but felt they should “always leave it uncertain whether the rescue will arrive in time or at all, so as to instil caution.” That seems to be official U.S. government policy at the moment, actually.

If more currently outstanding mortgages default, won't the problem just keep going on and on?

Yes, that's a big part of the concern at Treasury and the Fed. That economic trouble emanating from the financial system will cause even more people to fall behind on their mortgage payments which will lead to even more trouble in the financial system.

Are we all just supposed to trust that mortgage lenders and Wall Street types have 'learned their lesson' and will not continue to exacerbate the problem (or find ways to create new ones)? What safeguards are/will be put in place so that derivatives of the type that got this mess started will not continue to be created or traded?

I think it's fair to assume that mortgage lenders and Wall Street won't make these same mistakes for another generation at least. But they will do their best to figure out new ones to make. And while bubbles and crashes will always be with us, I think a regulatory structure that is far more restrictive of financial innovation is probably a good idea. Do we have that regulatory structure in place now? No.

Is the money going to the wrong people/institutions? Why should the money go to these institutions instead of homeowners or banks who hold the sub-prime mortgages?

A lot of the money would go to banks that hold sub-prime mortgages. Getting it to homeowners is a more complicated proposition. Would you just give the money to people struggling with their mortgages? How much would you give them? For how long?

If these so-called securities are 'mortgage backed' and the mortgages are in default, would the money be better spent just buying up the mortgages themselves instead of the securities? And re-negotiating mortgage rates to make it more likely that homeowners can pay down their mortgages and hold on to their homes?

A number of economists think that buying up the mortgages themselves would make more sense. I think the reason Treasury doesn't want to do it is that it would be a far more time-consuming and labor-intensive process than simply buying securities on the open market. It was easier in the Depression, when banks held whole mortgages on their books, than it is today.

As for renegotiating mortgages, a new program goes into effect tomorrow (it was part of the housing bill passed over the summer) that uses up to $300 billion in FHA guarantees to encourage mortgage servicers to move people out of adustable-rate subprime loans into fixed-rate loans with lower face values. And if Treasury owned a few hundred billion dollars worth of mortgage securities, it could put pressure on servicers to renegotiate loans rather than foreclose on them.

And what about the 90% of homeowners who are paying off their mortgages and dealing in good faith, who have seen their equity significantly lowered by the tanking of the real estate market?

That equity will go down more if banks continue to struggle.

Is there any chance that any of the bailout money will be recouped?

Yes. Mortgage-backed securities are still, you know, backed by mortgages. They're worth something--and in some cases more than what the feds would pay for them.

How/who will determine how much to pay for these securities?

They haven't really figured that out yet. One possibility would be to hire private managers who would get a share of any profits. And there's lots of talks about using various auction methods to price them. But I have yet to hear a really convincing explanation of how this would work.

Will every financial institution that holds mortgage-backed securities be able to sell them to the federal government? Who determines what will be bought and from whom? Will institutions be able to recover losses they have already written off?

In theory anybody could sell to the TARP (troubled asset relief program). The what and from whom would ultimately be up to the discretion of the Treasury Secretary. And if institutions were able to sell securities for more than they valued them at on their balance sheets, sure, they could reverse some losses.

What is to stop speculators from buying up these bastardized securities for pennies on the dollar anticipating enormous profit when the government buys them at higher rates?

The current owners of those securities aren't going to want to sell them for pennies on the dollar if they think the government will come in soon and buy them for dimes. That said, I think Treasury would love it if there were private vulture investors bidding for mortgage assets too.

How is the current real estate crisis different from the RE bust of the early 1990s?

1) It's bigger and more national--although it is worst in California, the Southwest, and Florida.

2) It's also (except in, say, Detroit and Cleveland) not the result of external economic factors like Texas in the 1980s or Southern California in the 1990s. It's a crash caused by the twisted dynamics of real estate finance in recent years.

3) The way mortgage-backed securities and related derivatives have acted to concentrate and transmit risk rather than diffuse it has added a whole new element to the crisis.

Who is at fault here? I have increasingly seen fingers pointed at home buyers for buying 'too much' mortgage (i.e. big eyes for big houses), who 'lied' on their mortgage applications about their ability to keep up payments. Surely significant fault lies with the mortgage lenders for approving such loans without due diligence? And greater fault with the creators of the mortgage-based derivatives?

Until 10 years ago, getting approved for a mortgage was a pretty good indication that you could afford to make the payments. So for the most part I really don't blame buyers--they were relying on a time-honored financial rule of thumb that mortgage lenders and their Wall Street backers had suddenly decided to throw out the window. I'd blame the lenders, the securitizers, the regulators and Congress first, and buyers probably last. Although I'd still blame 'em a little.

Speaking of fault, how logical (much less honorable, but we probably need not go there) was it for Wall Street to over-leverage itself? Or is it just a matter of 'because they could'?

It was logical for individual Wall Streeters because they could reap big rewards from overleveraging and not necessarily suffer from the eventual fallout. It was not logical for Wall Street firms to do so (because it put their survival at stake) but those firms are after all just collections of individuals.

Without the bailout, is it really likely that we will see the end of the world as we know it? And what, exactly would that Apocalypse look like?

Given the existence of the FDIC and the activist stance of the Federal Reserve, it's hard to envision a 1930s-style breakdown in which banks shut their doors and depositors lose all their money. I think the fear is of a situation where lending to both businesses and individuals stops almost completely, which would lead to a pretty sharp downturn. Not nearly as bad the Great Depression, but the worst we've seen since then.

What is the difference between Wall Street and a casino? (Not meant as a joke)

On Wall Street, the dealers get paid a lot more and are often allowed to bet alongside the customers. Oh, and much of the money raised on Wall Street actually goes to productive purposes. Except when markets are in bubble mode.

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WASHINGTON — For the Federal Reserve and the Treasury Department, the crisis continues.

Without the broad bailout plan they invented and lobbied hard for, the two agencies are once again forced to careen from one desperate path to another, and to dig deep into their toolkits to rescue the global financial system. Even before the House stunned the world on Monday by rejecting the Bush administration’s bailout bill, the Fed was already resorting to the oldest action in its book: printing money.

With money markets around the world seizing in fear, the Fed on Monday announced that it would provide an extra $150 billion through an emergency lending program for banks, and an additional $330 billion through so-called swap lines with foreign central banks to help money markets from Europe to Asia.

It was an extraordinary display of financial power, and it reflected acute new anxiety at the Fed and central banks around the world that the crisis of confidence in American financial markets had metastasized to money markets everywhere.

That was on top of the $230 billion the Fed borrowed last week so it could finance its previous efforts to prop up the American International Group and other institutions. But these are only the latest in a long series of jaw-dropping departures from normal policy that the Fed has undertaken this year as it seeks to inject vast amounts of capital into the financial system. And they are unlikely to be the last.

Even if Congress refuses to pass the bailout measure, there is more money where that came from. The Treasury Department has already created a series of “supplemental” Treasury securities to finance the Fed’s activities, and there is no limit to how many more it can issue and sell.

Treasury and Fed officials made it clear after the House vote on Monday that they still had a wide range of tools at their disposal. But most of the remaining options are ad hoc, rather than systemwide. The Fed, for example, can lend money to any company it deems too dangerous to fail by invoking the same Depression-era law it has already used to deal with failing firms like Bear Stearns and A.I.G.

The Treasury Department, meanwhile, has already vowed to buy up billions of dollars in mortgage-backed securities under the authority it received in the housing bill that Congress passed in the summer.

The bad news is that those attempts have done little or nothing to bolster confidence in the financial markets. Yields on three-month Treasury bills shrank to just 0.29 percent on Monday, a sign that investors were fleeing from any kind of risk, even if it meant earning a return far lower than the inflation rate.

Interbank lending rates climbed to new highs on Monday, as banks became even more fearful about lending to one another than they were last week.

“The liquidity measures are a stopgap,” said Laurence H. Meyer, vice chairman of Macroeconomic Advisers, a forecasting firm. “You’re funding the banks’ balance sheets, but nobody wants to lend money to them because they’re all afraid of insolvency.”

Administration officials were shocked at the House’s refusal to approve their bailout plan but are still hoping to rescue the plan later this week, by offering some modifications that will win over rebellious House Republicans without losing crucial Democratic votes.

“We need to put something back together that works,” said Treasury Secretary Henry M. Paulson Jr. Though he promised to “use all the tools available to protect our financial system,” he warned that “our toolkit is substantial but insufficient.”

In the absence of broader authority, Treasury officials are reviewing the options for creatively using the same kinds of case-by-case actions they have taken over the last six months — taking over Fannie Mae and Freddie Mac, bailing out A.I.G., and arranging shotgun marriages between failing institutions and healthy ones.

Robert A. Dye, chief economist at PNC Financial in Pittsburgh, said those efforts amounted to patchwork solutions and had thus far failed to bolster confidence in credit markets.

“The problem is that these are just a series of ad hoc solutions on a business-by-business basis, and they aren’t addressing the systemic problems in any basic way,” Mr. Dye said.

But other analysts said that credit markets around the world were almost entirely dysfunctional on Monday morning, when political leaders and investors alike assumed that Congress had reached a firm deal and would easily approve the bailout.

“It’s our view that this package, in a fundamental sense, will not solve the problem,” said Simon Johnson, a former chief economist at the International Monetary Fund. Mr. Johnson said that he had been hoping that the bailout plan would simply stabilize the markets through the presidential elections in November, but that he was now pessimistic about even that.

Michael Darda, chief economist at MKM Partners, an investment firm in Greenwich, Conn., said the Treasury’s bailout plan might have even unnerved many investors.

“I don’t see how it can help banks unless it’s clear that the government is going to buy these assets for substantially more than they are worth right now,” Mr. Darda said. “It’s such a big step in terms of government influencing the private sector, and it’s hard for investors to take a leap like that overnight, especially when they don’t know what’s going on.”

The Federal Reserve has stretched its resources to the limit. Before the crisis began in August 2007, the Fed had about $800 billion in reserve, nearly all in Treasury securities.

But because of all the new lending programs for banks and Wall Street firms, analysts estimate that the Fed’s balance sheet now has less than $300 billion in unfettered reserves.

The central bank can expand its reserves at will, because it controls the money supply and can create more to buy things like Treasury securities and mortgage-backed securities.

“We have a lot of money to play with,” said Kenneth Rogoff, an international economist at Harvard. “As long as foreigners have a lot of confidence in our ability to solve our problems, we can borrow the $1 trillion to $2 trillion we need to solve it.”

But Mr. Rogoff cautioned that the real limitation for American policy makers is whether they can maintain the government’s long-term credibility. “The real constraint is not a bookkeeping one,” he said. “It is a sense of faith on the part of foreigners that the U.S. government will repay its debt. Our most precious asset is that credibility.”

For Many Americans, Fear and Distrust Run High

By Joel Achenbach and Ashley Surdin
Washington Post Staff Writers
Tuesday, September 30, 2008; A01

The leaders of the country said: Trust us.

The people said: Not this time.

The Emergency Economic Stabilization Act of 2008 in the end was a $700 billion piece of legislation that few people could truly love, and it offered citizens from across the ideological spectrum a little something to hate. Conservatives said they could not abide the government intrusion on the free market. Liberals recoiled at government checks rescuing Gucci-wearing Masters of the Universe. There were those who sniped that this was a "No Banker Left Behind" program.

A political establishment held in higher regard might have been able to hold together some kind of coalition of the willing. But distrust of the nation's leaders, from the leaders of Congress to the president of the United States, foreclosed that possibility.

Members of Congress in both liberal and conservative districts were inundated with e-mails and phone calls from angry voters opposing the bailout. With Election Day a little more than a month away, many lawmakers appeared to pay greater heed to their constituents than to their party leaders.

In interviews across the Washington area and in several locations nationwide, Americans reacted to the congressional vote and the market plunge with opinions that carried a common denominator of consternation.

Here's Peter Kane, 60, an entertainment lawyer, getting a shave at Albert's Haircutting & Style in Santa Monica, Calif., the towel on his face puffing as he talked:

"There's got to be some kind of bailout, but the bottom line is that I just don't trust these guys." Look at the Iraq war, he said. "Everything this administration has touched has gone to hell."

Many people yesterday afternoon were still absorbing the news that the stock market had gone into a dive -- hitting a couple of ledges on the way down the cliff -- and it is possible that sentiment for some kind of bailout could increase as investors look at their portfolios.

"I thought: This doesn't seem to be affecting me or my family," said Chuck Taggart, 46, a New Orleans native who lives in Los Angeles. "Then I looked at my 401(k) today."

It was down 19 percent.

"I'm nervous about the whole thing."

To a degree that few Americans could have appreciated just a few weeks ago, the economy runs on credit. But politics runs on a form of credit, too, generically known as trust, and trust has been a scarce commodity recently in Washington.

President Bush, burdened with historically low approval ratings, was slow to try to sell to the American people what he called a "rescue." Academic economists frowned upon the legislation, and radio talk show hosts railed against it.

The bailout lacked a sympathetic character at the heart of the narrative. And many Americans simply did not believe that the government had the basic competence to do the right thing.

"You've got massive public distrust and dissatisfaction, with the bailout specifically, with government in general, and George Bush and the entire political establishment," said Doug Muzzio, professor of public affairs at Baruch College in New York.

In a USA Today-Gallup poll conducted Friday and Saturday, 39 percent of respondents said they approved of the way Democratic leaders in Congress responded to the financial crisis, 31 percent approved of the Republican congressional leadership's response, and 28 percent approved of Bush's handling of the situation.

"This vote is a reflection of a lack of political capital, not of financial capital," said Mitchell Moss, a professor of urban planning at New York University. "The bankruptcy exists in our political leadership, not on Wall Street. We need to bail out Nancy Pelosi and George Bush."

For some, this was not just an unwise bailout but also an outrageous one. Geoffrey Cotter, 65, a real estate broker in Henderson, Nev., who has seen the housing market collapse, said yesterday: "I work hard for my money. Why should I be giving it to these big banks?" He added: "Instead of having a bailout, why don't we have indictments?"

Some people said they support some kind of rescue package, because they see no alternative. In a Panera restaurant in Skokie, Ill., Yvonne Fogerty, 59, a retired federal probation officer, said that if Congress does not act to solve the problem, lawmakers will be voted out of their jobs. "The government has a role in keeping the economy going. If they don't do this, there's going to be a big crash. The economy could go down the drain."

Alberto Tumitati, 47, a maitre d' at an Italian restaurant in downtown Washington, said he found the House vote unsettling.

"The government should be helping the economy in any way it can -- big guy or small guy," he said, leaning against his Humvee near 19th and L streets NW. "If the big companies are in trouble, then we're all in trouble. We need a strong economy. Why do they want to screw it up?"

At a Manassas dry cleaner, Fauquier County resident Dana Conners, 51, said she feels conflicted about the bailout plan. On the one hand, she is outraged by the idea of a taxpayer rescue for financial executives. Then again, she is worried.

"We have to bail them out," said Conners, an insurance agent. "I don't want to work until I'm 85."

Sitting on a bench in front of the courthouse in Annapolis, Samuel Caldwell, 51, a parole agent for the state of Maryland, rubbed his hand across his forehead, contemplating what he said would be a massive economic headache about to hit the nation.

"Look, it's an election year. These folks in Congress know they're being scrutinized, being held to a higher standard. That's why it didn't pass. There's a fear of the unknown here. They still don't know what happened to the markets and what's going to happen to them. So no one wants to make a wrong move," Caldwell said.

Uncertainty is a kind of distrust of its own: Consumers do not know what will happen to the economy, to housing values, to loan rates. Home mortgage applications are down not only because credit is tightening but also because potential buyers are wary of taking a leap at a time like this.

That is the case with Sonya Shooshan, 51, an information research specialist at the National Library of Medicine who has been shopping for a house in Montgomery County. But she is worried about the chaos in Washington, and she is hesitant to buy right now.

"I'm skittish," she said. "God forbid if the economy falls off the cliff, I might be going out to my friends in the Shenandoah Valley and living off their farm and growing vegetables and raising chickens. Could it really get that bad?"

Two funeral directors -- Greg Houston, 45, and Clint Oxendine, 39 -- mulled over the bailout yesterday in the parking lot of a Wachovia bank in Manassas.

"These bankers should be liable," Houston said. "They made a lot of money off poor people, and it was just greed."

Said Oxendine: "Why should we pay for these bad decisions?"

He tried to put the best possible face on the economic downturn: "I don't think it'll be as bad as the Great Depression."

But Houston said he is bracing for tougher economic times -- and leaner funerals.

• Story Highlights
• Jeffrey Miron: Government encouraged lenders to relax their standards
  
• Mortgages were given to people unqualified to repay them, he says
  
• Miron: Rather than a bailout, government should let firms go bankrupt
  
• Talk of economic Armageddon is scare-mongering, Miron says