With large financial system losses imminent, the “bank bailout” debate is in full swing. Some are emphasizing the heavy cost to Main Street that would result from a further deepening of the financial crisis. This concern leads them to support government intervention in the banking industry aimed at averting systemic risk. Others say that by rewarding bad lending behavior, the government may do significant long-term damage to the U.S. economy.

But the pro-interventionist forces have already won the battle. The Federal Reserve and the Federal Home Loan Banks (FHLBs) are effectively seeking to bail out the financial system, primarily by accepting mortgage-backed securities (MBS) as collateral for its lending. Taxpayers should be concerned, not simply about the scale of these operations and their potential cost, but also about the piecemeal and non-transparent way in which these maneuvers are being conducted, apparently with little congressional oversight.

Among the examples of a backdoor bailout is the Federal Reserve’s recently created Term Securities Lending Facility, under which the large commercial banks and other primary dealers will be able to exchange $200 billion of MBS for highly liquid Treasury bonds at an undisclosed discount for 28-day periods. This program will have the effect of increasing the amount of MBS to $400 billion, or around half the Fed’s overall balance sheet, at a potentially massive cost to American taxpayers.

Even before the Fed’s recent spate of activity, the government-chartered FHLBs were making similarly large transactions. The most eye-catching of these took place in the third quarter of 2007, as the credit crunch intensified. During that quarter, the FHLBs advanced $180 billion (over 5 percent of U.S. GDP) in loans to financial institutions in return for mortgage-backed collateral. This pace of lending was five times greater than normal, and, in all likelihood, it has not slowed since then. What’s troubling is that around 25 percent of these banks’ outstanding loans were made to three very troubled financial institutions: Citibank, Countrywide Bank, and Washington Mutual Bank.

Goldman Sachs is already estimating that losses from mortgage lending could ultimately reach $500 billion.

With huge loan losses yet to be recognized, the stabilization of the financial system might require the temporary nationalization of a meaningful part of the banking system. So it is appropriate to ask whether the Fed and the FHLBs should be acting in such a knee-jerk manner. Now is the time to be thinking about how Congress and the Treasury Department might forge a comprehensive plan to stabilize the housing market and mend a broken financial system at the least cost to taxpayers and with the introduction of the least amount of moral hazard.

Given the scale of the problem, such a plan would have to be bold. In the absence of meaningful intervention, home prices are bound to fall by around 15 percent this year, after declining by 10 percent in 2007. Foreclosures, already running at record levels, are expected to climb to over 2 million households in 2008. Such a spike in foreclosures will only exacerbate our financial difficulties. Goldman Sachs is already estimating that losses from mortgage lending could ultimately reach $500 billion.

At this late stage of the housing market debacle, there are no easy solutions, only difficult choices. One course of action would involve forcibly rewriting mortgages to make them more affordable (and thus prevent costly foreclosures). However, this course of action would entail the abrogation of contracts, which is vital to the proper functioning of a market economy. An alternate course would be to implement a large-scale government support package. However, this would place a large burden on American taxpayers, and it would involve rewarding people for bad investment decisions.

When all is said and done, two things are clear. First, inaction in the face of a possible housing market and financial system meltdown is not a viable option. Second, in order to safeguard U.S. taxpayers, the problem needs to be addressed transparently, with the full concurrence of Congress, rather than in an opaque manner through the Federal Reserve and the FHLBs.

Desmond Lachman is a resident fellow at the American Enterprise Institute.