Yesterday, it was widely reported that US Treasury Secretary Henry Paulson ruled out the use of government money to rescue troubled financial institutions. But his statement during a press briefing leaves some room for maneuvering.

“We do not take, and I don’t take, lightly ever putting the taxpayer on the line to support an institution,” said the former head of Goldman Sachs (NYSE: GS). Responding to a reporter following up on whether it could be assumed that no more federal assistance for financial institutions is forthcoming, Paulson answered, “Don’t read it as no more; read it as that it’s important, I think, for us to maintain the stability and orderliness of our financial system.”

The reaction of the market today to American International Group’s (NYSE: AIG) plight doesn’t suggest widespread fear of systemic risk. AIG had a credit rating of AAA until the close yesterday. The rating agencies required AIG to raise additional capital valued at USD40 billion as a prerequisite for maintaining its AAA rating. After the close yesterday, two smaller rating agencies reduced their rating below AAA. Last night, Standard & Poor’s lowered its rating from AAA to A-. Later, Moody’s lowered its rating from AAA to A2.

AIG is contractually required to raise additional capital when its credit rating is downgraded. The new requirement after the downgrades is USD75 billion. AIG must find the USD75 billion by tomorrow. If they are unable, AIG is expected to declare bankruptcy.

Major North American indexes recovered from horrible opens Tuesday, and potential vultures to AIG’s carcass are firmly in the green. And it may simply be an interesting coincidence that the Dow Jones Industrial Average turned positive shortly after CNBC first reported that the New York Federal Reserve convened a last-ditch meeting to discuss US government involvement in an AIG rescue.

There are at least 62 trillion reasons why the New York Fed is interested in preventing an AIG bankruptcy. Credit default swap (CDS) contracts account for about USD62 trillion, three times the size of the US stock market, up from USD900 billion in 2000. A CDS is an instrument that provides insurance against the risk of corporate default and are issued by insurers such as AIG, with brokers such as Lehman Brothers (NYSE: LEH) acting as counterparties. AIG would charge a premium for a policy that paid the buyer if a loan went bad.

AIG reported a USD5.36 billion second quarter net loss that included a pre-tax charge of about USD5.56 billion for an unrealized loss related to its AIG Financial Products unit’s CDS portfolio. CDS trade is done over the counter, meaning there’s no clearinghouse for such transactions, and there’s no way to know who holds what and from what end.

The overriding fear is that counterparty risk and the potential collapse of many counterparties will lead to a systemic collapse of the global financial system.

AIG, in addition to being one of the world’s most important financial market players, also happens to be a pretty important property and casualty insurer. Policyholders are said to have pushed New York Gov. David Paterson, and Paterson in turn got the New York Fed involved again today. The State of New York is looking the other way while AIG borrows USD20 billion from its operating subsidiaries to be used to negotiate a new credit facility or a capital infusion and maintain credit ratings. Those funds may also be used as collateral. But Paterson is only giving AIG until Wednesday to secure new credit or capital; if it fails, no more looking the other way on borrowing from subsidiaries.

How will AIG survive? There’s probably not enough time to raise sufficient capital through asset sales to stave off bankruptcy, but there are several possible outcomes short of oblivion.

There’s still a chance that, although the odds are dwindling by the moment, a bridge loan from private sources such as Goldman Sachs and JP Morgan (NYSE: JPM) can be arranged. The feds have been pushing the two remaining independent investment banks to put together a USD75 billion loan since the weekend.

But the banks have been unable to come up with enough money–from themselves or from outside investors–to fund a pool. The amount of capital required, absent help from the government, may be just too immense.

Failing a Goldman-Morgan-led rescue, AIG could find help in the form of a high-interest loan from a sovereign wealth or private equity fund. Such a fund would likely negotiate an option to buy the whole company.

And failing any of those scenarios? Then we’re talking a serious game of chicken.

Sen. Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said on MSNBC that he talked to Treasury Secretary Paulson Tuesday afternoon and told him he opposes any federal bailout for AIG. But the feds can work the nuance by offering its own bridge loan, charging a high interest rate and asking for a whole lot of collateral. Forbes is reporting that the Federal Reserve could make a temporary loan through its discount window, using pieces of AIG’s insurance businesses–as opposed to its financial products operations–as collateral.

There is also the possibility that AIG could be taken over outright. A foreign insurance company such as Paris-based AXA (NYSE: AXA) or Zurich-based Swiss Re (OTC: SWCEY) or a domestic heavyweight such as Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A/BRK.B) could step up. The market seems to look fondly upon the potential competitive benefits insurers would enjoy should AIG go down; ACE (NYSE: ACE) is up 8 percent, Travelers (NYSE: TRV) is up 11 percent and Chubb (NYSE: CB) is up 13 percent. That also suggests there’s not much fear of AIG’s failure bringing down the entire financial system.

The broader implications of sovereign wealth fund involvement–from Abu Dhabi, Dubai, Saudi Arabia, Singapore or China–are less clear right now, but the mere suggestion that one could ride to AIG’s rescue, as Abu Dhabi Investment Authority did for Citigroup (NYSE: C) last spring, is but more evidence of the evolution of the global financial system.

As part of the steps taken over the weekend, the Fed expanded the collateral it will accept in its sale-and-repurchase operations, putting taxpayer dollars at risk in a less explicit manner. The situation may be devolving to point where Congress has to step in to spell out a rescue of the entire financial sector. With such a move would have to come an overhaul of the financial regulatory system.

If AIG does fail, and the CDS market unravels, the credit crisis will go on; poorly capitalized US and European banks will scramble to rebuild their balance sheets after risk-weighted assets increase. Central banks have moved aggressively to inject liquidity and loosen rules on what counts as capital in order to prevent that kind of metastasization.

Tuesday’s market action, particularly the largely positive response to what could have been a “disappointing” failure of the Fed to cut the fed funds rate, has tempered some fears, but it’s looking like a systemic solution–along the lines of the 1990s-era savings-and-loan cleanup–may be in order.

It’s time to at least move the discussion from the institution-by-institution approach to rescuing the entire system. Investment banks can’t find counterparties, and they can’t lend with hundreds of billions of dollars worth of bad mortgages. The risk won’t disappear unless the government takes some bad assets off balances sheets and holds them for a while. The investment banks need a clean slate.

The Financial Times recently reported that a Resolution Trust Corporation-style (RTC) solution was discussed extensively at an August meeting of central bankers; the Fed and the Treasury aren’t working up plans, but they have been studying such vehicles. The fundamental problem a new RTC would solve is that nobody wants to buy mortgage-backed securities, and few are willing to invest new capital into banks and financials holding them.

Look for talk of Resolution Trust Corporation Redux to pick up after the Nov. 4 US elections.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

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Crude oil’s fall from near USD150 a barrel to below USD110 was based on demand destruction. High prices cured high prices. The recent leg down is more about concerns over economic growth spurred by the further credit constraints implied by the Lehman Brothers (NYSE: LEH) collapse, the rescue from a similar fate of Merrill Lynch (NYSE: MER) by Bank of America (NYSE: BAC) and American International Group’s (NYSE: AIG) death march.

Canada’s energy and materials sectors combined for 65 percent of the loss on the S&P/Toronto Stock Exchange Composite Index Monday, as October crude shed USD5.47, or 5.4 percent, to settle at USD95.71.

ARC Energy Trust (TSX: AET.UN, OTC: AETUF) had already reigned in its second top-up distribution, bringing its monthly payment to CAD0.24 from CAD0.28; the “normal” payment of CAD0.20 was augmented by CAD0.04 in May and then again in June–while crude and natural gas prices headed toward USD150 per barrel and USD17 per million British thermal units, respectively, in early summer.

The good news Monday: Several oil and gas trusts–including Avenir Diversified Income Trust (TSX: AVF.UN, OTC: AVNDF), Baytex Energy Trust (TSX: BTE.UN, NYSE: BTE), Bonavista Energy Trust (TSX: BNP.UN, OTC: BNPUF), Crescent Point Energy Trust (TSX: CPG.UN, OTC: CPGCF), Peyto Energy Trust (TSX: PEY.UN, OTC: PEYUF), Trilogy Energy Trust (TSX: TET.UN, OTC: TETFF), True Energy Trust (TSX: TUI.UN, OTC: TUIJF), Vermilion Energy Trust (TSX: VET.UN, OTC: VETMF) and Zargon Energy Trust (TSX: ZAR.UN, OTC: ZARFF)–confirmed September distributions, perhaps merely a stroke of sound PR, but encouraging nonetheless.

“Although credit conditions in Canada remain challenging, they are better in many respects than those in other major markets,” said a Bank of Canada (BoC) spokesperson Monday. “The financial system in Canada remains sound.” The BoC also posted a statement on its Web site about the situation:

The Bank of Canada is closely monitoring global market developments. The Bank welcomes the initiatives of the Federal Reserve System to provide support to U.S. financial markets.

The Bank will provide liquidity as required to support the stability of the Canadian financial system and the functioning of financial markets.

The BoC also pledged to continue providing liquidity as necessary to ensure the functioning of financial markets but made no mention as to whether additional extraordinary measures would be taken.

In the September issue of Canadian Edge, we took a deeper look at Canada’s major banks. A couple of those institutions are well positioned to capitalize on US financials’ weakness once the dust clears from the Lehman/AIG tumult.

Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) has USD25 million of exposure. Toronto-Dominion Bank (TSX: TD, NYSE: TD) and Royal Bank of Canada (TSX: RY, NYSE: RY) described their exposure as nominal. A Bank of Montreal (TSX: BMO, NYSE: BMO) spokesman said the bank’s exposure wasn’t significant. Bank of Nova Scotia (TSX: BNS, NYSE: BNS) is listed as a creditor owed USD93 million in Lehman’s bankruptcy filing, but that relates to a credit line that wasn’t drawn and was terminated, thus leaving no exposure.

Whether banks are losing money or not on their exposure to Lehman can’t be determined at the moment because it’s not known what side of the trades they were on, or whether they were short or long credit.

The first question facing Canada’s big banks and other financials is whether they can re-hedge the exposures to avoid larger mark-to-market losses. Lehman’s demise played out over many days, so there was enough time to get a lot of work done as far as reducing risk relative to Lehman wherever possible. The size of whatever charges Canada’s financials take will depend on factors such as the amount of cash they get back from Lehman’s liquidation.

The Canadian banking system is fundamentally different from its southern counterpart, and that should help to keep it in better shape. Mortgage lending, for example, was much more disciplined, as were the activities of Canada Mortgage and Housing Corp, the equivalent of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

Canadians don’t have as much leverage, and the lenders aren’t in the same situation as US peers. Their relative lack of exposure to risky, mortgage-backed securities leaves them in good shape to grab North American market share.