Things are beginning to come apart at the seams now for the financials.  The Dow has given back all of its 2007 gains a second time after the January 2008 “rally” has fizzled.  And news now is that banks are facing $325 billion in margin calls.

Wall Street banks are facing a “systemic margin call” that may deplete banks of $325 billion of capital due to deteriorating subprime U.S. mortgages, JPMorgan Chase & Co <JPM.N>, said in a report late on Friday.

JPMorgan, which sent a default notice to Thornburg Mortgage Inc. <TMA.N> after the lender missed a $28 million margin call, said more default notices and margin calls were likely. The Carlyle Group’s mortgage fund also failed to meet $37 million in margin calls this week.

“A systemic credit crunch is underway, driven primarily by bank writedowns for subprime mortgages,” according to the report co-authored by analyst Christopher Flanagan. “We would characterize this situation as a systemic margin call.”

The credit crisis that began about a year ago will likely intensify after Friday’s weak February U.S. employment report “that most definitely signals recession,” JPMorgan said.

Where do the subprime mortgage losses end and the other larger losses begin?  It’s impossible to tell because they are all intertwined so deeply.  The banks have already written off $180 billion, now they face almost twice that in margin calls.

Friday’s unemployment numbers have sealed the deal for a lot of financial talking heads:  we’re in a recession now.  In actuality we’ve been in a recession since last summer, but only now are the numbers unable to hide it any longer.

Meanwhile, news today that the other shoe has dropped on Countrywide  as they face a federal fraud investigation.

Countrywide Financial Corp., the largest U.S. mortgage lender, is under investigation by the Federal Bureau of Investigation for possible securities fraud, according to a person familiar with the probe.

Investigators are focusing on whether Countrywide officials misrepresented the company’s financial position and the quality of its mortgage loans in securities filings, the person, who declined to be identified because he wasn’t authorized to speak about the probe, said yesterday. He described the inquiry, reported earlier by the Wall Street Journal, as preliminary.

Countrywide is among at least 14 companies that the FBI is checking for possible accounting violations related to the subprime lending crisis, including mortgage lenders, housing developers and Wall Street firms that package loans as securities. The FBI announced the review in January without identifying any of the companies.

“There’s a whole lot of excitement and hullabaloo, but proving criminal conduct is likely to be difficult,” David Lykken, president of Mortgage Banking Solutions, an Austin, Texas consulting firm, said yesterday. “A lot of people were caught up in the atmosphere when the housing market was booming.”

That’s a pretty weak defense:  “everyone was doing it”.  In fact, if an entire industry is colluding and perpetrating a fraud, it does become difficult to single out any individuals.  But it’s certainly a complete indictment of the watchdog agencies that are supposedly there to protect the taxpayer, isn’t it?

Regardless, the recession is now official in the minds of all but a few.  The real questions are “How bad will it be?” and “How long will it last?”  The problem is that the few that don’t believe we’re in a recession include the President and most of his advisers.   Indeed, Bush still thinks his “stimulus package” has saved the day.

“We expect they will use it to boost consumer spending and that will spur job creation as well,” he said.

Mr Bush had earlier said that “it’s clear our economy has slowed”.

He added: “Losing a job is painful and I know Americans are concerned about our economy.”

“I know this is a difficult time for our economy,” he said. “But we recognised the problem early and we provided the economy with a booster shot.”

Oh well, that’s all fine then.  Your $600 check will save the economy!

But what then?  Remember, 70% of our nation’s GDP comes from consumer spending.  What happens when we stop spending?

Deflation.  Our whole economy is based on people buying goods and services.  Rising prices now will cause people to buy less stuff.  The result?  Companies are forced to slash prices to get people to buy and they get less profit.  When the margins get too low, and companies are selling for less than their costs of buying the item wholesale, then they go out of business.  More jobs are lost.  People spend less…and the cycle continues.  

Deflation is far more dangerous than inflation.  Our just-in-time delivery system of goods and services means there’s no slack in the pipes.  We’ve already beaten all the inefficiencies out of the system, which means improving the process won’t work, it comes down to brute cost.  With oil above $105 and rising, this will raise the prices all along the delivery chain.   Those who can compete on cost will survive.  Those who can’t will  be forced out of business, raising unemployment and taking even more money out of the system.  Entire industries will be gutted, hundreds of thousands of jobs will vanish, if not millions.  With home prices plummeting and equity vanishing, there’s nowhere to turn for the consumer.

Stuff will remain on the shelves.  Goods will remain unsold.  Services will remain unneeded.  Jobs will vanish and the unemployment rate will skyrocket.  If Americans won’t buy, who will?

Nobody.  The damage will be global.  There’s a considerable danger that this country will be plunged into a crisis that may take years or decades to get out of, depending on if we have the will to make the hard and painful choices we’ll have to make to get out.

But nobody wants to make hard choices.  Certainly not our leaders…so whoever IS President will be stuck with the worst economy in generations.

What will they do with it?

That’s the question now, isn’t it?  There’s no margin for error here.  If we’re not careful, this country will plunge into darkness.