Fed Chairman Ben Bernanke and other U.S. financial regulators last week sounded downright hopeful about turning around the U.S. economy and financial institutions in short order. Maybe they're seeing things.

On March 2, the Treasury Department signed terms of its third bailout of American International Group Inc., the insurance giant brought to insolvency by bad bets on credit default swaps. That same day the Obama administration unveiled a 2010 federal budget that reserves $250 billion for additional bailouts of financial firms, if necessary.

Speaking to the Senate Budget Committee Tuesday, Federal Reserve Chairman Ben Bernanke was optimistic that the money won't really be needed, calling the request "a placeholder," in case the economy gets worse than expected.

"Whether further funds will be needed depends on the results of the current supervisory assessment of banks, the evolution of the economy and other factors," he calmly told the senators.

Regardless of whether more money is needed, Bernanke insists the government has been right to commit trillions in taxpayer dollars to shore up the country's floundering money center institutions. Bernanke and other members of President Obama's economic team are a rare bunch of economic experts who say the course taken so far, totaling $2 trillion in investments and liquidity measures and another $7 trillion in guarantees, are likely to be sufficient to restore the financial system's health.

Plenty of economists, meanwhile, think that is flat wrong.

The government's latest assist to AIG is a new $30 billion round of aid after the company posted a $60 billion fourth-quarter loss. This AIG intervention followed a new bailout (also the third) for Citigroup Inc. On Feb. 27, Citi asked the government for an increase in its holding of common equity to as much as 36% in return for converting preferred shares issued through the federal Troubled Asset Relief Program. The switch from preferred to common shares will save Citi billions in annual dividend payments, the exact amount depending on how many other preferred shareholders make a similar switch.

The latest intervention brings the government's total assistance for AIG to $162.5 billion. At Citi, where the latest move required no additional government cash, the federal assistance so far totals $45 billion in cash outlays and another $301 billion in guarantees against future losses. The next expected move of federal regulators is the creation of a public-private investment fund that will buy illiquid assets from financial institutions. This approach angers critics across the board: Some say private investors will offer prices far below what they are valued on balance sheets currently and that selling so low would cause some of the biggest institutions to fail. Others say taxpayers shouldn't have to buy rotten assets, picking up the tab for Wall Street's mistakes.

Many economists complain that the government's interventions on behalf of major financial institutions have succeeded only in staving off inevitable insolvency and reorganization of the most troubled firms. The consequence is that government resources are being diverted away from actions that would more effectively benefit the recession-mired economy. Some argue that the most troubled institutions should be seized by the government instead, existing shareholders wiped out and the institutions recapitalized and sold to private investors.

Bernanke insists that closing down the big banks will only prolong the recession. "Some measure" of financial stability will be restored if government actions are successful, the Fed chief told Congress Feb. 24. "Only if that is the case, in my view -- there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery."

Bernanke argues that it is necessary to break the "adverse feedback loop" -- in which weakened credit markets damage the economy, leading to layoffs and further depressing the lending environment. "It is essential that we continue to complement fiscal stimulus with strong government action to stabilize financial institutions and financial markets," he said. Federal Deposit Insurance Corp. Chairwoman Sheila Bair also defends efforts to keep these institutions afloat, arguing a government takeover wouldn't be as simple as proponents claim.

"I would be surprised if the FDIC had to step in as conservator or receiver of a large, systemically important institution," she told the Institute of International Bankers at the group's annual Washington conference last week.

More direct intervention "will present significant challenges," she said. "There's no clear process for resolving a large financial holding company with multiple affiliates."

Meanwhile, some of the country's most prominent economists warn that the government's actions will be insufficient to return the financial system to health. Many have offered their own plans, but as always, there is little consensus on what the alternatives should be, save for the common suggestion that the healthy portion of big bank operations should be recapitalized.

Edward Altman, the Max L. Heine professor of finance at New York University's Stern School of Business, suggests a spin on the Treasury plan to split bank assets into good and bad bank structures. Altman says that the approach he favors worked well for Mellon Bank Corp. in the late 1980s. After a rash of bad real estate loans put Mellon underwater, the institution was split in two. The bad assets, plagued by uncertainty over their true value, were moved into a bad bank that was christened Grant Street.

The assets were marked down and capital was injected into the institution to protect against further declines. With the uncertainty over the troubled portion of its portfolio removed, Mellon was then able to raise new capital on its own. Grant Street was wound down over seven years without the need for additional capital infusions.

This time, Altman says, the bad bank should be run by the federal government, which would purchase non-performing assets at book value or lower based on an independent valuation. The government would then assume the bank's liabilities up to the amount of the value of the bad assets.

"The good bank could then refinance itself, start lending again, since the bulk of its liabilities will now be guaranteed by the feds," he says.

One of the most vocal critics of the Treasury Department's approach is Altman's NYU colleague Nouriel Roubini, who has become a Cassandra-like fixture on cable television. In a recent report for his RGE Monitor, Roubini complains that the debate over whether to nationalize the most troubled institutions is "borderline surreal." Given the size of the government commitments and the large equity stakes already taken, "the U.S. financial system is de-facto nationalized," he says.

"With 36% ownership of Citi, the U.S. government is already the largest shareholder of Citi," he writes. "So what is the nonsense about not nationalizing banks? Citi is already effectively partially nationalized; the only issue is whether it should be fully nationalized."

Roubini argues that the unacknowledged beneficiaries of this government largess are AIG counterparties, which are also being propped up by the support. "Let us not kid each other: the $162 billion bailout of AIG is a non-transparent, opaque and shady bailout of the AIG counterparties: Goldman Sachs, Merrill Lynch and other domestic and foreign financial institutions," he says.

Without the direct interventions in AIG and the trillions in Fed liquidity measures made available, "Goldman Sachs and every other broker-dealer and major U.S. bank would already be fully insolvent today."

Lawmakers last week were shocked when New York State Insurance Superintendent Eric Dinallo insisted at a Senate hearing that not a single holder of collateralized debt obligations for which AIG has written $80 billion worth of credit default swaps has suffered a missed payment. "All the [AIG] losses we're talking about have been collateral calls that represent market deterioration but if held to maturity the securities could pay out at par," Dinallo said. "It's a market value issue as we speak today."

Senate Banking Committee Chairman Christopher Dodd, D-Conn., demanded the Fed disclose the identities of the counterparties that sold the CDOs to the government, a move Fed Vice Chairman Donald Kohn resisted. The Fed has argued that revealing identities of counterparties that have taken advantage of government liquidity efforts would label them as failing firms in investors' eyes. Dodd rejected that argument, noting that the counterparties in this case are owed money, not the ones coming up short. He warned that Congress and the public would be unlikely to support additional financial bailout funds if the Fed isn't forthcoming.

Kohn insists that the counterparties are not just a handful of major institutions as Roubini suggests. "With regard to these counterparties, there are a lot benefiting from the efforts of the government to stabilize AIG, not just a few. There are many households and business people with insurance polices, 401(k)s, etc."

Sen. Bob Corker, R-Tenn., said he saw no systemic threat to the financial system that warranted the massive Fed and Treasury response and questioned whether government officials panicked when they rushed with the first AIG bailout in September. To ward off any systemic threat, Corker suggested the government could have allowed AIG to go into bankruptcy and guaranteed the underlying CDOs rather than purchasing them outright from AIG creditors.

"AIG was the only entity in the world I think that sold these as insurance products, naked," Corker said. "So we have to keep putting up collateral because of the way they were written, yet the holders have not had any credit losses."

Willem Buiter, professor of European political economy at the London School of Economics, argues that government nationalize only the healthy components of banks, leaving the bad assets with the legacy holding companies, their shareholders and creditors. That solution avoids the lingering problem of how to price bad assets that has bedeviled asset aggregator proposals.

It also addresses the concerns of Bair -- the government won't have to manage the hydra-headed holding companies because it would manage only the bank. If the legacy bad banks fail, they can go through traditional bankruptcy proceedings. Similar strategies have been suggested by economist Joseph Stiglitz and hedge fund billionaire George Soros.

The government's critics say officials must eventually acknowledge that repeated infusions haven't stopped the deterioration of the recipients' conditions and that lending operations must be separated from their troubled asset portfolios. The only remaining questions, they say, are how long it will take the government to get there and how much it will ultimately cost taxpayers.

Joseph Mason, finance professor at Louisiana State University, thinks Treasury Secretary Timothy Geithner has already taken a tentative step in that direction in the recent redo at Citi. Mason adds that the package required Citi to name new directors, an indication Mason says that the government will eventually force CEO Vikram Pandit and other executives to step down, too.

"The government's rhetoric is beginning to sound right," he says. "For a turnaround to happen there needs to be a change in the banks' operations. You can't change operations without changing the management culture."