Things are looking a bit grim for the U.S. banking system.

On Tuesday morning, U.S. Treasury chief Tim Geithner rolled out his new plan for rescuing the banks, committing more than $1 trillion to convince private investors to buy up the “toxic assets” that are fouling up the system.

Lobbyists for the big banks praised the plan, the New York Times reported. Investors were less impressed. Shares of Bank of America, Citigroup, and Morgan Stanley plunged by well more than 10 percent Tuesday; Goldman Sachs fell by a relatively merciful 8 percent. Overall, the Dow Jones Industrial Average shed nearly 400 points.

Why the ugly reaction? Martin Wolf, the venerable markets reporter for the Financial Times, ventured an answer on a TV news program (part I and part II): the U.S. banking system appears to be insolvent, sunk under the weight of bad investments. According to Wolf, the Obama team is too “politically frightened” to tell the public and investors that our banking system has essentially failed.

To a casual observer me, Wolf’s analysis seems obviously right. What’s weighing the system down is bad real estate bets. Essentially, our bank execs — decorated with fancy b-school degrees and robustly compensated for their trouble — bet heavily U.S. real estate prices would rise indefinitely. Now that prices have plunged, they’re left with reams of essentially worthless mortgage-backed paper. And as the economy continues to unravel, real estate prices look set to continue falling — which means still more of the assets held by the banks will become “toxic,” i.e., worthless.

And here’s where we get to the trouble with the Geithner plan: He seems to be assuming that private investors can be convinced, by government guarantees and financing, to buy assets that are essentially worth nothing. But where’s the upside in buying worthless assets in the first place?

One of two outcomes now look likely: 1) a wholesale nationalization of the U.S. banks (an extremely dicey proposition for a Democratic president); 2) or the the descent into bancruptcy of a vast and iconic bank like Citigroup — with who knows what consequences.

None of this should be contemplated with panic. Rather, as the banking system teeters, we should be thinking about other finance models, other styles of economic development. In the weeks to come, I’ll be focusing on other models laid out in Woody Tasch’s Inquiries into the Nature of Slow Money: Investing as if Food, Farms, and Fertility Mattered and Gus Speth’s The Bridge at the Edge of the World: Capitalism, the Environment, and Crossing from Crisis to Sustainability.

Update [2009-2-11 7:42:54 by Tom Philpott]:

Martin Wolf has now aired his dire view in the pages of the FT. Wolf lays out two scenarios for the banks: the rosy one being acted on by the Obama team, and a more urgent one, which he says he says he has “little doubt” is correct. The second scenario is as follows:

Under the second view, a sizeable proportion of [U.S.] financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.