By Katie Benner

News that giant Belgian bank Dexia needed a $9.2 billion government bailout was yet another shock to the increasingly fragile global finance system. But if you’ve been listening to a shortseller named Bill Ackman, it wasn’t much of a surprise.

What most people don’t know is that in 2000 Dexia bought a municipal bond insurer called Financial Security Assurance, which would ultimately be the bank’s undoing. In June, the activist hedge fund manager predicted that FSA was headed for serious trouble.

Like rivals MBIA (MBI) and Ambac (ABK), FSA had strayed from the safe business of insuring municipal bonds into the more profitable and riskier business of insuring complex investments created from bad mortgages, said Ackman. Many of those structured bonds have defaulted. Speaking to a group of 100 hedge fund managers, he called FSA an “example of what happens when you start with a low-risk business, then add more risk to get higher returns. A company will keep doing that until it does something stupid.”

Ackman didn’t believe that Dexia had the money to cover the likely losses on FSA’s guarantees, so he shorted FSA. Lo and behold, FSA has run into so much trouble that its need for money finally sank its parent bank. Note to regulators who think short sellers are behind the recent collapse of some of the world’s biggest financial institutions: no amount of protection from Ackman would have saved Dexia. It dug its own grave long ago.

By Katie Benner

The death of the investment banks. The ban on short selling. The unrelenting pain for anyone who needs to borrow money. Chaos has descended on Wall Street, and at least one hedge fund manager isn’t going to take it anymore.

Cliff Asness, managing partner of AQR, a $30 billion hedge fund firm, produced a searing, angry, and hilarious piece for Joe Nocera at the New York Times that rails against the Securities and Exchange Commissions “temporary” ban on short-selling. God only knows how Asness fared when the ban, which prohibits investors from betting against a company’s stock, went into effect. But it forced funds to cover short positions (Wall Street speak for scrambling to buy shares of companies they hate and had therefore shorted). And quantitative funds that use computer models, like Asness’ AQR, undoubtedly did not have a “what if the government bans shorting” contingency built into their algorithms.

Unsurprisingly, Asness is hopping mad. He hits all the expected notes: The government greenlighted Wall Street greed and the residential real estate bacchanalia. The Federal Reserve under Alan Greenspan led the way by refusing to let the country go into a recession when it should have, creating a massive real estate bubble.

But he also includes zingers like, “So, what goes through the minds of the politicians and bureaucrats and what do they say to themselves? Perhaps it’s the following: ‘What this crisis absolutely requires is that a really futile and stupid gesture be done on somebody’s part and we’re just the guys to do it.’ It was funny when Bluto said it in Animal House. Appropriately if you stayed for the end of the movie you discovered he went on to become a senator. It’s not funny in real life.”

But you know Asness is a man at the end of his rope if you bother to click on the disclosure that accompanies the story. His views and opinions, of course, do not necessarily reflect the views of AQR Capital Management, LLC its affiliates, or its employees. But they are, he concedes, the work of a man who is “criminally insane.”

“Anyone trading on my advice, or a client, consultant, employee or Iraqi insurgent thinking he has been wronged by my attitudes or opinions can have a $250 out-of-court settlement right now if they’ll sign a waiver, otherwise we’ll break you. Oh, and we lied about the $250, but seriously, we will break you.

“Furthermore, if you read one guy’s opinion on a blog and do anything based solely on that, you are an idiot.”

As Nocera wrote at the top of the story, we too hope to hear from Asness as often as possible as this crisis plays out.

More pain for short-sellers. The latest rally in Fannie Mae (FNM) and Freddie Mac (FRE) brings the stocks back to their levels of July 10, when hedge fund manager William Ackman has said he began shorting the mortgage giants. Fannie traded around $15 Monday after briefly trading above $18, and Freddie was above $9 after earlier breaking $10 for the first time in almost two weeks.

The latest installment of what has become a four-day-long rally comes after Ackman proposed a restructuring of the companies that would wipe out shareholders and told CNBC he had begun betting against shares of Fannie and Freddie. Ackman made those comments last Tuesday - the day when the latest plunge in the mortgage companies’ shares bottomed out ahead of an announcement by Securities and Exchange Commission chief Chris Cox that the agency would restrict short-selling in Fannie, Freddie and 17 other big financial stocks. Since then, the financial stocks have surged, with Fannie and Freddie doubling off their July 15 lows. Moreover, Monday’s moves put shares in both companies in line with their highs of July 10 - meaning that any short positions in them are, for now, out of the money.

Of course, Ackman is unlikely to care whether his short is in or out of the money a week and a half later. The debate over the solvency of the mortgage giants and other big financial firms will almost surely play out over months and years rather than weeks. Still, it’s remarkable that in the space of just three weeks, Freddie’s shares have have plunged into the low single digits and then back again - while average daily volume for the month has soared to 139 million shares, from 11 million last month.

The financial rally intensified Thursday, as investors continued to snap up the shares of hard-hit brokerages a day after the S&P 500 financial index posted its biggest-ever daily gain. JPMorgan Chase (JPM) surged 13% after its stronger-than-expected earnings, and Merrill Lynch (MER) rose 10% ahead of the release of its earnings report, due out after the close Thursday. Other big gainers were Fannie Mae (FNM) and Freddie Mac (FRE), which were each up more than 20% for the second straight day, and Washington Mutual (WM), which was up 15%.

WaMu’s rise is worth noting because, unlike the big mortgage companies and the major broker-dealers, WaMu isn’t among the stocks covered in a new Securities and Exchange Commission rule banning so-called naked shorting - the practice of betting against stocks without first locating the shares that will later be used to cover the trade.

John Tabacco, CEO of locatestock.com - a service that finds stocks for hedge funds and broker-dealers executing short sales - calls the SEC move against naked shorting “a step in the right direction,” but wonders why smaller firms such as Washington Mutual and National City (NCC) - big targets of short-sellers in their own right - aren’t being protected as well. “What about the middle-tier regional banks?” he asks. “Why shouldn’t you need to preborrow there?”

So far, there’s no clear sign that traders are making a distinction based on the list: While National City was down 4% at midmorning Thursday, another bank left off the naked shorting list, Regions Financial (RF), was up 18%.

Tabacco says some of the criticism of the SEC order stems in part from the desire of the big prime brokers - investment banks such as Goldman Sachs (GS) would be one example, though Tabacco declines to name names - to protect their lucrative stock-lending franchise (by some estimates, a $10 billion profit gusher. At a time of shrinking balance sheets and falling earnings, the brokers aren’t going to sit idly and see those profits go up in smoke. “You find me one person to say what’s so bad about this rule,” Tabacco says.

Stocks are rolling higher as investors bet a “pragmatic” Fed will cut rates again next month. Among the biggest gainers are Citi (C), up 7% a day after it posted a 2% decline in spite of a big investment from Abu Dhabi, and Freddie Mac (FRE), up 12% on a plan to sell preferred stock. Many of the other names on the most active list are smaller, less well known names such as bond insurer Security Capital (SCA) and footwear maker Genesco (GCO). Barry Ritholtz compares the market, on the verge of its first two-day winning streak in weeks, to the Knicks — while cautioning that the wild swings suggest a poor market for stocks. But whatever you do, don’t call this a short-covering rally: Bespoke Investment Group says stocks with heavy short interest tend to outperform whenever the market rallies. It’s only a matter of time till someone reminds us this is a stock picker’s market.

The collapse of the subprime mortgage market is burying much of Wall Street in writedowns, but that hasn’t kept some hedge funds from raking in huge profits. The Financial Times reports that Santa Monica, Calif.-based Lahde Capital is up more than 1,000% after fees this year because it has been shorting, or betting against, securities tied to low-quality home loans. Other winners among the subprime short crowd are John Paulson’s Paulson & Co. of New York, which the FT says is up $12 billion on its subprime shorts.

But the FT also notes that Lahde principal Andrew Lahde is returning some funds to investors, suggesting he believes time is running out on the subprime short trade. And venture capitalist Paul Kedrosky, not referring to Lahde, turns a skeptical eye to hedge funds triumphal claims. “Expect a blizzard of funds to come forward over the next few weeks playing up their subprime gains,” he writes on his Infectious Greed blog. “However, like hedge funds that said they made oodles shorting the dot-com collapse, most will be lying — or at least being highly selective about data and strategies.” Message: Don’t try this subprime-shorting act at home.