naked capitalism

Vegetable oil tested on NZ flight BBC

Fannie, Freddie, Bear & Hard Times: Wall Street’s Collapse, Told in Rhymes Wall Street Journal

Falling House Prices: It’s Worse Than It Looks Dean Baker

The Scariest Housing-Related Chart Ever Mr. Mortgage

Is Buying Bonds Really a Good Idea? Felix Salmon

A Renter’s Market for Manhattan Offices New York Times

German minister warns of “growth bubble” Sydney Morning Herald (hat tip reader Glen)

Another Big Bank Failure: More Likely Than Not to Occur Reggie Middleton, Seeking Alpha

Money flows out of hedge funds at record rate Financial Times. Note that December is expected to be the highest redemption month yet, and by a considerable margin.

Seems right to me: China has losts its appetite for risky assets Brad Setser

Antidote du jour:

We have worried out loud that the policy remedies being pursued by the US amount to trying to restore the status quo ante to as great a degree as possible, particularly in trying to resturn US overconsumption to something approaching its former levels. Although it may be difficult to work two agendas, crisis response and addressing the root causes of our economic mess in parallel, focusing solely on the former runs the considerable risk of that we will see only a shallow recovery, with many of the elements of the crisis soon reasserting themselves in more virulent form.

Similarly, the Chinese, who at least in theory had accepted that they needed to let their currency rise (and presumably over time move to a more balanced, less export-dependent economy) have similarly gone into full reverse gear. The RMB has now been more or less re-pegged to the dollar, and China is moving in other ways to shore up exporters (such as pressuring banks to lend).

Michael Pettis points to a related, troubling development: other emerging economies are seeking to restore or increase trade surpluses. That in turn means SOMEONE has to import. But the US wants to increase exports (and the move by the Fed to quantitative easing will have the side benefit, from its perspective, of weakening the dollar). Euroland is neither keen nor able to step into the US role of importer of the last (and first) resort (boldface ours):

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.

This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Pettis addresses another issue, namely, that China’s interest rate cuts will do little for consumers, and will instead exacerbate global imbalances:

For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

In down times, it’s every man for himself. The interesting question is whether these conflicts come to the fore in 2009 or take a bit longer to become acute.

Wellie, the incumbents are not yet out of office, yet the Bush Administration blame shifting spin doctoring is already in high gear.

Henry Paulson gave an interview to the Financial Times that appears either to have been remarkably brief (even the 10 minute Bloomberg videos typically yield more quotable material) or Paulson has gotten very good at a style of speech perfected in Japan, where nothing substantive is conveyed.

Nevertheless, the bits that were FT-worthy were clearly an effort to make the Treasury appear the victim of circumstance and institutional/legal constraints:

He {Paulson} said that even after Congress in October approved the $700bn (€496bn) troubled asset relief program, the US still lacked tools such as an adequate special bankruptcy regime for non-bank financial firms.

“We’re dealing with something that is really historic and we haven’t had a playbook,” he said. “The reason it has been difficult is first of all, these excesses have been building up for many, many years. Secondly, we had a hopelessly outdated global architecture and regulatory authorities  . . . in the US.”

Ahem. And whose fault, pray tell, is the lack of “an adequate special bankruptcy regime for non-bank financial firms?” The Bear collapse made crystal clear what a big issue this was. Lehman, Morgan Stanley, UBS and Merrill (in roughly that order) were all perceived to be risk. This was a live issue.

Did Paulson do bupkis about it? He announced his proposal for financial regulatory reform later in the spring, and it was effectively a call for simplification and consolidation of regulatory functions under the Fed. Not a peep about bankruptcy.

Given the importance and urgency of the issue, Paulson should have made it top priority to get new legislation passed. But there is no evidence I am aware of any thinking at Treasury along this line, and certainly no initiatives.

Also note “we haven’t had a playbook”. A mere week and a few days ago, Paulson used the “no playbook” comment to argue that he had managed the crisis effectively:

Mr. Paulson and other senior advisers to Mr. Bush say the administration has responded well to the turmoil, demonstrating flexibility under difficult circumstances. “There is not any playbook,” Mr. Paulson said.

I took that comment to be an admission of a lack of much (any?) planning; other claimed that the football imagery was used more narrowly, in the sense that the Treasury did not have pre-planned reactions to specific developments.

Perhaps Paulson has decided to shift his message while appearing consistent by using the same turn of phrase. Regardless, in the Financial Times article, Paulson almost seems to be complaining that the situation he faced was outside historical bounds, therefore they had no models to turn to.

But that is utter bunk. We have pointed out before that the powers that be have ignored the Swedish model and the lessons of other banking crises as to what approaches are likely to be most effective. In fact, we noted in August that the TARP bill, which Paulson defends in the interview, was almost diametrically opposed to what an IMF study of 124 banking crises had found to be the most effective responses. An illustrative excerpt:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.

More from Paulson:

“People say banks aren’t lending enough,” he said. “I agree with them – banks aren’t lending enough. But there would be much less lending if the actions were not taken that were taken to increase the confidence in the banks.”

Yves here. Paulson’s assertion is unprovable and the IMF research would suggest he is wrong. Back to the piece:

Mr Paulson said any future regulatory overhaul should emphasise “better and more effective” regulation. It also needed to make sure that infrastructures and powers were robust enough to allow large institutions to fail.

“The organisations [financial firms] cannot be too big or too interconnected to fail,” he said.

More revisionist history. Paulson was singularly uninterested in regulation, and there was NO effort to address the “too big to fail” issue. In fact, allowing (or more accurately) encouraging big firms like JP Morgan and Bank of America to acquire other big firms like Bear and Merrill only make the government an even bigger hostage of the financial system.

One might infer that was the real point of the exercise.

Dwight Cass at BreakingViews makes some astute and troubling observations about the GMAC rescue, which spurred a market rally in the face of truly awful economic releases (one might take the cynical view that, given how thin trading is this week and the tape-painted appearance of the end-of-day recovery in stocks yesterday, that a rally was in the cards absent anything short of the onset of nuclear war).

There were essentially two observations in the piece, the first, that the “rescue” is more likely to be a down payeant:

More worrying is the possibility that this $6bn is the first of many trips to the well. After all, GMAC is still losing money – it has haemorrhaged almost $7.5bn since the start of 2007 – and isn’t overflowing with capital. It had $9bn at the end of September, is raising $2bn from shareholders – including the rights offering – and now has the $5bn in Tarp money.

It just concluded a debt for debt-and-preferred exchange offer, the deadline for which it had to extend several times. It says enough bondholders swapped their debt for it to meet the Fed’s capital requirement, but that doesn’t leave it with a huge amount of excess cash to leverage into new loans, or act as a buffer against future losses.

Admittedly, GMAC is expected to trim its dealer network considerably, but that does not do anything for the assets now on its balance sheet. And given the considerable investment that dealers have usually made in their enterprises, many observers doubt the ability of the automakers to make meaningful reductions of their dealer networks absent Chapter 11. Look how recalcitrant GMAC bondholders proved to be when asked to take a pretty minor haircut in order to become a bank holding company.

But Cass raises a more interesting point, that Treasury and the Fed are working at cross purposes here. Since Paulson has less than a month to go, the consequences of his playing badly with Ben will (presumably) not have any impact on market psychology. However, in the discussion below, note how the Treasury action was in conflict with the Fed’s requirements to bringing the finance operation to a reasonable level of capital adequacy were it to become a bank holding company . Will we see more pressure in the Obama Administration to pursue expedient fictions (in this case, that the band-aid for GMAC is a lasting solution)?

The Fed imposed tough conditions on GMAC last week when it approved its application to become a bank holding company, giving it access to oodles of government lending facilities. It required the company to scrape together about $30bn of equity in order to be “well capitalised” and to cut Cerberus’s and GM’s ownership stakes sharply over time.

But the Treasury seems to be pushing in the opposite direction – $1bn of the funds it has siphoned from the Troubled Asset Relief Programme has been lent to GM so that the carmaker can participate in an upcoming rights offering by GMAC. That will actually increase GM’s stake.

Coral springs back from tsunami BBC

One World, Many Minds: Intelligence in the Animal Kingdom Scientific American

Disagreeing With Martin Feldstein on Defense Spending Stan Collander (hat tip Mark Thoma). A paragraph-by-paragraph refutation of a WSJ op-ed that argued for even more DoD feeding at the trough.

Hedgies Still Hearing “Redemption Song” Joshua Brown

Community Reinvestment Act Makes Bankers Stupid, According to AEI Research James Kwak (hat tip Brad DeLong)

People Pulling Up to Pawnshops Today Are Driving Cadillacs and BMWs Wall Street Journal

HUD Kills FHASecure HousingWire. We were singularly unimpressed when the program was created (see “Bush’s FHA Band-Aid” and “Bush’s Mainly Cosmetic Homeowner Rescue Proposals“).

Kudos for the contrarian John Kay, Financial Times

I Am Shocked That You’re Shocked…!! Cassandra. More on Madoff from someone who was skeptical early on.

Aggregate Demand and Finance and the Collapse in Trade Menzie Chinn, Econbrowser

GMAC Gets $6 Billion From Treasury to Help Revive Auto Lending Bloomberg. And this with the fate of the debt swap “unresolved” meaning management did not get the votes (which as Felix Salmon points out, means the refusniks did very well indeed). So the bondholders won’t take a haircut even to enable GMAC to become a bank, Cerberus is missing in action, and the Treasury stumps up with a $5 billion equity stake and $1 billion in loans. Charming. There was not doubt good reason they chose to announce it this week. And Mish has a nefarious theory.

First two installments of a series at the Washington Post on AIG: The Beautiful Machine and A Crack in The System.

IMF argues for large stimulus packages Financial Times. It also makes approving noises about the Obama program.

Antidote du jour:

A useful piece at the Wall Street Journal discusses the poor prospects for the US banking industry, which will in aggregate post a fourth quarter loss despite heroic interventions by the Fed and Treasury.

The article makes much of recent and almost-certain-to-get-worse bank credit losses as the economy continues to deteriorate. Commercial real estate vacancies, particularly of retail space, are starting to mount. Construction loans were an important business for local and regional banks; a high proportion almost assuredly no longer look viable. And we of course have the grim outlook for credit cards and ongoing weakness in housing.

But the credit losses are masking a second problem: banks’ earnings engine in broken. As many have noted, as long as they are taking losses, they are not terribly keen to extend new credit.

But more serious is the fact that banks had shifted their business model to be more depended on fee income, and much of that was related to the securitization of real estate. Pending changes in credit card rules will dampen down some of the non-interest charges banks could formerly extract. Similarly, a world where the Federal government has become the 800 pound gorilla provider of mortgage credit offers far fewer fee opportunities to banks (and that’s even before considering that transaction volumes are down too).

And as we (and others) have complained, “Where’s my bailout?” maybe it’s time we also start on the less catchy but no less important, “Where’s the good bank/bad bank?” Until the dud assets are recognized, sold off, and banks recapitalized or liquidated, the industry will have a heavy millstone around its neck.

From the Wall Street Journal:

Banks and savings institutions in the U.S. appear headed for their first overall quarterly loss since 1990, as troubled loans pile up faster than the federal government’s unprecedented efforts to aid the battered industry….

“The earnings power for this industry has absolutely collapsed,” says Eric Hovde, chief executive of Hovde Capital Advisors LLC, a money-management firm in Washington that specializes in financial services.

Nearly a quarter of U.S. financial institutions reported a net loss for the quarter ended Sept. 30. The percentage is likely to climb when fourth-quarter results are announced in January, with some analysts predicting that even stalwarts like J.P. Morgan Chase & Co. could tumble into the red….

The glum fourth quarter is an ominous sign for 2009. The U.S. government so far has poured $169 billion into more than 130 financial institutions through its Troubled Asset Relief Program, according to Keefe, Bruyette & Woods Inc. But some banks already are looking for more money or hoarding their existing capital in expectation of another awful year.

Yves here. Repeat after me: you need recapitalization AND price discovery. The near pathological avoidance of the latter by the officialdom would seem to support widespread suspicions that marking assets to market, or even a realistic notion of longer-term value, would confirm that the industry is insolvent.

Back to the article:

In the past few weeks, some analysts have cut 2009 earnings forecasts and stock-price targets for a slew of big and small banks. These analysts expect rising unemployment to trigger deeper losses on credit cards, mortgages and home-equity loans as more consumers fall behind on their bills. Combined with newer problems rippling through commercial real-estate and other types of loans, many banks will need to bolster loan-loss provisions, eroding profits further.

“We believe that deteriorating economic conditions will cause asset quality to get worse in 2009, revealing the inadequacy of loan-loss reserves and impairing profitability,” Jonathan Glionna, an analyst at Barclays Capital, said in a report earlier this month. Nonperforming assets among the 27 financial institutions he covers will rise to $125 billion in the fourth quarter from $43 billion a year earlier, he estimates.

By the end of next year, the figure could top $200 billion, he said…..

As conditions worsen, struggling banks are expected to turn to private-equity firms and other outside investors for capital. Even some of those getting a government infusion may need more capital, analysts warn. Interest in shoring up financial institutions is rebounding as regulators warm up to granting bank charters to nonbank investors.

Ahem, PE firms like to buy assets they can leverage. The reason everyone wants to PE firms to inject capital into banks is to help increase their equity bases, which would lead to a reduction in leverage. That would seem to be an out-trade.

Plus the example of TPG’s $7 billion investment in WaMu blowing up so quickly and completely has no doubt had a considerable deterrent effect on other PE firms who might otherwise have considered taking a flier.

Storing the Breeze: New Battery Might Make Wind Power More Reliable Scientific American

An Eye For An Eye Makes The Whole World Blind Hizoy

Fifty Herbert Hoovers Paul Krugman, New York Times

Deficit or Depression? Robert Kuttner, Huffington Post. Some good ideas on how to achieve fiscal stimulus quickly. MIght be worth noting if ideas of this sort are prominent in what finally gets passed next year.

Demand for oil will fall by largest margin in 25 years Guardian (hat tip reader joe c)

Europeans see euro trumping dollar Financial Times

Discounts Not Enough to Revive Online Retail Sales Wall Street Journal

The collapse of financial globalization … Brad Setser

Antidote du jour:

Wolfgang Munchau has a good piece in todays’ Financial Times delineating his economic policy wish list for 2009. It has the merit of being to the point and pragmatic.

His preamble contains some some striking tidbits. Munchau considers himself relatively optimistic about US housing, despite anticipating a 40 to 50% peak to trough decline, and far more worried about financial firms.

While I agree with his three objectives, forestal deflation, ratoinalize the financial sector, and improve coordination, Munchau fails to acknowledge that the Federal Reserve and Treasury’s actions suggest that they view keeping deflation at bay and reducing the size of the financial services industry to be in conflict. As this blog and others have noted repeatedly, the authorities instead appear to be taking a page from the Japanese playbook, of trying to shore up the value of impaired assets rather than allow price discovery to occur (and a huge number of bottom fishers would wade in once they had confidence that was indeed taking place) and contain the damage via firm-specific liquidity measures and recapitalizations for ones that appeared viable, liquidation for the rest.

From the Financial Times:

It is easy and difficult at the same time to predict the economy in 2009. It is easy to predict it will be an awful year for the US, Europe and large parts of Asia…

The difficult part of the forecast is to predict whether policymakers will succeed in preventing the recession turning into a depression and lay the foundations for a sustainable recovery in 2010. What I can predict with near certainty is that policy will matter a great deal next year.

We know that the current driving force behind this downturn is “deleveraging”…There is no chance of a sustained economic recovery until that process is almost complete.

We are still some way from that point. For example, on my calculations it will take a total peak-to-trough decline in real US house prices of some 40-50 per cent to get back towards long-term price trends and for price-rent ratios to return to more sustainable levels. We are about half-way through this process. The good news is that most of the nominal adjustment will have taken place by the end of 2009 or early 2010.

I am a lot less optimistic about the financial sector. While it is also reducing its leverage, it will not achieve a sustainable position quickly without a lot more government capital. But this would require deep restructuring and would take time.

On the basis of this admittedly brief sketch, I arrive at three policy priorities for 2009. The first is for central banks to avoid deflation. If ever there has been a need for a central bank to target price stability, it is now. I mean this in the European sense of the term, meaning a small but distinctly positive rate of inflation, say 2 or 3 per cent annually. I assume that central banks will succeed in this endeavour, given the full power of policies deployed. I worry, though, that the US will try to raise inflation afterwards, which would reduce the real level of US debt but create massive distortions in exchange rates and financial flows and produce another global financial and economic crisis.

The second priority is to shrink the financial sector. A disorderly collapse would be catastrophic, but it is neither desirable, nor possible, to maintain the financial sector at its current excessive size. Take the market for credit default swaps, an unregulated $50,000-$60,000bn casino that serves no economic purpose except to enrich its participants at massive risk to global financial stability. I would be in favour, as a matter of principle, of regulating any financial activity on the basis of its economic purpose. Since a CDS constitutes insurance from an economic point of view, we should treat it as such and subject it to insurance regulation (which would kill it of course).

In particular, we should try to avoid the temptation to regulate too much in detail. This is a game regulators will lose. The financial sector is good at deploying existing instruments, and creating new ones, to circumvent any inflexible rule set. We should instead focus on breaking up too-large-to-fail banks and reducing the size of the financial sector in relation to a country’s GDP. In particular, we should not try to guarantee the obligations of a banking sector several times the size of our economies.

Third, and perhaps most important, we need to co-ordinate the policy response at global level, since this is a global crisis with many global spillovers. What I would like to hear from US President-elect Barack Obama’s economic team is not a narrow-minded discussion about whether the stimulus will be $700bn or $850bn, or which programmes it will be spent on. What I want to know is how they intend to co-opt the Europeans and the Chinese into a joint strategy.

What national governments should not do is blow even more money on infrastructure investments and on education. Whatever problem this is supposed to solve, it is a different problem from the one we need to solve right now.

Nor do I see any real policy co-ordination, in which governments commit to policies they would otherwise not have considered. At present, in Europe at least, the co-ordination process works the other way round. Each government decides unilaterally what it wants to do. And then, at European Union level, they dress it up as policy co-ordination.

It is not difficult to construct a plausible scenario of an economic catastrophe. Pick some of the following and you could end up with a depression that beats every modern record: a rise in global protectionism; competitive currency devaluations; a sterling crisis; social unrest in China, leading to political instability; a well-timed terrorist attack; continued refusal by eurozone leaders to co-ordinate; a payment default by a large sovereign in the eurozone; an acute emerging market crisis; continued lack of synchronisation of monetary policies, or a collapse of the CDS market. Obviously, the insolvency of a large global bank or the annihilation of the hedge fund industry would not go unnoticed either.

Alternatively, we can try to keep the lid on the 2009 recession and lay the foundations for a sustainable but unspectacular recovery. This would be the best outcome. But for that we would have to recognise that the global economy is more than the sum of its parts. It implies that policymakers will have to smarten up, work together and start thinking outside the box. The trouble is this is not what they usually do.

There is a piece I regard as truly odd in the Wall Street Journal tonight. Either much of what I have read about investment bank bankruptcies is wrong, or something peculiar is at what used to be the house of Lehman.

A Wall Street Journal article, “Lehman’s Chaotic Bankruptcy Filing Destroyed Billions in Value,” comments at length on a report by Alvarez & Marsal for the Lehman board of directors:

As much as $75 billion of Lehman Brothers Holdings Inc. value was destroyed by the unplanned and chaotic form of the firm’s bankruptcy filing in September, according to an internal analysis by the company’s restructuring advisers.

A less-hurried Chapter 11 bankruptcy filing likely would have preserved tens of billions of dollars of value…An orderly filing would have enabled Lehman to sell some assets outside of federal bankruptcy-court protection, and would have given it time to try to unwind its derivatives portfolio in a way that might have preserved value, the study says.

Based on what I had read (and perhaps misinterpreted) at the time of the Bear collapse and the Lehman bankruptcy failing, I had the very strong impression that Chapter 11 simply was not a viable option for a securities firm failure (at least a large one with extensive trading operations). If this is indeed correct, then it begs the question of why the board would engage a consulting firm to spend three months developing a report on a fictive premise (presumably to avoid liability).

Let us review the facts of the case. When Lehman was on the ropes, most commentators assumed that the fundraisings the firm was attempting to get done (the abortive foray with the Korean Development Bank, the sale of the asset management operations) would raise $10 billion, perhaps more, and allow the firm to kick the can down the road at least a couple of quarters. Bearish sorts like yours truly did not see that as a long-term solution, but a lot can happen in six months.

But when Lehman failed, the losses were (very crudely speaking) an order of magnitude greater. We have grumbled that there has been no explanation of this disparity, and that given that the firm was on the rope for nearly six months, the failure of the officialdom to get a better handle on the possible downside of having Lehman fail was a major dereliction of duty.

Some readers have contended that in fact they did but decided to cut the firm loose anyhow. I sincerely doubt that. The SEC did not make an independent assessment (as did the Treasury in the case of Fannie and Freddie). Fuld would never in private have fessed up that things were worse than the financial statements said (aside from his massive ego precluding that, it would have been an admission that the public financials were misleading and/or incomplete, a hugely damaging admission from the standpoint of corporate and personal liability). So where could the Fed and Treasury gotten further insights? In theory Lehman’s counterparties, but if the belief was that Lehman really had a $100 billion hole in its balance sheet (prior to the hasty weekend due diligence by Barclays and Bank of America), how could Paulson been so deluded as to think that he could get anyone in the industry to take on a garbage barge that bad with no government backstop? All it would to was to transfer toxic waste to another party, incurring huge damage to their balance sheet in the process.

Fast forward to the mysterious Alvarez & Marsal report. The premise of the report is that Chapter 11 was a viable option for a considerable portion of Lehman. The Journal discussion does not spell out what the alternative process would have looked like, but does specify some of the damage the Alvarez & Marsal report contends could have been avoided:

Much of the destruction of value came from the bankruptcy filing of the parent guarantor, Lehman Holdings. The filing triggered a cascade of defaults at subsidiaries that held trading contracts. That created what is known as an “event of default” for Lehman’s derivatives. This resulted in a termination of more than 80% of the transactions with counterparties — typically major European and U.S. banks such as J.P. Morgan Chase & Co., said Mr. Marsal. In all, the bankruptcy canceled 900,000 separate derivatives contracts.

The problem for creditors is that this also terminated contracts in which Lehman was owed money. Mr. Marsal said a few extra weeks would have allowed Lehman to transfer or unwind most of its 1.1 million derivatives trades, preserving more cash for creditors.

Overall, the losses from derivatives trades and related claims cost Lehman’s unsecured creditors at least $50 billion, according to the analysis. The findings, yet to be made public, eventually will be presented to the U.S. Bankruptcy Court and to Lehman’s creditors.

“This filing, which was pretty much dictated to the board of directors at Lehman that weekend, occurred with no planning,” said Mr. Marsal, whose New York firm was hired by Lehman’s board around 10:30 p.m. Sept. 14.

Here is where readers are encouraged to correct me if I have something wrong or a bit askew. I was under the very strong impression that securities firms do not decay in an orderly fashion, but instead collapse rapidly once certain triggers are breached, making it well-nigh impossible to contain the unwind. In fact, you’d need pretty substantial changes in both bankruptcy law and the way that trading counterparties deal with each other to have the sort of managed process that the A&M reports argues should have taken place.

Specifically:

1. Once a firm is downgraded beyond a certain threshold, any counterparties that trade with it will be downgraded due to their exposures. And when other firms stop being willing to enter into repos (which do involve a credit exposure) a securities firm is toast. Liquidity is the life blood of a trading firm. And a bankruptcy filing has the same effect. From Jim Bianco:

If Lehman does file, Moody’s has to downgrade their counter-party rating to junk. This forces everyone to stop doing business with Lehman. If you do business with a junk counter-party, you risk your rating falling to junk as well (you are only as good as your shakiest counter-party). Most buy-side accounts have fiduciary rules that bar them from doing business with a junk rated counter-party. Recall that this was the trigger that buried Bear.

No way that Moody’s will agree to keep a bankrupt broker with an investment grade counter-party risk rating.

2. The A&M report appears to have ignored the 2005 bankruptcy law changes that rendered the claim made above, that Lehman could have blocked the unwind of its derivatives book via a Chapter 11 filing, incorrect. From the Financial Times:

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG….

Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”.

Now perhaps the Wall Street Journal summary does the A&M report a disservice, and they did correctly parse out any that might have been spared the 2005 bankruptcy law changes. But the FT article gives the impression these changes included most if not all derivatives.

And there is another issue. Chapter 11 filings require debtor-in-possession financing (you need to keep paying bills while holding the creditors at the time of filing at bay). Lehman would have been a very big DIP. The financial community is a really small pond. Word of Lehman attempting to line up a big enough DIP would have lead to an immediate run on the firm. No counterparty wants to risk having trading assets frozen for months, perhaps longer.

So if the logic above is correct, the A&M report looks like a costly ass-covering exercise to protect the board from lawsuits. And the Journal did the board a favor by giving it reasonably prominent placement.

There has been some discussion of the possibility of buyer revulsion eventually reaching the Treasury market as a burgeoning calendar bumps up against demand. But a Financial Times article points out that the issuers most at risk from a big US and advanced economy government bond sales program is emerging economies, with Hungary and Ukraine already in precarious shape and others in considerable peril.

From the Financial Times:

Record volumes of government bonds from the industrialised nations – intended to reverse what could be the worst recession since the Great Depression – threaten to curb access to credit markets by emerging economies.

Analysts warn that emerging market borrowers could be crowded out of the credit markets by $3,000bn of government bonds expected to be issued by the big developed economies in 2009 – three times more than in 2008. The US alone is expected to issue about $2,000bn next year….

Mr [Nick] Chamie [head of emerging markets research at RBC Capital Markets] said: “Governments or companies that are highly rated will still be able to attract buyers, but ….they will have to pay higher interest rates…”

Brazil, Russia, India and China face external debt payments of $205bn, $605bn, $257bn and $2,437bn respectively, but can rely on large foreign exchange reserves to help meet bills.

Argentina has $64bn of external debt due in 2009; Turkey has $36bn falling due, ING says.

Food needs ‘fundamental rethink’ BBC

Sikh Signs For Package, UPS Driver Enters His Name As “TERRORIST” Consumerist

Amex drops credit limit on customer for shopping where poor people shop Tom Barlow

The yield curve (wonkish) Paul Krugman

British banks may face second credit crunch in the New Year Independent

Bailout of Long-Term Capital: A Bad Precedent? Tyler Cowen, New York Times

Holiday Thoughts about Three Especially Vulnerable Groups Robert Reich

Nine out of 10 shoppers plan to cut spending in new year Guardian

Is Prozac causing all of these stock market bubbles? RFK Action Front

Germany resists calls to spend its way out of trouble International Herald Tribune

Accounting Standards Wilt Under Pressure Washington Post

A Mortgage Paper Trail Often Leads to Nowhere New York Times (hat tip reader Don). OK, you tell me, are servicers really this incompetent, or is this a design feature. or an unholy mix of the two? You don’t see this inability to trace transactions in checking accounts or credit cards.

Krugman’s “hangover theory”, revisited Steve Waldman

Antidote du jour:

A New York Times report on WaMu’s Grande Bouffe in the mortgage market is worth reading for the former employee quotes alone.

For instance, use of controlled substances was acceptable as long as they were the productivity-enhancing sort:

“I’d lie if I said every piece of documentation was properly signed and dated,” said Mr. Parsons, speaking through wire-reinforced glass at a California prison near here, where he is serving 16 months for theft after his fourth arrest — all involving drugs.

While Mr. Parsons, whose incarceration is not related to his work for WaMu, oversaw a team screening mortgage applications, he was snorting methamphetamine daily, he said.

“In our world, it was tolerated,” said Sherri Zaback, who worked for Mr. Parsons and recalls seeing drug paraphernalia on his desk. “Everybody said, ‘He gets the job done.’ ”

As I am sure readers know all too well, that sort of thing is quietly prevalent in investment banks (well, except for being so indiscreet as to have your implements on view), as coke-snorting traders and institutional salesmen were sufficiently common in the 1980s so as to become a staple of fiction and magazine articles. Even in the seemingly innocent early 1980s, a member of Goldman’s corporate finance department was known to use uppers and downers on what was presumed to be a daily basis. He made partner. A attorney buddy realized how naive he was when on a deal, with all too great frequency, the room where negotiations were being held would empty itself. It took him a couple of days to figure out everyone else wasn’t making urgent phone calls, but repairing to bathrooms, and not to have sex with each other, either. I’ve also been told of very high level IT guys (the kind who built and ran mission critical systems, and made seven figures in the peak years) having meth habits. (Based on my very very limited anecdotal sample, meth does appear to live up to its billing and leads to much more rapid personal train wrecks than other stimulants).

But banking, at least until financial institutions started moving in a serious way onto each other’s territory, was a sober, repetitive, low discretion, high reliability business. The comparatively modest stress and pay levels weren’t terribly conducive to costly drug habits (not that it prevented them, mind you, but they were decidedly acultural, except for the trading operations).

Nevertheless, WaMu appears to have brought an exceptionally freewheeling approach to retail banking on many fronts:

“It was the Wild West,” said Steven M. Knobel, a founder of an appraisal company, Mitchell, Maxwell & Jackson, that did business with WaMu until 2007. “If you were alive, they would give you a loan. Actually, I think if you were dead, they would still give you a loan.”…

“I never had a clue about the amount of off-the-cliff activity that was going on at Washington Mutual, and I was in constant contact with the company,” said Vincent Au, president of Avalon Partners, an investment firm. “There were people at WaMu that orchestrated nothing more than a sham or charade. These people broke every fundamental rule of running a company.”

The article also confirms a practice that some borrower advocates have claimed is not unheard-of, namely, that brokers had mortgage applicants sign forms with key sections (like income) blank, to be filled in by someone other than the borrower to make the loan “work”:

Martine Lado, an agent in the Irvine, Calif., office, said she coached brokers to leave parts of applications blank to avoid prompting verification if the borrower’s job or income was sketchy.

“We were looking for people who understood how to do loans at WaMu,” Ms. Lado said.

Of course, under the law, that makes the chump borrower the perpetrator of the fraud, not the person who inked in the blank section.

Go read the piece. Lots of juicy stuff.

Houses With No Furnace but Plenty of Heat New York Times

Skipping sleep ‘hardens arteries’ BBC

Gazan invents alternative to cooking gas Ma’an News

Another unholy mess created by a message from the Pope Willem Buiter

Burning Coal at Home Is Making a Comeback New York Times

White House in foreclosure Rolfe Winkler

UBS on Initial Claims John Jansen

Naughtiest And Nicest C.E.O.’s Of 2008 Huffington Post

Retailers Brace for Major Change Wall Street Journal. By “change” they mean lots of bankruptcies…and collateral damage. Read the piece, the estimates are striking.

Friday Movie Night – The Secret History of the Credit Card The Economic Populist

Chutzpah Unlimited Independent Accountant

Low Mortgage Rates to Spur New Wave of Defaults Mr. Mortgage. Whether or not you buy the conclusion, a useful discussion of the impediments facing borrowers trying to refinance.

Antidote du jour:

In past times of geopolitical stress, the dollar has generally rallies as investors move to safer havens. That behavior was not evident today as investors fretted about possible escalation of conflicts in the Middle East and South Asia. The euro went up a teeny bit, the yen faded slightly, the pound retreated.

So where did investors go? To gold, apparently. From Bloomberg:

Gold prices rose the most in a week as mounting tensions in the Middle East and South Asia boosted the appeal of the precious metal as a haven.

Palestinian militants yesterday launched their biggest rocket attack on southern Israel in at least six months after a truce expired Dec. 19. Pakistani troops are being diverted from tribal areas near Afghanistan to the border with India, the Associated Press reported. Gold gained 4 percent this week.

“The only possible explanation for gold’s gains are the geopolitical tension in Gaza and in India and Pakistan,” said Leonard Kaplan, the president of Prospector Asset Management in Evanston, Illinois.

Gold futures for February delivery climbed $23.20, or 2.7 percent, to $871.20 an ounce on the Comex division of the New York Mercantile Exchange, the biggest gain for a most-active contract since Dec. 17. The metal is up 6.4 percent this month.

Silver futures for March delivery gained 18 cents, or 1.7 percent, to $10.53 an ounce. The metal is still down 29 percent this year.

The Wall Street Journal’s daily human interest story featured a holiday season tale of the Fuggerei, a Roman Catholic housing compound for the poor in Germany. The price of admission for those lucky enough to get in is yearly rent of one Rhein guilder, which equals 88 euro cents or $1.23, plus daily prayers for the founder, Jakob Fugger and his descendants.

How does such a marvel exist? The settlement is funded by a charitable trust, and the rent remains unchanged since the trust was established…in 1520.

Think about that. Can you think of another pool of capital that has lasted that long, let alone a commercial enterprise? The Fugger family is still well off, but no where near as rich as in Jakob Fugger’s day.

The story does not give much detail about how the trust survived (a few nasty events like the German hyperinflation and World War II intervened), and gives a few tidbits about the last 200 or so years.

The core holding is forestry properties, which is both a renewable resource and inflation-hedged (admittedly with some volatility) and also owns some local real estate. The article does not indicate whether it holds securities.

Annual returns have been 0.5% to 2.0% over inflation

A fund manager who has quite a successful track record and manages money for families once told me that most investors fail to understand the importance of preserving capital and the value of keeping inflation. He said if you could consistently beat inflation by 2 or 3 percent, you would do far better than most understand. But too many investors chase greater returns, take on undue risk and in the long haul wind up worse off than if they had set more modest and attainable objectives (and note that this manager does seek and generally achieves higher returns because that is what customers want).

There is a second, behavioral issue with seeking higher returns and accepting the attendant risks. Let’s say you do have a good year, or perhaps even a run of good years. You come to perceive this level of returns as sustainable, when it may be luck or an unusual set of investment conditions that will not persist. But human nature being what it is, most people would increase their expenditures in line with their new level of wealth, and are ill prepared for a reversal of fortune, as the last year has shown.