Were these low-profile, federally chartered banks just doing their jobs, as their defenders argue — or did the massive loans deepen the credit crisis by allowing business-as-usual to continue at some of the nation’s riskiest lenders? TWI’s Mary Kane has the story.

“People should be looking at this, including Congress,” said Peter Wallison, an American Enterprise Institute fellow who studies financial deregulation and a former general counsel for the Treasury Department. “It’s a very serious problem. The home loan banks kept the Countrywides and the IndyMacs in business. And they were the lenders who were the source of some of the problems we’re having now. Of course taxpayer dollars are at risk.”

From the Financial Times:

The revival of these trade practices, used rarely in the last 20 years and usually by nations subject to international embargoes and the old communist bloc, is a result of the countries’ failure to secure trade financing as bank lending has dried up.

The countries have not disclosed the value of any deals, and some have refused even to confirm their existence. Officials estimated that they ranged from $5m for smaller contracts to more than $500m for the biggest.

Josette Sheeran, head of the United Nations’ World Food Programme, said senior government officials, including heads of state, had told the WFP they were facing “difficulties” obtaining credit to purchase food. “This could be a big problem,” she told the Financial Times.

The return of bartering reminds us that this is a truly global financial crisis — and less prosperous countries that are already struggling will face even tougher times. While it’s clear the Obama administration has quite enough on its plate, it’s also true that other countries are looking to the United States for leadership in dealing with the crisis, and hoping we can pull the rest of the world out of it, as Bloomberg noted recently. That’s a tall order, and it’s not clear that even the most powerful nation in the world has the ability to do that.

For us, a credit crisis means cutting back on consumer spending and trips to the mall.  For poorer countries, it means struggling to find ways to pay for rice or vegetable oil, and to keep their people from starving.

For years, the obscure banks had a reputation for poor risk controls and sloppy accounting, as regulators looked the other way, investors said. The banks also were used as a lender of last resort as the credit crunch tightened, lending billions of dollars to keep banks like Countrywide Financial and Washington Mutual afloat. Those banks failed anyway, and now the Federal Home Loan Banks are in trouble because of losses on risky mortgage-backed securities. Based on their reputation, Wall Street firms think their books may be in worse shape than they’ve revealed.

But all this could change, Bloomberg reports. The banks’ new regulator, the Federal Housing Finance Agency, plans to draft new rules for both the banks and for mortgage giants Fannie Mae and Freddie Mac, which the agency also now oversees. From Bloomberg:

The Federal Housing Finance Agency plans to propose new financial requirements next week for Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks. The regulatory agency may place new restrictions on Fannie and Freddie’s investments and will revamp capital requirements for the home loan banks, director James Lockhart said in an interview. Under draft regulations “that everyone fought long and hard for,” the agency will determine the “size and composition” of Fannie and Freddie’s $1.7 trillion combined mortgage portfolios, Lockhart said yesterday. He said his agency also plans to release new minimum capital rules for the 12 regional FHLBanks by Jan. 27, as called for by Congress when it enacted legislation in July to strengthen oversight. “The 14 of them are so critical to this mortgage market,” Lockhart said of the government-sponsored enterprises his agency regulates.

Looks like things are changing quickly, with daily exposés of banking misdeeds and a new administration in charge. The idea of cracking down on these enterprises would have been considered radical just a year ago. But when Merrill Lynch doles out billions of dollars for executive bonuses three days before its sale to Bank of America – which needed billions of dollars in government bailout money to seal the deal – the days of anything goes in the financial sector are quickly drawing to a close.

That’s a dramatic departure from the transition process for most new presidencies. But these are unusual times, with the economy on a precipice. There’s little for the White House to do on most policy matters in the next 11 weeks — but 11 weeks is “a lifetime in the financial markets,” said Daniel Gross at Slate. Decisions that may get made now will have long-term consequences, and if Obama is going to end up being responsible for them, he might as well try to weigh in now, according to Gross:

It’s possible that further dramatic efforts won’t be necessary in the next 11 weeks simply because, with all the bailouts, there’s nobody left to fail. But plenty of other things could go wrong. We’ve given the Treasury secretary unprecedented powers to make life-or-death decisions about large financial institutions and to enter into financial arrangements that will last for several years. Given that Obama’s team will be dealing with the decisions Paulson made in August and that they’ll have to deal with the decisions Paulson makes in November and December, it’s imperative for them to get into the rooms where those decisions are being made — now. Think of it this way: If you’re slated to assume control of a mutual fund — say, one that has a concentrated portfolio in large financial companies — in January, and if you’re going to be held accountable for its performance, wouldn’t you want to sit in on the investment committee meetings right now?

David Leonhardt at The New York Times made the same point today:

This year’s election coincided with an important moment in the financial crisis. The credit markets have stabilized in the last few weeks and even improved a bit. But the rest of the economy is deteriorating fairly rapidly. It’s now in danger of falling into a vicious spiral, in which spending cuts by consumers and businesses lead to further layoffs and then more spending cuts.

To prevent that from happening, the Obama administration will need to move quickly — before it takes office — to put together some emergency plans for the financial markets and the broader economy.

Normally this time in a new presidency is filled with the sorts of things we’re seeing right now — recriminations on the losing side, and speculation about who will serve in the new administration. That’s why it’s so unusual to have a growing chorus of calls for Obama to take action on the economy before taking office.

It’s further evidence of the unprecedented nature of the credit crisis we’re in, and of the damage it threatens to do — even in just the next 11 weeks.

We were in a neighborhood of spacious two-story homes with two- and three-car garages. While built in the past five to 10 years, the architecture of the houses was reminiscent of the stately styles of old parts of Alexandria. The houses did not have a cookie-cutter feel about them. There were many different models, complete with brick facades and manicured, sprawling lawns.

Just as I was thinking how prosperous this neighborhood must be, the bus turned a corner and I saw a beautiful new home whose windows were boarded up. There was a notice attached to the front door with red tape.

I thought of that abandoned house when Alaska Gov. Sarah Palin hit Sen. Barack Obama for wanting to “spread the wealth” during her rally here. The crowd cheered when she said it wasn’t time to “experiment with that,” suggesting that Obama’s policy of taxing the highest-income earners amounts to socialism.

I’m imagining the former owner of that house wasn’t here today cheering.

flickr (TW Collins)

In “The Arabian Nights,” the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the king, who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.

The worldwide economic drama and tumult are not symptoms of the disease but the cure. The “disease” is the excessive debt and leverage in the financial system — especially in the United States, Britain, Spain and Australia. The “cure” is the reduction of the level of debt — the great “de-leveraging.”

In 1931, Treasury Sec. Andrew Mellon explained this process to President Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. … Enterprising people will pick up the wrecks from less competent people.”

Illustration by: Matt Mahurin

The first phase of this cure is reduction of debt throughout the financial system. So far, overall losses to financial institutions are $400 billion to $600 billion, and that may well go higher. This requires cutting balance sheets — assuming banks are levered around 10 to 1 — of around $4 trillion to $6 trillion in in lending and asset sales.

For example, the bankruptcy of Lehman Bros. meant about $600 billion of debt was eliminated. This inflicted losses on holders of Lehman debt, and that  flows through the chain of capital. The destruction of Lehman Bros.’ capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.

The second phase of the cure is the higher cost and lower availability of credit. This forces corporations to sell assets, reduce investment and raise equity — for example, as General Electric has done. It also forces consumers to cut debt by reducing consumption or selling assets.

Reducing investment and consumption lowers economic activity. That puts stress on corporations and individuals that may result defaults that trigger losses in the financial system, which further reduces lending. De-leveraging continues until overall debt levels reach a sustainable level, set by lower asset prices and available cash flows.

This process of destruction echoes W.B. Yeats’ words: “All changed, changed utterly: A terrible beauty is born.”

Within the financial sector, de-leveraging is well advanced. In the real economy, however, it is still in the early stages. Fairy tales in financial markets focus on the “superhuman” abilities of regulators and governments to avoid this de-leveraging.

Central banks and governments,  accepting an increasing range of collateral, have aggressively supplied liquidity to the money markets. Central banks may soon accept items akin to baseball cards — maybe, for example, Lehman, Bear Stearns and Fortis memorabilia, like mugs and tote bags.

Central banks are acting as “buyers of last resort” rather than “lenders of last resort.” They are providing cheap funding. The loans will have to be rolled over, as the banks cannot repay them. They will only be repaid from the underlying cash flows of the assets counted as collateral.

Government and central banks have also “bailed out” a number of financial institutions using a variety of strategies. Lower interest rates and increased government spending have been used to reduce the effects of the financial crisis.

The U.S. government’s $700-billion bailout package is the latest magic potion. It is puzzling why this initiative is seen as the “silver bullet” that can “fix” the problems.

A look at the Troubled Asset Relief Program, or TARP, reveals confusion about what problem it is addressing. The plan to purchase up to $700 billion in “troubled” assets is not dissimilar to existing support provisions. If assets are correctly valued on the books of the banks, then purchase at fair value only provides funding to the bank. The difference is that the risk of the securities is now transferred to the government — but so is any potential recovery in price.

There are different views about how much the government should pay. Under one approach, the government would pay a “hold-to-maturity” price that may be, perhaps significantly, higher than the “market” price, or the value on the bank’s book. This would give the bank liquidity as well as capital.

The alternative approach would be to pay “market” values. This would provide liquidity to the banks but no capital. It could even trigger additional losses where the assets are carried at higher values — creating incentives against participation.

There is also a small problem in that nobody has a  clear idea what these securities are worth.

Purchases of troubled assets are also conditional on (correctly) protecting the taxpayers against losses. This requires banks to provide the government with equity, or equity-like interests, in exchange for participating in the program.

Alternatively, the institutions selling the assets will need contingent arrangements to minimize the risk of loss to the taxpayer. Commentators have gone into rhapsodies about the ability of the taxpayer to “profit” from the program. This creates potential conflicts for financial institutions, whose fiduciary duties require maximization of returns for shareholders.

It is not clear what securities will be eligible for purchase and who will be allowed to participate. Amusingly, the recent short-selling ban on financial institution stocks saw a curious array of companies claim that they were financial institutions! Gaming the system will be practically difficult to control.

In fairness, the final form of the bailout plan is not yet settled and may provide greater clarity. But the bailout could merely transfer the problem onto the U.S. government and taxpayer balance sheet.

Government support for financial institutions in this crisis is already approaching 6 percent of gross domestic product — compared to less than 4 percent in the savings and loan crisis. This could ultimately place increasing pressure on the U.S. sovereign debt rating and undermine Washington’s ability to finance its requirements from foreign creditors.

Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. But the failures are unsurprising.

At the height of the boom, banks used various techniques to increase the velocity of money. Now, as the system de-leverages, the velocity of money has sharply decreased.

Money being supplied to the banks is not being lent through. Banks are parking the money in short-dated government securities, in anticipation of their own funding requirements. Around $2 trillion to $3 trillion of assets are returning to bank balance sheets from the “shadow” banking system that can no longer finance itself.

In addition, banks have large amounts of maturing debt — estimates suggest $1.5 trillion by the end of 2008 — that they must fund. Fear of bank failure, especially after the Lehman bankruptcy, and shortages of capital also limit the banks’ ability  to lend.

Ultimately, nothing can prevent the de-leveraging of the financial system now in progress. At best, actions can smooth the transition and reduce disruption of the economy.

The risk is that well-intentioned steps would prevent the required adjustments from taking place, delay recognition of big problems and discourage action that must be taken by financial institutions, corporations and consumers.

The extent of de-leveraging is substantial and likely to take time. For all asset prices must adjust significantly. The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, an illusion. As the system de-leverages, it seems clear that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in U.S. Treasury bonds, GSE paper and AAA rated asset-backed securities. It will be difficult to convert them into the home currencies of investors without large losses.

Government and central bank actions, meanwhile, need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas.

First, banks must be forced to write off bad loans without delay — even if this means breaching minimum solvency capital requirements. Second, bank capital needs must be addressed by forced mergers and restructuring, new equity issues and even nationalization or liquidation. Third, central banks need to guarantee (for a fee) all major bank transactions, enabling normal transactions between banks and other parties in the financial markets to resume.

On Wednesday, Oct. 8, Britain announced a program that addressed some of the above issues. However, coordinated global action is needed so that people do not merely move money from one country to another to take advantage of superior government protection.

A global conference along the lines of Bretton Woods, under a respected chairman — Paul Volcker is the obvious choice –  should be convened. It could bring together all major players — including vital creditor nations, like China, Japan, Russia -– to develop a framework for the major economic reforms in areas like currency policy and fiscal disciplines, to work toward resolving the crisis.

A principal objective could be ensuring supply of funding for the U.S. in the transition period. Recent comments by China about Washington’s responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed the U.S. financial may “affect the whole world.” All creditors have much to lose if the de-leveraging process becomes disorderly.

Like a giant forest fire, the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit  damage to the U.S. economy and the international financial system until the fire burns itself out.

“The Arabian Nights” had a happy ending. The king, after 1,001 night of enchantment and three sons, pardons the beautiful  Scheherazade — who becomes his queen. Despite the fairy tales that investors are now putting their faith in, the de-leveraging at the heart of the current financial crisis may not have such a happy ending.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

The list of major subprime lenders for 2006 and 2007 resembles the casualty roster from the Battle of Verdun in World War I. Only difference: way fewer walking wounded this time.

Of the 30 biggest subprime home lenders in 2006, measured by dollar volume, 22 have gone bankrupt, shut down, been sold or been seized by Uncle Sam. Most of the survivors have scaled back.

I guess the warnings all those years from the housing and consumer groups who regularly testified before the Federal Reserve were right on the mark after all. Too bad no one ever listened. The only bright spot here: It’s not like we’ll miss any of these lenders.

RIP, subprime.

And remember about the door on your way out.

Investment editor John Authers traces many of today’s problems back to the rescue of Long Term Capital Management in 1998 — the weekend when the New York Federal Reserve and the titans of Wall Street got together to save the troubled hedge fund. From that plan came the start of cheaper money from the Fed to keep the markets moving, a trend that continued for a decade.

But the rescue also created the moral hazard problem – the belief that it was fine to take on greater risks than normal, because the government would be there to step in as a last resort.

As Authers explains, shares of the now-failed Lehman Bros. bank rose steadily from 1998, until its recent crisis. Lehman wasn’t alone, as Wall Street engaged in riskier investments, with higher returns. There always was the implicit belief — based on the Long Term Capital Management experience — that a bailout would be a possibility if things went wrong. That belief encouraged firms to take on risks they might otherwise have avoided.

Now, he says, with the government refusing to bail out Lehman, the markets are tanking and the future of other firms is shaky. No one knows what will happen.

But one thing is clear, Authers says, based on the Lehman bankruptcy and the government’s decision to draw a line in the sand — “The decade of moral hazard is over.”