There may be a new rule coming from the Fed that will make banks stronger but will hurt investors. There's a good possibility that banks will have to raise their "well-capitalized" capital requirement from 7% to 8%. The current definition of "well-capitalized" is 6% but the unofficial rate that regulators like to see is 7%. That means for every asset on the books of $100, there is now $7 of capital to back it up. With the new rule, that capital cushion would go to $8. That means the FDIC would have more protection against losses ($8 of protection is better than $7). But the question is: where do banks find the extra $1?

They can come up with it several different ways, none of which help current investors. The first, and easiest way, is to simply sell assets and lower the total size of the bank. If a bank of $1 billion has capital of $70 million, it could sell enough assets to shrink to $875 million. Then the capital base stays the same at $70 million (assuming no gain or loss on the sale of the assets) but the percentage of capital is now 8% rather than 7%.

The credit crunch has pretty much brought the private equity industry to a halt: Without access to cheap, readily available, debt with liberal terms, the leveraged buyout shops lack the paper they need to get the deals done.

But the Wall Street Journal reports (subscription required) that some firms are now trying "equity buyouts" or EBOs -- deals that involve taking companies private without the use of debt. With companies available as cheap as they are now, some titans are betting that they can earn excellent returns without the leverage the has historically led to outsized profits.

Tonight I am appearing on a Boston TV program to discuss whether there are other Madoff disasters lurking as well as eight lessons from 2008. The first half of the program will feature Congressman Barney Frank (D-MA) who chairs the House Financial Services Committee.

The TV producer suggested that I should give Congressman Frank some thoughts about how to fix the financial services industry if I get a chance to talk with him in the green room before the show starts. I am not sure whether I will get to do this or not; however, here are four ideas I will share if I get the chance:

• Limit leverage. Starting with an SEC ruling in 2004, banks could borrow as much as they wanted -- in some cases over $30 for every $1 of equity. This borrowing has endangered the global financial system. Washington should limit leverage to 8:1 or less.
• Put banker pay in escrow. As I posted, banks should not pay bankers to close big deals and then let them keep the bonuses after the deals fall apart. Instead, they should do what Morgan Stanley (NYSE: MS) is starting to do, which is to put the bonuses in an escrow account -- if the deals lose money in the years following the contract signing, the money goes to pay off the investors. Otherwise, they get to keep the money.

Beige book weakness, nationwide. Holiday retail sales tepid at best (so far). Business investment lackluster. And Friday yet another employment situation report from the good statisticians at the U.S. Department of Labor. Consensus: the U.S. economy probably shed another 300,000 jobs in November.

A decade of descent

One can't say we weren't warned about the recession that we're now in - - not with the increased concentration of wealth and concomitant increase in poverty, lack of job creation, and wage stagnation that accompanied the recent economic expansion, to go along with excessive leverage, system-wide.

New York Times (NYSE: NYT) columnist and Nobel Prize-winning economist Paul Krugman provides a little perspective on how we got here and also offers some hope, regarding these trying economic times.

On the signals, or signs, some in economics, corporate, and public policy circles are suggesting that we didn't have any signs of economic trouble ahead. "Why weren't we warned?"

Ah, but you were warned, Krugman said. And these warnings were ignored. Item: Clear signs of a housing bubble, after the dot-com bubble a decade earlier. Item: The implosion, and required dissolving of Long Term Capital Management in 1998 - - just one hedge fund, but one that nevertheless temporarily paralyzed credit markets, globally. Item: The near-universal belief in the market's ability to self-correct, self-police, and if need be, self-punish transgressors, when there was little case precedent to hold that mistaken notion. In sum, there were plenty of warnings, Krugman argues.

It's a pattern that's been all too familiar in the oil market these past few months: the price of oil moves slightly higher, but then can't sustain its increase and the rally fails, usually with oil closing lower at the end of the day.

What's causing it? Energy traders and economists will tell you that the price decline is being driven by slowing oil demand growth in emerging markets, combined with real, year-over-year demand reduction in the world's biggest market, the United States.

Investors exit oil

But that's not the whole story behind oil's stunning drop from $147 to the $60-per-barrel-range, so says Energy Trader Jim Dietz. Dietz who argues that the global reduction in the availability of leverage -- money borrowed for use in trading -- has taken a considerable amount of the buying pressure out of oil, as well as other commodities.

"We clearly are not seeing as many hedge funds and investment funds establishing positions in oil, and the ones who are in the market are establishing smaller positions," Dietz said. "As a result we rarely see any more powerful moves to the upside with powerful momentum characteristics. I'm not saying hedge fund buying is the only reason oil hit $147 this summer, but they certainly played an important role."

The dollar and yen surged Friday -- with the yen the clear winner head-to-head versus the dollar -- as traders and institutions added both currencies in a flight-to-safety on concern that all of the world's major economies will fall into a recession at the same time.

The dollar surged 3 cents versus the euro to $1.2642 and 6 cents versus the British pound to $1.5606.

The yen strengthened 4.7 yen to 92.64 versus the dollar and about 10 yen to 144.73 yen versus the British pound.

Institutions raise cash in dollars, yen

Currency Trader Andrew Resnick told BloggingStocks Friday, this morning's flight-to-safety is not solely due to economic fundamentals, which suggest slowing growth in the world's major economies, but also hedge fund / investment fund de-leveraging and closing out of losing stock positions.

"We're seeing many things happen at once, and that's producing these enormous moves. First, the carry trade [where traders borrow yen and invest it elsewhere] is unwinding. Leverage for investing purposes is declining as a trading strategy," Resnick said. "Second, major players are raising cash to cover redemptions, which is also causing stock markets globally to plunge."

"Third, we're seeing a re-pricing of risk to the higher, which is forcing some funds to raise even more cash, boosting the dollar," Resnick said. "Some of the moves are cash-necessary moves, but many are clearly panic-based, with traders exiting positions that have little chance of succeeding if the global economy continues to slow."

Most investors / readers know about inflation -- an increase in the price of a good or service not connected to an improvement.

But fewer know about its flipside -- deflation -- a decline in prices.

Moreover, while inflation is a serious problem -- it erodes purchasing power and makes it hard for businesses to project and plan for costs, moving forward- - deflation is an even bigger menace.

That's because deflation decreases the amount of money flowing to businesses for their products/services, reducing the money needed to keep commercial activity alive and the economy growing.

Deflation: a danger sign

Don't misunderstand: a price cut after a company becomes more-efficient, or implements a 'holiday or promotional' sale, is fine. Deflation is different: it's pervasive price cutting and asset price declines -- falling prices across the product/service spectrum -- usually driven by a lack of consumer / wholesale demand.

Further, if deflation persists it can, you guessed it, lead to lay-offs. Companies and factories with lower revenue and demand for their products / services scale-back production to reduce expenses by laying-off employees. Those laid-off employees then cut expenses as they search for new work assignments by cutting spending, resulting in even lower demand for products, further price cuts, and lower company revenues, and a vicious cycle can ensue.

Washington Post business columnist Steven Pearlstein does not mince words: too many people just don't get it.

Moreover, yours truly is not one to alarm, and typically views 'sweeping and dramatic statements' with a journalist's skepticism and a scholar's critical review.

But when the best economists you talk to, and business executives, and others in financial and investment circles, start reaching the same conclusion, from decidedly different vantage points, the dramatic statement begins to take on more weight, becoming more compelling.

'The reality of the facts on the ground'

Further, as Pearlstein incisively points out, there are reasons why a considerable portion of the American people are not 'getting it' regarding how serious the current situation is. Politicians are more concerned about ideology, partisan posturing, and teaching people a lesson -- if you can believe that they could be so irresponsible (my astonishment added, not Pearlstein's). Financiers have been very slow to admit to greed, arrogance, and incompetence. And foreign government leaders still view the financial crisis as 'an American problem.'

But none of the above changes what Pearlstein, and what my closest economist colleagues (David H. Wang, Richard Felson, Peter Dawson, M. Chandler, and Glen Langan) all argue is "the reality of the facts on the ground," to borrow a phrase from Israel's former Prime Minister and Defense Minister Ariel Sharon. Namely, that a massive, global deleveraging is taking place, and that absent a systemic rescue/intervention by the U.S. Government, in conjunction with interventions by other governments around the world, the world risks the bursting of a credit bubble that threatens to bring down the global financial system.

The Lehman Brothers opened for business in 1850, even before the civil war (1861–65). Now, after 158 years, the illustrious financial powerhouse is gone and the founders must be turning in their graves.

You could be sure that the careful and methodical practices of the founders were lost by its current management team that strayed from sound business practices when they indulged in risky lending adventures and extremely high leverage.

From the company's web site:

The history of Lehman Brothers parallels the growth of the United States and its energetic drive toward prosperity and international prominence. What would evolve into a global financial entity began as a general store in the American South. Henry Lehman, an immigrant from Germany, opened his small shop in the city of Montgomery, Alabama in 1844. Six years later, he was joined by brothers Emanuel and Mayer, and they named the business Lehman Brothers.

Cotton was the cash crop of the time, and the Lehmans accepted it from the local farmers as currency to settle accounts. The brothers traded the cotton for cash or merchandise, becoming brokers for buyers and sellers of the crop. In 1858, they opened an office in New York, which was the commodity trading center of the country.

The perceptive and common sense-rooted Ben Stein, in a business column in The New York Times, has weighed-in on the credit crisis, and for market absolutists, it's an argument they probably don't want to hear.

Stein, like many of us, has pondered how the massively well-paid men and women of Wall Street could create such a catastrophe. How did some of the smartest, talented executives, Stein ruminates, generate such immense losses that "they made banks clam up on lending -- at great risk to the economy?"

Compelling questions

Stein asks: Where were the fail-safe devices? The government watchdogs? The ratings agencies? A speech by Greenlight Capital hedge fund manager David Einhorn at a Grant's Interest Rate Observer event, provided the answers -- the unfortunate truths of the recent housing/credit boom -- which Stein summarized:

Billionaire investor George Soros believes the current financial crisis is the worst since the Great Depression, and said stocks have not bottomed yet, Bloomberg News reported Thursday.

Soros said the most recent market bottom "will probably not prove to be the final bottom," adding that the current stock rebound will last six weeks to three months as the United States moves closer to recession, Bloomberg News reported.

Further, Soros, in an op-editorial column in The Financial Times, argued that the cause of the market's current problems is a flawed premise: the belief that markets are self-correcting and tend toward equilibrium. They aren't and don't, Soros argues, and the laissez-faire policy creates bubbles, including the most-recent housing bubble, which, in turn, when it started to burst, led to the current credit crunch.

Soros cites deregulation

Soros added that the market's current troubles originated in 1980 when U.S. President Ronald Reagan and United Kingdom Prime Minister Margaret Thatcher led a laissez-faire movement that reduced/eliminated regulation of banks and financial markets, the FT reported.

Banks are demanding more capital from hedge funds to support outstanding loans resulting in the dissolution of some funds forced to liquidate assets, Bloomberg News reported Monday.

``If you have leverage, you're stuffed,'' Alex Allen, chief investment officer of London-based Eddington Capital Management Ltd., which has $195 million invested in hedge funds for clients, told Bloomberg News. Allen said the crisis is like a bank panic turned upside down with bankers, not depositors, concerned they won't get their money back. He added there are likely to be more collateral /margin-related liquidations of hedge funds in the weeks ahead.

The $2 trillion hedge fund industry is in the throes of its worst capital crunch since the Federal Reserve successfully encouraged the securities industry to provide $3.6 billion to bail-out Long Term Capital Management L.P. in 1998. Amplified by leverage and aided by innovative investment formulas, many hedge funds generated outstanding returns for much of this decade, often aided by high-performing asset-backed securities. However, as the housing market slowed and mortgage-backed securities began to fail, hedge funds started to experience the down side of their deployed leverage: banks and other counterparties who lent money for these investments had the right to and initiated requests that hedge funds put up more capital. Hedge funds that could not meet the capital requirement have been liquidated.

The stock market has been experiencing a tremendous amount of turbulence over the past three weeks. We have seen wide swings in the Dow Jones Industrial Average ($INDU) of hundreds of points up, and then down, and back up and back down. Today,the Dow had its second-worst loss of the year. If you are losing sleep or getting a queasy stomach over any of this then your portfolio is not right for you. You have made big mistakes in allocating your capital and you need to make a change.

Anybody that has been investing for any period of time has been told to be diversified, or even more simply -- do not put all your eggs in one basket. After each market swing Wall Street prognosticators, be they analysts, brokers, media talking heads or us at BloggingStocks attempts to rationally explain what is happening in the market. Some times the explanations make sense, and sometimes they do not. But, it is important to remember that even when the explanation is rational, plausible, and backed up with a few facts IT CAN BE WRONG!

There are many aspects of the stock market that replicate gambling. The most important one of them all is this: Do not play with money you cannot afford to lose! You should consider diversity of risk and limiting risk to levels that allow you to be at peace with your decisions. Diversification does not mean you need to own a large quantity of stocks or funds. You can be diversified with as few as four or five stocks as long as they are not in the same industry. You can be diversifed in just one mutual fund, if that fund includes diversification as one of its goals.

Leverage, the use of borrowed money for investing, goes in and out of favor. When times are good and people are making money, it's great. It amplifies returns (positive or negative) and, particularly in real estate, can lead to mind-bogglingly high return on investment numbers. But the downside is also huge, as anyone who lost a job in the wake of a failed leveraged buyout of the 1980s found out.

My summary of the positives and negatives of leverage is this: Everything that's good about leverage is also bad about leverage.

Having said that, this paragraph from Saturday's New York Times scares the bejesus out of me: Let's say you are very wealthy and have $25 million to invest in a portfolio of hedge funds. Banks like BNP Paribas, Royal Bank of Canada, or Barclays will leverage your investment, say four to one, allowing you to invest $100 million, using derivatives. Barclays estimates that roughly $60 billion to $80 billion in leverage is being put on by investors in hedge funds or funds of hedge funds. Other market players say it is more than double that.

Then you add that leverage to the leverage that the hedge funds are already using. It's like buying stock on the margin, on the margin. And I don't even know what that means. But that's what it's like. Of course, like all leverage, this will be fine as long as the markets are fine, which is kind of like saying driving 120 miles per hour is fine as long as you don't hit anything.

If markets go south, people undoubtedly are going to look back on this leverage on steroids and say "What were we thinking?"

The "Heard on the Street" column in last Tuesday's Wall Street Journal (registration required) talked about a growing trend of companies borrowing large amounts of money to pay dividends. When I started writing for BloggingStocks several months ago, one of the first pieces I wrote was called A rally of declining yields: Should you care? If you read that piece, you will get a good idea how I feel about dividends.

Let's take a logical look at the idea of borrowing money to pay a dividend: A company borrows money at an interest rate which, however low, will likely be substantially higher than what an investor would earn with a savings account (even if it is a high-yield account such as those offered by EmigrantDirect and ING Direct). So, assuming the investor puts the money in a savings account, he is effectively borrowing money at X% to invest it at X-2%. This is not a good deal.

But let's assume that the investor doesn't put it in a savings. Let's say he decides to put it in his favorite stock that he considers to be undervalued. Let's say he puts it in the stock that paid the dividend. If he does that, he will essentially have been charged a hefty tax to plow the money back into the company. This is also not a good deal.

In cases where a company's management believes the stock is undervalued and the company is financially stable, borrowing money to buy back shares can be a good way to increase shareholder value. But, in my opinion, borrowing money to pay a dividend never makes sense.