Highlights include Dominique Strauss-Kahn, managing director of the International Monetary Fund, scolding leaders of the developed countries for promising to cleanse the balance sheets of their financial institutions with some haste, and then (to his mind) dragging their heels. He went so far as to say they’d done nothing—an overstatement he rather quickly retracted. But he stuck to his guns that the process of getting the toxic assets out in the open was “much too slow… There are lots of losses that have so far not been exposed.” (The IMF puts “lots” at about $500 billion.”)

Something of a debate that emerged in the forums this morning was the question of why, if “the worst of the banking crisis is behind us” (a phrase tossed about repeatedly), credit flows remain impaired. In other words, if the banks really are on a sounder footing again, why don’t they start doing their job and lend more money?

The most lucid answer came from Jan Hatzius, chief US economist for Goldman Sachs. (Hatzius was among the few economists to correctly call the widespread effects of the US housing bust.) His reply to the question of impaired credit flows? Lack of demand.

Banks are not lending money because the private sector is not borrowing it. For instance, U.S. consumer spending in the second half of ‘08 fell by 4%—a huge drop in a short period of time. Consumer borrowing is falling and the U.S. savings rate, which had been negative for years, is positive and rising. So it’s not that there isn’t money to borrow anymore. Lack of credit supply was a “2007/08 issue,” Hatzius said. “Demand for credit is an ‘09 issue.”

Hatzius, who by the way came out on top of the Wall Street Journal’s economic forecaster rankings for ‘08, was more upbeat (in his way) about the US dollar. He said that he thinks concern over a “deluge of debt” undermining the U.S. Treasury is “overblown.” He pointed out that the US trade deficit has shrunk sharply in a very short period of time, so effectively private sector savings are funding the debt expansion in the States.

The economist was downright upbeat about Asia, however. When it comes to China, Hatzius said he tends not to rely on statistics solely out of China as they are hard to decipher or rely upon, but he does look at other Asian economies, like Korea’s. And “there’s no question that the Asian countries are coming back.” He suggested, in fact, that a classic V-shaped recovery is occurring in Asia right now, even as the West is waiting for the recovery to start.

Look for that around the end of the year…

An article recently proposed clawing back the bonuses that imprudent Wall Street executives awarded themselves during the era of frenzied growth. After all, it would be one step toward addressing the moral-hazard problem. And it would seem rather unfair to expect taxpayers to foot a multibillion-dollar bill for cleaning up the mess while the executives got to keep the spoils from creating it. It seems only fitting that a first stop in collecting funds should be at the doorsteps of those who helped perpetuate it – the amounts can be rather significant as Lehman’s example illustrates.

I was thinking the return of the bonuses could be compelled through legislation — but creditors might beat the government to it, at least in the case of Lehman. Adam Levitin, an associate professor of law at Harvard University, notes that the bonuses might be recoverable as fraudulent transfers if a creditor succeeds in demonstrating the firm was already insolvent in 2007.

However, the actual amount recoverable would be less than $5.7 billion. A substantial portion of that figure represents stock grants that vest over time (and those vesting after Sept. 15 are now worthless).

There is some evidence it at least partly reflects hedge funds scrambling to raise cash to meet redemption requests. Financial stocks have risen for sure but that likely reflects hedge funds buying back short positions to generate cash, not to go long because they think the fundamentals are turning.

I remain somewhat skeptical of the thesis that the U.S. economy is close to coming out of the downturn, and so the places to shift into are U.S. stocks and the U.S. dollar. When one looks at the problems the U.S. has, especially in its financial sector, they would seem to have the potential to inflict more pain on the economy than we have seen to date.

Cash balances in hedge funds rose to a record $155 billion (U.S.) in July. A lot of this could be coming out of the market and going into investors’ hands. It may be erroneous to assume it will all be going into U.S. stocks.

The Federal Deposit Insurance Commission (FDIC) currently has reserves of $53 billion (U.S.) to compensate bank customers for lost deposits in the event of a bank failure. About ten percent of these reserves will be needed to pay off depositors at failed Indymac, leaving at best no more than $50 billion in the FDIC kitty, remarks Narayanan.

According to FDIC estimates, total insured deposits in the U.S. banking system were $4.43 trillion at the end of the first quarter. “Thus the FDIC is operating with a cushion of no more than $50 billion to insure $4.43 trillion in deposits” at a time when dozens of regional and other banks are expected to go under. There is a risk depositors may become fearful for their deposits and start lining up to get their money out.

Moreover, another $2.42 trillion of bank deposits are uninsured by FDIC. These deposits are at even greater risk of fleeing the banking system, Narayanan believes.

Narayanan goes on. “Fannie Mae and Freddie Mac … are technically bankrupt when their assets are marked to market ….” Thanks to leverage ratios (total assets/equity) of anywhere from 20 to more than 80 times (depending on how one chooses to look at their off-balance sheet risks), their equity has been wiped out by asset impairments. They both have negative equity positions of more than $5 billion each, which could be disconcerting considering they jointly guarantee over S$4.7 trillion of mortgage securities, notes Narayanan in his monthly report.

The forced selling is prolonging the underperformance of the value investing approach — which has been quite extensive lately. Research published on the U.S. market by Joseph Mezrich, head of quantitative research at Nomura Securities, shows a model portfolio of momentum stocks gained more than 70% year-over-year while a model portfolio of value stocks fell about 50%. Value stocks haven’t been this cheap in 35 years.

Historically, when value stocks get beaten up to this extent, they usually go on to do very well. However, this time round, they are cheap mainly because of the financial sector, which is facing ahistoric problems. Some say the business models in the financial sector are busted, just like dot-com business models were busted in the early 2000s.

On the other hand, some would say monetary policy in the U.S. is based on central banks feeding the commercial and investment banks enough liquidity to keep them lending and dealing liberally. So the business models of the financial institutions will survive and flourish because they are a necessary adjunct of the central banks’ modus operandi for managing economic fluctuations.

Sure, the U.S. CPI hit an annual growth rate of 5.7% in July. But the main cause of the inflation surge, soaring oil prices, is beating a hasty retreat — as are prices for commodities and foodstuffs (other important contributors). Even rising import prices are going into remission thanks to the recent rise in the U.S. dollar.

Look at how financial markets yawned when the CPI figures came out. Futures on federal fund rates barely moved. Yields on inflation-protected Treasuries (TIPs) fell (the spread of the 10-year TIPs yield over regular 10-year Treasuries yield — a proxy for inflationary expectations — has now collapsed from 2.57% to 2.22% in a little over a month).

Retail sales volumes have been dropping despite the tax rebates issued by the U.S. government. Job losses, falling house prices, and credit rationing are taking their toll. With most rebate cheques already disbursed, retailers are likely to pick up the pace of price discounting in the months ahead, says BMO Financial.

The forces of recession do indeed appear to be in the ascendancy. Japan’s economy contracted at an annual rate of 2.4% in the second quarter, its worst performance in seven years. The eurozone economy shrank in the second quarter, the first contraction since the launch of the euro in 1999. The Reuters-Jefferies CRB index has fallen almost 20 per cent since the peak in July.

The Fed’s latest survey of lending officers shows continuing tightening of credit standards. In the three months ended June 30, total bank credit contracted at an annual rate of 3.7% — the biggest drop in 60 years.

A slowdown in loans coincides with a slowdown in bank deposits — which in turn slows growth in the M2 definition of money supply. M2 had annualized growth of only 2.5% in the three months ended July, compared to 13.2% in the three months ended March, 2008. If inflation is “always and everywhere a monetary phenomenon,” as the great economist Milton Friedman said, then a deceleration in the money supply implies a deceleration in inflation.

In fact, the M2 slowdown implies a drop in economic growth when inflation is taken into consideration. The real money supply (adjusted by consumer price inflation) has contracted at an annual rate of 7.3% in the three months to July 30, “the sharpest three-month contraction since early 1980,” according to Northern Trust.

Besides, there is no need for higher Fed rates if inflation is going to moderate on its own. Some may think negative real interest rates are a stimulative monetary policy bound to accelerate inflation — but policy remains restrictive, according to Sherri Cooper, chief economist at the Bank of Montreal.

That’s because of the credit crunch. As the Fed’s April survey of loan officers showed, there “has been a record level of tightening” in U.S. credit standards. Going by my very rough calculations, this puts the effective Fed rate closer to the 3.75% rate recommended by the Taylor Rule.

Lastly, for inflation to enter a runaway phase, wages need to begin rising too. However, workers don’t have much bargaining power when job losses are piling up. The chances of a wage-price spiral commencing appear to be rather small.

So suggests BMO Nesbit Burns strategist Michael Herring in a recent publication. The banks can borrow the cheap funds and buy higher-yielding Treasury and agency bonds, pocketing the spread in yields to replenish their balance sheets over time.

This “carry trade” is what happened after the savings and loan crisis nearly 20 years ago. “The Federal Reserve held the Fed Funds rate at 3% for almost a year and a half so the banks could borrow cheap and buy U.S. government bonds to rebuild their balance sheets,” writes Herring.

Citigroup is the archetypical, supermarket-style financial firm, made possible by regulatory changes. The Glass Steagall Act of 1933 created deposit insurance in the U.S. and to limit risk prohibited mergers between banks and brokerages, insurance companies and other financial firms. But Fed Chairman Alan Greenspan endorsed the merger of Citicorp and Travelers in September, 1998, to give birth to Citigroup. The Clinton administration, with Robert Rubin as Treasury Secretary, then pushed for a repeal of provisions in the Glass Steagall Act to give Citigroup more scope to operate. In the fall of 1999, the Act was repealed and days afterward, Robert Rubin joined Citigroup.

The new Citigroup, with chief executive Sanford Weill in charge, was “riddled with internal conflicts of interest” and had a culture where “profits were given undue importance,” says Narayanan. For example, Jack Grubman, Citigroup’s star telecommunications analyst, was reportedly influenced by Weill to upgrade his rating on AT&T Corp. because the latter’s chief executive was on the Citigroup board and Weill needed his vote in a boardroom showdown with another board member.

Also, Citigroup “was a key player in the Enron scandal where it averaged one deal a month with the firm from 1997 till bankruptcy,” and was found by the bankruptcy examiner to have helped Enron produce misleading statements. Yet another example of pushing the limits was the directive from Japan’s stock-market regulator in 2004 to close Citigroup’s Japanese private-banking operations because of “unscrupulous violations” of rules and regulations.

In the mid-2000s, Weill passed the reins to Chuck Prince, while Weill’s team, including Rubin, stayed on. Narayanan believes “Rubin pushed the bank to increase its activity in high-growth areas like structured credit” – just as things were peaking. Rubin may have also assisted with the $800-million (U.S.) purchase in 2007 of the Old Lane Partners hedge fund, which was months before formed by a team led by Vikram Pandit. Just over a year later, the fund had to be written off.

Now Rubin is in charge of Citigroup following Prince’s resignation and has hired Pandit (from the failed hedge fund) to be chief executive. Yet, “Mr. Pandit has no prior experience to speak of in classic banking, let alone with one as large as Citi,” states Narayanan.

What Citigroup’s example shows is that “regulators and investors exercised little to no oversight of the bank and allowed it to operate unchecked.” It also shows that original participants in events leading up to the financial messes are still at the helm. “If an investor of sound mind were presented with Citigroup today it all its glory with its complex balance sheet and rivers of red ink, how could he possibly feel comfortable about investing in the firm to shore up its capital base …,” wonders Narayanan.

All of which is leading to speculation that the Canadian banks could be getting ready to swoop in and buy up some ailing U.S. financial institutions at bargain prices. “I think they’re in a position to really pick over the carcasses,” a portfolio manager with Toronto-based mutual-fund firm CI Investments, Eric Bushell, is reported to have said at a Morningstar Canada investment conference held in Toronto on June 11, 2008.

In other words, as agued in this Canadian Business Online article, the global financial crisis may actually end up benefiting the Canadian banks. They could emerge as bigger and more global players. “Canadian banks are going to be in the driver’s seat for the next decade,” said Dennis Gartman, editor of The Gartman Letter, at the same conference.

Nevertheless, the financial crisis has weighted on the share prices of the Big Five chartered banks in Canada during the past year – most of all CIBC (-48%), followed by Bank of Montreal (-42%), Royal Bank (-28%), TD Bank (-23%) and Bank of Nova Scotia (-13%). CIBC was worse hit because of its exposure to credit derivatives and monoline insurers.

The Bank of Montreal, Royal, and TD are down in large part because their U.S. subsidiaries expose them to U.S. loan defaults. The Bank of Nova Scotia is getting off lightly because it has pursued expansion into overseas markets instead of the U.S. Of the five, I suspect (without having done a great deal of digging) that Royal Bank shares could be the most likely to benefit from the growth opportunities in the U.S market. It has long been the biggest of the Canadian banks and its existing U.S. operations are not as exposed to U.S. loan defaults as the other Canadian banks with a U.S. presence.

Declines of this magnitude in bank loans have never been seen before in the data (which goes back to the mid-1970s). By comparison, the worse recession of the post-war era — in the early 1980s — saw less than a 3.5% drop.  As if we didn’t have enough bad news already emanting from the U.S. financial sector, the latest being the loss of confidence in Fannie Mae and Freddie Mac.

When individuals and businesses don’t get loans, they pull in their horns and the economy wilts. Furthermore, credit contraction makes the banking system a poor conduit for stimulative monetary policy. If the recent decline in bank credit continues, could the much anticipated U.S. recession finally make an appearance? And could it be of the hard-landing variety? 

As reported May 12 by the Associated Press, Chinese inflation rebounded in April to 8.5% on a year-over-year basis, just shy of the 12-year high of 8.7% established earlier this year. In recognition of the inflation peril, the Chinese central bank this week boosted bank reserve requirements by 50 basis points to a record high of 16.5%, promising more hikes along with interest rate increases.

Sooner or later, China will succeed in bringing its galloping inflation problem under control. But it has built up so much momentum that stopping it will probably require a substantial contraction in the Chinese economy … just like it did in the U.S. and Canada during the 1970s. Developed economies learned the value of a price-stability target from that era; China and the emerging economies appear to still be on the learning curve in that department.

A contraction in China will likely add another squeeze on the global economy on top of the credit crunch and sky-high prices for energy and other commodities. One casualty could be the current commodity boom itself. And as substantial appreciation in the Chinese Yuan would seem to be a virtual certainty, companies benefiting from importing cheap products from China, particularly Wal-Mart, could face more of challenge.