From this week’s Economist…

CAPITALISM without bankruptcy, it is said, is like Christianity without hell. With recession looming, the air in America’s bankruptcy courts is thick with brimstone and the coals are being heated in readiness for the many sad souls whose sin was to borrow too much. After several heavenly years, in which bankruptcies fell to record lows, going bust is back. How bad will things get?

If the debt markets are to be believed, companies could be in at least as much trouble as they were in the previous two downturns, in the early 1990s and at the start of this decade, after the dotcom bubble burst. A leading indicator is the spread between yields on speculative “junk” bonds and American Treasury bonds. A year ago, the spread was only about 280 basis points; the long-term average is around 500 points. This month the spread exceeded 800 points for the first time since March 2003, reaching 862 on March 17th…

It’s a deliciously incomprehensible article. At one point, for example, it explains that

the difference between corporate-bond spreads and actual default rates is unusual and hard to explain: on the previous occasions when spreads have exceeded 800 points, the default rate was already 9.43% in 1990 and 5.44% in 2000. That said, the huge amounts of “covenant lite” debt issued in the credit boom of 2005-07, which gives lenders much less power to demand their money back than in the past, may have delayed the moment of default for many underperforming firms. So FridsonVision looked at the ten firms in which spreads exceeded 1,000 points by the smallest amounts. If these were merely victims of irrational pessimism in the market, they ought to be in relatively good shape. In fact, the analysts found plenty of reasons to worry. The companies included household names such as Beazer Homes, Ford and Rite Aid, all of which are “exhibiting classically distressed behaviour of downsizing amid recurring losses.”

And as for the mischief that hedge funds might get up to in the present crisis, well…

In a bankruptcy, a hedge fund could use the voting rights attached to different securities to maximise the overall value of its holdings in the firm at the expense of other investors.

Imagine, for instance, a hedge fund that owns debt secured against a company asset. It may prefer to force the firm into liquidation in order to win that asset rather than engage in a restructuring negotiation that will keep the firm alive. Meanwhile, it can boost its returns by short selling its unsecured debt and its equity. Or suppose that a hedge fund owns credit-default swaps as well as a firm’s debt. If the fund makes enough money from the pay-out of the credit-default swaps, it may prefer to use the voting rights on its debt to ensure that the firm goes bust rather than negotiate a way to avoid bankruptcy.

Got that? Good. Neither have I.

…in 1979, America’s worst commercial nuclear accident occurred inside the Unit Two reactor at the Three Mile Island plant near Middletown, Pennsylvania.

From his NYT column…

Nobody expects an investment bank to be a charitable institution, but Bear has a particularly nasty reputation. As Gretchen Morgenson of The New York Times reminds us, Bear “has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.”

Bear was a major promoter of the most questionable subprime lenders. It lured customers into two of its own hedge funds that were among the first to go bust in the current crisis. And it’s a bad financial citizen: the last time the Fed tried to contain a financial crisis, after the collapse of Long-Term Capital Management in 1998, Bear refused to participate in the rescue operation.

Bear, in other words, deserved to be allowed to fail — both on the merits and to teach Wall Street not to expect someone else to clean up its messes.

But the Fed rode to Bear’s rescue anyway, fearing that the collapse of a major investment bank would cause panic in the markets and wreak havoc with the wider economy. Fed officials knew that they were doing a bad thing, but believed that the alternative would be even worse.

As Bear goes, so will go the rest of the financial system. And if history is any guide, the coming taxpayer-financed bailout will end up costing a lot of money.

The U.S. savings and loan crisis of the 1980s ended up costing taxpayers 3.2 percent of G.D.P., the equivalent of $450 billion today. Some estimates put the fiscal cost of Japan’s post-bubble cleanup at more than 20 percent of G.D.P. — the equivalent of $3 trillion for the United States.

If these numbers shock you, they should. But the big bailout is coming. The only question is how well it will be managed.

As I said, the important thing is to bail out the system, not the people who got us into this mess. That means cleaning out the shareholders in failed institutions, making bondholders take a haircut, and canceling the stock options of executives who got rich playing heads I win, tails you lose.

Couldn’t have put it better myself. But will it happen? Don’t hold your breath.

And another thing… The Reagan era savings-and-loan scandal mentioned by Krugman went largely unexposed by the fearless American media. Just as the sub-prime scandal did — until it became unmissable. I went to a fascinating dinner in London about two years ago in which the great Mark Anderson did one of his famous tours d’horizon. He went on and on about the “coming sub-prime crisis” and I began to feel embarrassed because I’d never heard the phrase until that moment. And I’m a pretty assiduous reader of newspapers — American as well as European.

From Robert Peston’s Blog

The Financial Services Report into its supervision of Northern Rock is a catalogue of mistakes, a tragedy of errors rather than a comedy.

The City watchdog admits to inadequate record keeping. Proper notes weren’t taken of important meetings with Rock executives.

There was no rigorous assessment of the serious business risks being run by the Rock, both in the way that the bank was rapidly increasing its mortgage lending and in its financial dependence on selling these mortgages to investors in the form of bonds.

In some ways, it was the riskiest bank in the UK.

But here’s what will shock many.

It was treated by the FSA as though it was the least risky bank in the UK: it received deep assessments of its operations less frequently than most other banks; FSA staff had far fewer meetings with Rock executives than they did with executives at other banks; and unlike what happened at other banks, there was no attempt to force the Rock to reduce the risks it was running.

As the FSA itself says, this was not just a failure of more junior staff. Responsibility for these failings ultimately rests with senior FSA management…

I’ve got a good friend who runs an investment company — and who therefore has had many dealings with the FSA. Long before the Rock fiasco, he told me that the FSA was the most incompetent and arrogant organisation he’d ever dealt with. And yet it had powers of life or death over his business.

And another thing… One of the most disgraceful aspects of the whole story is the way the FSA and its City acolytes tried to frame Mervyn King, the Governor of the Bank of England, for the failure to deal with the errant bank. The whole thing stinks. But I bet nobody in the FSA will fall on his sword.