There is a true keeper of a gloating column in Monday's Wall Street Journal from an Australian journalist explaining how wonderful, sound, and profitable her country's banks are, and how Australians long ago figured out that not everyone needs a home, etc. etc.

Really. That's fascinating. She should, me-thinks, pay a little more attention to the capital structure of her own banks. Sure, they carry AA ratings, which is nice, but ratings are made to be broken.

Specifically, there are two risks in Australian banks. First, they depend far too much on wholesale funding. Something like 60 percent of bank funding in that country comes from debt markets, and almost half of that figure comes from international debt markets (which is an increasingly meaningless distinction). According to the IMF, Australian banks have $222-billion in short-term debt which must be turned over every 90 days. Admittedly, these are banks with far fewer stresses than your average Icelandic bank, say, but with short-term credit markets studying their collective navel for a month or three, turning over that debt at anything other than usurious terms is going to f-ing hard. In short, the Australian banks have a mismatch between their funding and their obligations, and as we have learned to our collective dismay, that sort of things bites when you least like it.

The second problem with Australian banks is their reliance on mortgages. Over the last twenty years debt has gone from less than half of average income in the country to more like 1.5 times income. At the same time housing affordability remains crummy, and the country's housing prices have gone into a second boom without correcting for one back in 2002. So, what if house prices fall, which isn't inconceivable given how far they've run in recent years, and given a global recession banging on the door (which will hit Australia harder than it thinks, despite the absurd mantra there that "what China doesn't buy, India will")? A 15% decline in house prices would, according to the IMF, increase defaults to 2 percent, but that strikes me as low given what we're seeing elsewhere, and given a weakening economy. What about a 25% decline and a long-ish recession? The numbers change dramatically.

Lots of people are newly smart and chattering away about the essential stupidity of value-at-risk modeling. Oh, those dumb financial engineers, they keep saying, How stupid do you have to be to imagine that the real world would conform to a mere formula? Ho-ho.

The trouble is, value-at-risk -- a statistical measure of financial losses your portfolio faces given various holdings and market conditions -- actually worked well for some time. It isn't that it was dopey and didn't work; it's that it made some logical and theoretical sense and approximated the real world fairly well -- right up until it stopped working.

We need to stop pretending to be so smart now, and think more clearly about what we propose to do to avoid repeating the mistakes of the past. And I hope the answer isn't that we'll do no more risk modeling, because that's dumb; and I also hope the answer isn't that we plan to get much smarter about how to measure risk, because that's naive (and an academic project). Instead, we need to think about the relationships that do work,  and understand when they stop working, and what to do then (other than panic).

Put differently, we need to understand the boundary conditions of what we know. We have a financial data set, one bounded in both time and circumstances, and when we venture outside it nothing can happen (we get lucky and/or our model is more useful than we knew), or bad things can happen.

Sociologist Diane Vaughan had a great expression for what happens when you don't know what you don't know, and you creep outside the boundary conditions without failing. She called it "normalization of deviance", the business of convincing yourself that what you used to think was outside safe conditions, was actually okay because you got away with it last time.

It's sort of like what happened with the launch of the Space Shuttle Challenger. The launch team didn't adequately understand how far outside design conditions they were taking the shuttle during that cold, early morning launch, and it led to disaster. It depends, in part, on how you look at the data, as the following two figures show. The first presents the data on chronological form, which masks that we are exiting our boundaries into bad places, while the second figure shows the problem clearly.

1) A chronological plot of shuttle o-ring damage by launch date:

2) A plot of temperature vs damage to shuttle o-rings:

Nice to see that the Feds aren't the only ones bailing people out. Tonight I see a release from BofA wherein it essentially bails itself out itself via a $8.4-billion mortgage modification program for people with home mortgages obtained through its Countrywide subprime subsidiary. Granted, it did this at the urging of various state Attorneys General, but still.

The centerpiece of the program is a proactive loan modification process to provide relief to eligible borrowers who are seriously delinquent or are likely to become seriously delinquent as a result of loan features, such as rate resets or payment recasts.

Various options will be considered for eligible customers to ensure modifications are affordable and sustainable. First-year payments of principal, interest, taxes and insurance will be targeted to equate to 34 percent of the borrower's income. Modified loans feature limited step-rate interest rate adjustments to ensure annual principal and interest payments increase at levels with minimal risk of payment shock and redefault.

Modification options include, among others:

• FHA refinancing under the HOPE for Homeowners Program;
• Interest rate reductions, which may be granted automatically through streamlined processing; and
• Principal reductions on Pay Option adjustable rate mortgages that restore lost equity for certain borrowers.

Of course, it still keeps people in over-priced houses, but as long as mortgage holders are okay with that, then it's a step.

In about 10 minutes you'll be able to watch Dick Fuld of Lehman at Congressional hearings at this C-Span link. Should be amusing, and possibly market-moving.

Quote of the day comes from 92-year-old investing legend Seth Glickenhaus:

People are frightened and very angry. They feel that everything that has been done is to benefit Wall Street and these preposterous salaries and termination pay packages that leaders of these companies get, irrespective of how good or bad a job they have done. In some cases, they did a more miserable job than you believe. I am not so pessimistic about the future of the stock market. I am more pessimistic about the future of business.

More here.

Amidst all the equity carnage, some neck-snapping stuff going on today in exchange rates.

Some screenshots from the carnage out there today:

WSJ

NYT

NYT 

Cramer's sell call

Former Fed chair Paul Volcker has chaired a new report/survey on global financial market regulation. It's very, very long, but it is worth reading.

See here. One thing that jumps out, for better worse, is how much of an exception the U.S. model remains.

Quick tag cloud of Lehman's Dick Fuld's testimony in the House this morning.

On days like today when the abyss seemingly yawns open, only to (at least temporarily) shut again, it's good to remind yourself that market participants are mad. Watch the classic Bird/Fortune skit again for a reminder -- especially the first few minutes:

An interesting visualization of pulses and periodicity of the word "cramer" on Twitter today during the stock market festivities.

Pimco's Bill Gross has out his latest missive, and if recent history is any evidence then it has a solid chance of being causal, as opposed to being merely predictive. The key part is this:

A systemic delevering likely requires a systemic solution, which moves beyond cyclical interest rate cuts, liquidity provisions, or even the purchase of subprime mortgage-backed bonds. We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past. [Emphase mine]

I'm just spitting in the wind here, but given the continued logjam in credit markets, and given Gross's causal skills of late, I'm willing to bet the Fed starts buying commercial paper -- like maybe this week.

More here.

[Update] And like clockwork, not ten minutes later, the WSJ runs this breaking news headline:

U.S. officials are examining ways to ease deepening strains in the commercial paper market, which have been hit by an unwillingness among money market investors to hold risky assets.

Not that I'm necessarily objecting to doing something about the CP problems, but does the Fed have to leap to action so quickly every time Pimco's Gross writes a column?

Yesterday's 60 Minutes segment on subprime and the evolving credit crisis was surprisingly good. Watch it.

Something Wall Street has done very successfully in the current crisis is export risk. Through syndication it was able to move a lot of toxic paper around the world, perhaps not as much it wishes it had, but a surprising amount.

Driving that point home is the following figure showing credit-related banking writedowns in the U.S. and Europe. The latter region leads in a big way, which helps explain the current pain being felt in regions otherwise  not connected to the U.S.

More here.

Lest anyone think that having big-footed government beasties running through credit markets can happen without unintended consequences, think again. From a story in the WSJ about the Fed's plan to backstop the commercial paper market, this disturbing nugget:

In mid-September, the Fed unveiled a new lending program aimed at helping U.S. banks finance purchases of a kind of commercial paper called asset backed commercial paper, which is secured by collateral such as securities backed by mortgages or car loans.

The move was aimed at stabilizing money market funds that were being forced to dump illiquid or risky holdings as investors redeemed their money.

Some commercial paper brokers lamented that the Fed's backstop for the ABCP market may have at the same time reduced investor demand for unsecured commercial paper issued by many foreign banks and companies. So officials, who see strains in short-term funding markets as a dangerous development, are looking for ways to backstop this market, too.

You know, those public radio folks sure do good capitalism talk. Or at least This American Life does. The two most intelligent and accessible media segments on the credit crisis have now both appeared on that excellent Public Radio International show, most recently with the following entry:

365: Another Frightening Show About the Economy
Alex Blumberg and NPR's Adam Davidson—the two guys who reported our Giant Pool of Money episode—are back, in collaboration with the Planet Money podcast. They'll explain what happened this week, including what regulators could've done to prevent this financial crisis from happening in the first place. You can learn more about the daily ins and outs and join the discussion on the Planet Money blog.

Prologue.

Host Ira Glass goes to Union Square, a 15-minute subway ride from Wall Street, where it doesn't look like we're on the edge of an economic abyss. (3 minutes)

Act One. The Day the Market Died.

Alex Blumberg and Adam Davidson recount the 36-hour period, two weeks ago, when the credit markets froze. Plus, what it’s like now for businesses to get short-term loans, and how the hardship is spreading to every sector of the economy. (16 minutes)

Act Two. Out of the Hedges and Into the Woods.

One more confusing financial product that’s bringing down the global economy. And one of way to think about this product is this: If bad mortgages got the financial system sick, this next thing you’re about to hear about, helped spread the sickness into an epidemic. These are "credit default swaps." Alex explains. (19 minutes)

Act Three. Swap Cops.

Ira talks with Michael Greenberger, a former commodities regulator, who tells the story of when it was decided not to regulate credit default swaps. And how that decision was emblematic of the way we didn’t regulate a lot of the toxic financial products we’re hearing about now. (8 minutes)

Act Four. What's Next?

Ira and Adam answer the question: Was the $700 billion bailout bill signed into law today a good idea or a bad one? (10 minutes)

[Update] This post was updated to reflect that This American Life is a Public Radio International Program, not an NPR one. I get those two confused all the time, so I appreciate the PRI folks straightening me out.

My current favorite Lehman email released for today's hearing is this one. I'm not sure whether I'm more amused by the "huge brand" comment, or the "kill the bad hfunds" thing.

I'm also fond of this Lehman email, where the company's fine and upstanding executives plot to use a capital raise to buy back stock and hurt Lehman short-seller David Einhorn. Nice to see they have such productive capital uses in mind.

Lots of chatter in various circles, including my weekend comments, that we could see the banking crisis in the U.S. and Europe mutate into a currency crisis in Europe. It is not an idle question to wonder what it might take to break -- or maintain -- the Euro if stresses continue given massive bank bailouts, comprehensive deposit supports, etc.

Here is Wolfgang Munchau in the FT:

For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe's monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.

More here from John Mauldin's latest.

It isn't much, but the most positive thing I've seen today is this paragraph hidden deep in a release from the President's Working Group on Financial Markets:

The new legislation also enables Treasury to directly strengthen the balance sheet of individual institutions. These authorities allow Treasury to act to remove some of the uncertainty regarding financial strength, and provide financial institutions with greater operating flexibility and enhance their ability to raise additional capital in the private marketplace.

I could be wrong, but I think this is the first time we have seen a statement that the Treasury may soon start making direct investments in individual banks. It has to happen, I think, and it's too bad it didn't happen sooner. Unfortunately, however, the Fed is giving indications that it won't do this proactively.

More here.