To hear the heads of Wall Street’s largest financial institutions speak, the worst of times are behind us. But a new wave of pressure seems mounting as corporate borrowers get squeezed by tightening credit and a slowing economy. High yield bond defaults are up and going higher as companies find lenders unwilling to refinance risky loans (non-investment grade lending is down 70% this year). And now companies have begun drawing down on their revolving lines of credit, sucking even more capital away from Wall Street, the New York Times is reporting.

Those of you not involved in corporate finance might not appreciate how much banks hate when borrowers draw down on revolving lines of credit. Typically a corporate borrower will have a revolver built into its larger credit facility. But unlike bond issuances and syndicated term loans, banks cannot easily hand the credit risk and capital requirements onto other investors. In short, when borrowers draw down revolvers that money comes out of Wall Street’s coffers.

Banks are already under tremendous balance sheet pressure following the $300 billion write-downs and credit losses over the past year, and the threat of corporations drawing down their revolvers could exacerbate the situation. The New York Times, in a somewhat panicky tone, notes that in a worst case scenario of massive revolver draws, banks could be forced to sell assets or raise money to cover the loans.

The banks are downplaying the risk, of course. “Even in the most volatile markets, including last summer, we have seen very few companies draw down their revolvers,” Chad Leat, chairman of the alternative asset group at Citigroup, tells the Times. “Occasions when it did happen have been unique.”

We find this completely reassuring. Banks, especially Citigroup, have proven so effective at anticipating crises in the past year that we wouldn’t even dream of doubting Chad.

Banks Fear Increased Demand for Corporate Emergency Loans [New York Times]

There are gray storm clouds hanging over Wall Street this February but Merrill Lynch’s Greg Fleming appears to be weathering the storm. The Securities and Exchange Commission has initiated a formal investigation into whether the brokerage knew more than it revealed to shareholders about the value of its subprime investments prior to announcing the giant write-downs with its third-quarter results. Federal prosecutors have opened a preliminary investigation, leading to speculation that criminal charges could possibly brought against some Merrill executives. But sources at Merrill Lynch say Fleming, who continues in his role as president of the bank after the losses forced the departures of a co-president and the chief executive, was not involved in the businesses reportedly being scrutinized and they do not expect him to be a subject of the investigation.

Wall Street abounds with speculation that Greg Fleming, who has managed to hold on to his position as sole president of Merrill Lynch through a whirlwind of management changes, might finally be facing a challenge that could shake him out of his elevated position.

Fleming’s presidency has endured the worst losses in the history of Merrill, internal criticism, and alleged pressure from newly minted chief executive John Thain. Although the Justice Department’s investigation is in its earliest stage, rumors are already spreading, both within and outside of Merrill, that the threat of a criminal investigation might bring Fleming down.

Despite rapid changes in the management structure at Merrill Lynch, Greg Fleming has held onto his position as the president of the firm. He has insisted that he will remain the sole president, and resisted any plans to elevate others at the firm to be co-president. But his inflexibility on this point may be imperiling his position, according to people familiar with the situation.

“He’s on the verge of a nervous breakdown,” a source tells DealBreaker. Others dispute this characterization however, saying that Fleming shows no signs of anything like "a nervous breakdown."

When John Thain took over as chief executive of the bank, one of the very first changes he announced was a flatter management structure. More executives now report directly to Thain, in effect circumventing Fleming’s office. Under Stan O’Neal, the risk management executives did not report directly to the top—a situation which has been blamed for some of the excesses that lead to enormous losses over the last several months.

Fleming, who also serves as chief operating officer and oversees the investment banking business, is said to have dug in as president, and told others that he will not accept a co-presidency with others at the firm. This is seen by many as resisting the flatter structure Thain is putting in place, and may be alienating him from others at Merrill. Perhaps more important, Thain is thought to be chagrined by Fleming’s stance.

“Fleming could have been a team player. He’s still got the investment bank under him,” said one person with knowledge of the dynamics within the firm. “But he went the other way. He saw moving back to being just head of investment banking as a demotion.”

Some feel that the flatter management structure has effectively demoted Fleming already. With the new head of risk management, the top spokesperson, their general counsel, the chief financial officer and the brokerage head of the brokerage arm, among others, reporting directly to Thain, the office of the bank’s president may be superfluous. Last week, both Market Watch and Bloomberg referred to Fleming as the “chief operating officer” of Merrill without mentioning his role as president.

Fleming remains respected as an investment banker at the firm, even by those who are surprised at his alleged inflexibility. He remains youthful, plain-spoken and full of energy, according to people at Merrill Lynch. He is known as a perfectionist and an investment banking star—which is all the more reason his continued grasping to the title of sole president has some feeling “mystified.”

Merrill Lynch would not comment on this story.

Bear Stearns has more than $1 billion of short positions on subprime, up $400 million from the end of November, Bloomberg reports. Of course, since Bear Stearns got the subprime trade so wildly wrong last year, people are already wondering if this might be a signal that it is time to go long subrime.

Over at The Big Picture, Barry Ritzholz writes, “While I do not expect us to be done with the subprime slime yet, I do get a ‘Is this a bottom indicator?’ sense from Bear on this.”

JPMorgan Chase, which emerged relatively unscathed from the credit market debacle, is apparently taking the opposite position. Yesterday Jamie Dimon was reported to have said that the bank plans to expand its role in the subprime mortgage business. Goldman is also rumored to have reversed it’s position on subprime, taking a net long position.

Bear Stearns Is `Short' Subprime Mortgages $1 Billion [Bloomberg]

Yesterday we heard two discordant voices on the possibility of the monolines getting downgraded. Jamie Dimon, the chief executive of JPMorgan Chase, said that he does not think downgrades of the insurers would be “a big deal.” Deutsche Bank chief Josef Ackerman, however, described the potential downgrades as “a tsunami-like event comparable to subprime.”

So who is right? Well, maybe both chiefs are. As Yves Smith has explained, the European banks were major buyers of CDOs and RMBS. Operating under Basel II, which links reserve requirements to the riskiness of a bank’s investments, the Euro banks were able to treat triple A paper as basically risk free investments they could hold without impacting their reserve requirements. But a downgrade of the insurance on this paper could result in the banks having to bolster their reserves, possibly worsening the credit crunch or requiring a firesale of the CDOs

“A downgrade to AA increases the reserve requirements markedly, and CDOs are generally downgraded more than a mere grade or two when they fall (I wish I could be more crisp here, but Basel II makes matters more complicated). Thus a loss of the bond guarantor AAA has a quick and nasty impact on bank capital adequacy,” Smith writes.

Which is to say, because Basel II requires banks either to hold highly rated (and, on paper at least, less risky) portfolios, or to hold high levels of capital in reserve, the banks could be forced to slow lending in order to accumulate capital, go hunting for additional capital injections or sell off their now risky CDO portfolios.

In the US banks had less incentive to invest in highly rated paper because they have been required to hold the same amount of capital against AAA-rated paper as they do against BBB-rated paper. This is the most likely explanation for why the European banks are more worried about a downgrade of the monolines than their US counterparts.

Deutsche Bank CEO: Bond Insurer Downgrade Will Create Debt " Tsunami" [Naked Capitalism]

Credit Suisse is totally not going steady with Bear Stearns. Ruddy Brady Dougan—the Irishman who is somehow chief executive of the Swiss bank—told Credit Suisse bankers at the meeting of the Committee To Run The World in Davos, Switzerland that a deal to acquire Bear Stearns is a “non-starter,” according to Mark DeCambre at TheStreet.com.

But now everyone is awkward about it. Bear spokespeople decline to comment, look away embarrassed. The Swiss aren’t talking either, just staring down at their shoes mumbling about already having plans and such.

Credit Suisse CEO Squashes Bear Stearns Takeout Talk [TheStreet.Com]

So who is on this list of 14 companies under investigation by the FBI for their involvement in the subprime mortgage crisis? The FBI apparently intends to keep us in suspense because they won’t give details. All we know is that they are looking into “allegations of fraud at various stages of the mortgage process, from companies that bundled the loans into securities to the banks that ended up holding them.”

So let’s recklessly speculate. Two companies that are sure to be on the list are Bear Stearns—which is already under investigation by federal prosecutors and the SEC—and Countrywide, which is both the biggest home loan lender and also facing an SEC inquiry. Goldman Sachs is very likely on the list. It was accused on the pages of the Sunday New York Times of misleading clients by packaging CDOs while shorting the mortgage market. We know that at least one Senator read the article and has been making a stink, and we know that federal investigators often get their leads by reading the paper. What’s more, Goldman Sachs has said that it is cooperating with an unnamed government agency.

Morgan Stanley has also admitted to cooperating with unnamed government authorities. At first, everyone assumed this was the SEC. But why wouldn’t they come out and say that? More likely they declined to name the agency out of fear that saying they were cooperating with the FBI would tar them with serious criminality—rather than the everyday Wall Street shenanigans implied by an SEC investigation.

So that gives us four good leads. Who else is a cylon on the list? No doubt some additional mortgage companies and some home builders. Maybe the ratings agencies are also. Leave your guesses in the comments section below.

FBI Launches Subprime Probe [Wall Street Journal]

Unsurprisingly, only one of these little elves is smiling.

One reply to our insistence about this Citadel discount thing has been to call it an "Armageddon Scenario" that is simply too horrible to contemplate. An old friend just wrote to us that what's keeping the banks from marking down their CDO portfolios based on Citadel is not wishful thinking but sheer terror.

What are they afraid of? Well Peter Cohan has helpfully showed exactly what there is to fear. In a recent column on blogging stocks he says that the capital of three banks would be wiped out if that 27 cents on the dollar valuation was applied to their Level 3 assets and written off from their most recent capital levels.

So who are the three banks who are imperiled by the 27 cents? After the jump, check out Cohan's list.

We thought that our wrap-up of the reaction to Ben Stein’s piece might finally put our day-long obsession with his Goldman Conspiracy Theory Essay to rest. But then Stein himself decided to lash out against one of his opponents.

The news comes from our friends at New York magazine’s Daily Intel, who actually got a hold of Stein and asked him about the reaction.

"It is hardly to be expected that I could question an institution as powerful as Goldman Sachs and not get some response," Stein told Daily Intel. "As to Paul Krugman, I don't like to deal with people so full of hate. His recent piece on [Milton] Friedman [in the New York Review of Books] was so thoroughly debunked by Anna Schwartz that I would well imagine he's not happy."

Of course, this is a slimy—if tactically smart—move. No doubt Stein is particularly hurt that another New York Times writer with economic credentials bashed his essay. (Isn’t there some policy that says they aren’t supposed to openly mock each other? We’d always assumed that there must be. How else do you explain the lack of open mockery of Maureen Dowd in the pages of the Times?) But going after Krugman is slimy-smart because a lot of Stein's detractors are also not the biggest fans of the Krug. It even makes us uncomfortable to find ourselves agreeing with him. And reminding everyone that Krugman is a Friedman-basher and, more broadly speaking, an Keynesian enemy of free-markets is rhetorical hardball.

But it’s probably a misstep for Stein to imply that his column was criticized because he questioned “an institution as powerful as Goldman Sachs.” Take a look at that long list of critics from our earlier post. Not a one of them is routinely a defender of Goldman or of institutional power in general. In fact, pretty much every single one of the critics we quotes is far better known for biting at the ankles of our financial titans. This just makes Stein looks sadly defensive.

Ben Stein Thinks Paul Krugman Probably Just Has Low Self-Esteem [Daily Intel]

We’re not the only ones who have called out Ben Stein for yesterday’s column. It’s getting roundly trounced by most commentators. Here’s a quick round-up of some of the comments we’ve come across today.

• Roger Ehrenberg thinks the main sin of Goldman economist Jan Hatzius did was dissenting from Stein’s rosy view of our economic prospects. “Just because his paper doesn't comport with Mr. Stein's view of the world doesn't make it wrong or its methodology flawed - it's just that Mr. Stein doesn't like it,” Ehrenberg writes.

• Athenian Abroad says that Stein doesn’t seem to understand the difference between capital requirements and reserve requirements. “Hatzius's paper describes the impact of the sub-prime crisis on bank lending via the hit to banks' capital. Stein dismisses this, because the Fed can create reserves, and because Stein doesn't know that these are completely different things,” the Athenian writes.

• Naked Capitalism goes back an re-reads that Alan Sloan piece Stein refers to and discovers that the New York Times columnist totally misread it and seems to have confused events of 2006 with those of 2007.

• Stein’s even getting it from his fellow denizens of the New York Times. “Maybe I don’t have what it takes to be a serious columnist. I mean, it would never have occurred to me to suggest that the only way to explain an economic forecast I don’t agree with is to say that it must be part of an evil plot to drive down the market, so that Goldman Sachs can make money off its short position — and to suggest that Goldman should be the subject of a federal investigation,” Paul Krugman says.

• Leftist economist Dean Baker won’t even support the Goldman bashing. “Stein gives no reason whatsoever to doubt that Hatzius wrote a serious analysis of the current state of the U.S. economy,” he writes.

• Dan Altman turns Stein’s conspiracy theory around. “You could also ask whether Stein, a friend of the Bush family and sometime cohort of the president, is just trying to prop up the economy to help his old pal,” he writes.

• Surveying the scene—the Stein piece, the reaction to it (we cribbed a couple of these links from his earlier post)—Portfolio’s Market Mover Felix Salmon finds himself depressed. “It's not illegal – in this country – for Stein to make such allegations. But it is quite shocking, and depressing, that the Gray Lady would willingly allow herself to be used as a vehicle for this kind of yellow journalism – and would place it on the front page of its business section, no less,” he writes.

• Even Fake Ben Bernanke takes a shot: “Stein goes on to say in reference to Goldman ‘It is far worse when the sellers were, in effect, simultaneously shorting the stuff they were selling, or making similar bets.’ Of course, Stein innocently points out that he’s simultaneously a shareholder in the company he’s criticizing. Why not have it both ways?”

• Oh, and because of the wonders of the internet, we have already heard from Henry Blodget, whose crooked stock analysis was cited by Stein in the column. “The real lesson here is that Wall Street analysts can't win: No matter what they say, it is easy to suggest that their conclusions might be motivated by something other than the facts. This is fair (who knows what truths lurk in the hearts of men?), but let's at least note that Wall Street shares this conflicted condition with many other industries,” Blodget writes.

So far, Stein’s only defenders seems to be our pals Charlie Gasparino, who has been appearing on CNBC to balance what has been a brutally critical reaction by most of the networks anchors and guests, and Wall Strip founder Howard Lindzon. Over on his blog, Lindzon writes that “Goldman is the world’s largest bookie that fixes games and legally sells you shit while they are dumping it out the back door.”

While we're on the topic, we might as well mention that Ben Stein also seems to have an inflated view of the role of economists at investment banks, and perhaps in the world. Most traders and brokers we know tend to regard their economists as irrelevant at best and hazardous at worst. They are used to economists taking positions that are unhelpful to their book or to their sales efforts. But they don’t mind that much because they don’t think many people listen to—much less follow the advice of—their economists.

“These guys are talking heads for us. Part of brand promotion on a grand scale. They might as well work for the PR department. They get the firm’s name out there but, internally, no one really trades on what they say,” one equity trader with over twelve years experience tell us.

We at my apartment (so me and Marissa) have heard that the invasion of employee privacy by Wall Street firms has taken a bold step forward: hacking into employee Facebook accounts. According to a sometimes reliable, sometimes not source, the human relations department at a certain investment bank has been using creative technology to get into the profiles of current (and prospective) minions, to monitor their off (and on) the clock activities. This is bull shit and I'll tell you why: it would be one thing, if you and those with the power to get you fired willingly entered into a Facebook friendship, thereby granting them full-access to see what's a-poppin' in your personal life whenever they pleased. But this means that someone who doesn't even have the bedside manner to ask "You wanna do this" first, or worse, someone whose online friendship you've formally said no thanks to, can see that you've added "Boiler Room" to your favorite movies (sheep) and changed your status from "Billy is working at Bear Stearns" to "Billy is getting a public citation for having relieved himself on the sidewalk in front of Bear Stearns which he wouldn't have had to do in the first place if those FUCKS hadn't fired him." Anyway, try and guess which firm we're talking about via Facebook message (thereby granting me access to see your profile for one week even if we're not friends) and I will respond shortly.

Don't count on a recovery of the mortgage-backed securities business any time soon. Sure, Blackstone says they're going long subprime but Goldman is still short and, more importantly, investment banks are slashing leverage provided to hedge funds for mortgage trades.

Roddy Boyd of the New York Post describes today how some of the biggest prime brokerage banks, including UBS and RBS Greenwich Capital, have cut back on their financing for hedge fund clients.

Brokers' Woes Trim Hedges [New York Post]

It’s an email that many on Wall Street have received countless times by now, forwarded around from one bank to another, often with some minor details changed. It tells the story of an intern at a bank who emails his bosses about needing to take a day off work in October to take care of some family business in New York City. But his bosses discover a picture of him at a party in Worcester, Massachusetts, uncovering his duplicity. Worse, his boss attach ed the picture to a response email to him and BCC the entire North American staff of the bank. And, even worse, in the picture the intern—a young man named Kevin—is dressed a fairy—complete with green wings and a star-tipped wand. “Nice wand,” the boss adds in his email.

Wall Street quickly grabbed hold of the email and it spread like wildfire. It spread through banks and jumped from bank to bank. It was a tale of a quite ordinary employee misdeed—a fib to a boss explaining an unscheduled absence—coupled with a humiliating factory. Overworked and threatened with unemployment and—relative to past years—underpayment, Wall Streeters were happy to enjoy the schadenfreude and, perhaps, the relief that comes from being able to say, “There but for the grace of God go I.”

But is it real? We received the email many times. Sometimes Kevin was an intern at Goldman Sachs. Once at Bear Stearns. Most frequently, however, he worked for Anglo Irish Bank, which has offices in Boston. The confused details—including a Yankee cap supposedly at a Worcester party—left an air of implausibility about the email. And, what’s more, it seemed almost too perfect to be true.

[Spreading more fairy dust after the jump.]

The great write-down debate is well under way. And one thing that is apparent is that there is a lot of confusion about how—or even if—the credit products held by some of our biggest financial institutions should be valued. Merrill’s estimates of its losses jumped from $5 billion to nearly $9 billion in the space of a few weeks, and Citigroup is now saying that downgrades in credit ratings of some of their holdings will result in a fourth-quarter write-down of between $5 billion to $7 billion. Some analysts are expecting write-downs all across the Street.

[More after the jump]

The Treasury's Entity is seen as a Citigroup bailout by lot of people for the very simple reason that it is a Citigroup bailout. That might not be the only thing it is, but stupid is as stupid does, and one thing this stupid thing does (or will do, if it ever gets off the ground) is bailout Citigroup, which is reportedly on the hook for as much as $80 billion from it’s four mammoth SIVs. Since the fund could buy Citigroup's SIVs, it would reduce the amount that Citigroup would need to write off. And reducing write-offs is something Citi desperately wants to do right now.

There’s at least a fair amount of quiet clapping about the Treasury Department’s role in creating the Entity. Citigroup, some say, is too big to fail, and the Treasury Department should step in to prevent the kind of financial market disorder that would come from the toppling of the towering financial giant.

But this kind of logic has some rethinking the wisdom of the financial regulatory reforms that allowed banks such as Citi to grow so large in the first place. When lawmakers reformed depression era laws that stood in the way of these financial super-markets, they tended to sound libertarian notes about allowing financial innovation and the operation of the free market to control the size and scope of Wall Street firms. The era of government planning was over. So the Glass-Steagall Act of 1933, which had separated investment houses from commercial banks—most famously requiring JP Morgan to part from Morgan Stanley—was changed to permit the growth of the universal banks.

Many now think that the universal bank is a failed strategy. From Citi to Merrill to Bear Stearns, there are calls for Wall Street firms to slim down, break-up and concentrate on the core businesses that made them wealthy and famous to begin with. But was it a failure? If growing into financial giants allowed them to unilaterally acquire a secret—and nearly costless—government insurance policy, it seems like a great gamble. The executives and shareholders get the upside, while the broader public insures against failure.

“What a scam that is,” writes William Greider in The Nation.

And it’s a scam the Greider thinks is over. Banking regulation will inevitably make a big comeback, he predicts.

“At least the unambiguous truth about ‘financial modernization’ is now on the table for all to see,” he writes. “That should keep the Wall Street guys from whining for a while about the oppressive nature of bank regulation. The next reform era, when it does finally arrive, will head in the opposite direction--restoring public protections for the little guys against the greedy excesses of big hogs.”

What Greider doesn’t mention is that this era of new regulations might be coming too late. Or, rather, right on time, depending on your point of view. Resistance to a new wave of banking regulation requiring bank breakups and dividing Wall Street according to regulatory fiats rather than market demand is likely to be weak in an era when many think the financial supermarket model has failed and should be abandoned. No-one expends much time, money or energy defending a right to do something they don’t want to do anyway. What’s more, there will be plenty of money made by investment bankers spinning-off, selling and acquiring the fragments they are shoring up against the ruins of the toppled giants. Some of these people may actually be the same ones who made fortunes building the giants.

And we’ll all raise a glass to the only saloon in town where it’s never last call: the Wall Street punch bowl.

Citibank: Too Big to Fail? [The Nation]

In all the talk about losses at individual banks and brokerages, sometimes it's easy to lose sight of the bigger picture. A report issued by the New York City comptroller yesterday nicely pointed to the forest made up by those trees. The collective profit loss at Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup, Lehman Brothers, J.P. Morgan Chase and Bear Stearns was 65%, according to the report. And the damage would have been even worse if not for Goldman's miraculous/evil genius performance.

New York City, State Budget Outlooks Dim as Wall Street Falters [Bloomberg]

Earlier this afternoon we asked if some of the guys at Bear Stearns might be smiling in the darker parts of their souls at the troubles—losses, snakepits, messes, ousting, disorganized succession plans—Merrill Lynch has been going through lately. Or, more likely, some of the guys who used to be at Bear Stearns, like former head of trading, equities, fixed income, energy and asset management Warren Spector.

We thought that maybe the guys who saw first their hedge funds and then their jobs go down the drain after a Merrill led rush of creditors started grabbing their assets—which, for all anyone knows now, might have turned out of have been worthless anyway—might be experiencing some joy at watching credit market losses take down some of the folks who took them down.

This afternoon Portfolio’s politics guy asks the same question but for a totally different reason. “If Stan O'Neal is out at Merrill, doesn't that offer some comfort to the likes of Warren Spector,” writes Matthew Cooper. “Merrill is a case of the guy at the top taking the fall. At Bear, it seemed like the number 3, Warren Spector, took the hit instead of James Cayne. Where's the fairness in that?”

We’re not sure that why exactly anyone would comforted by this. But whatever. Maybe that’s why we’re not writing about politics. But we’re not convinced that Cooper is right when he says that the “guy at the top ought to take the fall when things go so wrong.”

It’s not the first time he’s said it. Back in August Cooper wrote: “It's hard to see why the firm's chief executive, James Cayne, would summarily execute Spector but not take the rap himself. The Buck Stops Here, not there.” But we weren’t convinced that time either.

Cooper’s model is clearly a political one—although we can’t remember when the last time a top guy resigned after being disgraced by the activities of his underlings either. Well, we’ve heard about Nixon but that was a long, long time ago! And Nixon is not usually held up as a model of American leadership. So let’s say Cooper’s is a model an idealistic one that is rarely realized in reality.

It’s hard not to suspect that Cooper is trying for some sort of hobgoblinistic, liberal consistency. Liberals think Bush should step down or get impeached because of the activities of, say, Alberto Gonzalez. So that means everyone should step down when their underlings allegedly lead things off the rails.

But should Cayne go? The market, the business media and the rank-and-file if Bear is hardly clamoring for his ouster. There have been losses at Bear Stearns—and investors in those two ridiculously named funds lost buckets and buckets of money—but not on the scale of Merrill Lynch’s. And, perhaps more importantly, Cayne has left investors and employees with a feeling that he understands what went wrong and is acting to contain the damage. O’Neal failed this damage-control test, in part because he had made enough enemies who went for the kill when they scented blood. And that failure, more than anything else, appears to be what doomed him

That may not be ‘fair’ in some cosmic sense. But Wall Street is hardly a place to be if you want cosmic justice.

James Cayne v. Stan O'Neal [Capital blog, Portfolio]