Jeremy Grantham, chairman at value shop GMO, said that he thinks there will be far more write-downs than is currently assumed, and that to reach the necessary debt levels the U.S. will suffer some serious pain.
“To be successful, we really need to halve the level of private debt as a fraction of the underlying asset values,” said Grantham. “This implies that by hook or by crook, somewhere between $10 trillion and $15 trillion of debt will have to disappear.”

Grantham calculated his figure by assuming write-downs of 50% in equities, 35% in housing, and 35% to 40% in commercial real estate, amounting to a loss of about $20 trillion of perceived wealth from a peak of about $50 trillion. He then estimates private debt — corporate and individual — to be about 50% of that peak level. In straitened times, he said, debt will be lent at closer to a 40% level, meaning that today’s $30 trillion in wealth will lead to ideal private debt levels of $12 trillion.

Grantham believes that there are only three ways to bring private debt levels down in relation to reduced asset values: drastically write down debt, inflate the debt to reduce its real value or adopt the Japanese model of long-term saving.

“Each of the three realistic possibilities…would be extremely painful, each is loaded with uncertainties and even the quickest of them would take years,” said Grantham.
…
Despite his feelings about the broader economy, Grantham sees value in the markets. He recommends investors “slowly and carefully” invest cash into stocks, with a preference for high-quality U.S. blue chips and emerging markets stocks.

Now I have lost over 1/3 of my 401k and personal nest egg. With each new rise in the market, I am encouraged to ride it out. With each dip, I think maybe I should put everything into a money market fund and wait it out. But the thought of making my paper losses permanent when, who knows, Obama and his crew may be able to get the economy on track, has me totally immobilized.

In 1933, he was approached by none other than Adolf Hitler, who commissioned a car designed for the German masses. Porsche accepted, and the result was the iconic Beetle, manufactured under the Volkswagen (lit. “people’s car”) brand. Today, Porsche’s company is one of the world’s premier luxury car brands, while Volkswagen (VW) is itself the world’s third-largest auto maker after General Motors and Toyota.

Three years ago, Volkswagen found itself fearing a foreign takeover. Porsche, the company, decided to step in and start buying VW stock ostensibly to protect the landmark brand, widely fueling market expectations that it would eventually buy Volkswagen outright. Of course, this isn’t quite what came to pass.

For three years, Porsche kept accumulating VW stock without telling anyone how much it owned. Every time it purchased more, the amount of free-floating VW stock would decrease, driving the stock price up slightly; your basic supply and demand at work. Eventually the share price became high enough that, to outside observers, it wouldn’t have made any sense for Porsche to buy Volkswagen. It would simply have cost too much.

To explain what happened next, I’m going to first tell you about a financial maneuver called shorting.

At any given point, only a certain amount of a publicly traded company’s stock is floating freely in the market. The rest is held in various portfolios, funds, and investment vehicles. Now, everyone’s familiar with the basic idea behind the stock market: you buy stock when it costs little, and you sell it when it costs a lot, profiting on the difference.

But that assumes a company’s value is going to increase. What if, instead of betting a company will go up, you want to make money betting the company will go down? You can — by selling stock you don’t own.

Say you borrow a certain amount of stock from someone who already owns it. You pay a fixed fee for borrowing the stock, and you sign a contract saying you will return exactly the same amount of stock you took after some amount of time. So, you might borrow a thousand shares of Apple stock from me (I don’t actually own any, but play along), pay me $100 for the privilege, and sign an obligation to return my stock in 3 months. At the time, Apple stock is worth $10 per share.

After you borrow the stock, you immediately sell it. At $10 a share, you get $10,000. Two and a half months later, another rumor about Steve Jobs’ health sends AAPL crashing to only $6 per share for a few hours, so you buy a thousand shares, costing you $6,000. You give me back those shares. Because you successfully bet the company would go down in value, you earned $4,000 minus the borrowing fee. This is called short-selling or shorting the stock, and the downside is obvious: if your bet was wrong, you would have lost money buying back the shares that you have to return to your lender.

Now things get kinky.

When Volkswagen’s share price exceeded the point where it made sense for Porsche to buy the company, a number of hedge funds realized that Volkswagen shares have nowhere to go but down. With Porsche out of the picture, there was simply no reason for VW to keep going up, and the funds were willing to bet on it. So they shorted huge amounts of VW stock, borrowing it from existing owners and selling it into circulation, waiting for the price drop they considered inevitable.

Porsche anticipated exactly this situation and promptly bought up much of these borrowed VW shares that the funds were selling. Do you see where this is going? Analysts did. According to The Economist, Adam Jonas from Morgan Stanley warned clients not to play “billionaire’s poker” against Porsche. Porsche denied any foul play, saying it wasn’t doing anything unusual.

But then, last October 26th, they stepped forward and bared their portfolio: through a combination of stock and options, they owned 75% of Volkswagen, which is almost all the company’s circulating stock. (The remainder is tied up in funds that cannot easily release it.)

To put it mildly, the numbers scared the living hell out of the hedge funds: if they didn’t immediately buy back the Volkswagen stock they were shorting, there might not be any left to buy later, and it isn’t their stock — they have to return it to someone. If their only option is thus to buy the VW stock from Porsche, then the miracle of supply and demand will hit again, and Porsche can ask for whatever price it wants per VW share — twenty times their value, a hundred times their value — because there’s no other place to buy. They’re the only game in town.

And that, my friends, is called a short squeeze.

Porsche’s ownership disclosure sent the hedge funds on such a flurry of purchases for any Volkswagen stock still in circulation that the VW share price jumped from below €200 to over €1000 at one point on October 28th, making Volkswagen for a brief time the world’s most valuable company by market cap.

On paper, Porsche made between €30-40 billion in the affair. Once all is said and done, the actual profit is closer to some €6-12 billion. To put those numbers in perspective, Porsche’s revenue for the whole year of 2006 was a bit over €7 billion.

Porsche’s move took three years of careful maneuvering. It was darkly brilliant, a wealth transfer ingeniously conceived like few we’ve ever seen. Betting the right way, Porsche roiled the financial markets and took the hedge funds for a fortune.

The selling in equities that occurred in the first full week of trading in 2009 was not overly alarming to investors in the wake of a better-than-expected “Santa Claus rally.” But this week’s action, which saw the S&P; 500 lose more than 4% of its value amid a slight rise in Libor and a bit of renewed concern in the credit markets cannot be easily sloughed off.

The week was dominated by the hijinks of Citigroup and Bank of America, both of whom have discovered, far too late, that building a profitable, successful company for the long haul need not be done by utilizing a strategy that most would associate with taking the 72-ounce steak challenge at the Big Texan Ranch in Amarillo, Texas.

Those that choose to participate in that enjoyable activity only endanger those in the immediate vicinity with the after-effects — whereas the entire country has been forced to react to the banking mess, and to watch the bewildering sight of executives going back to the government kitty to complete an acquisition that they botched the first time around.

But to hear Mr. Lewis tell it, it’s being done out of patriotism. When asked Friday on his company’s conference call as to why the company did not decide to back away from the proposed acquisition of Merrill Lynch when it suddenly realized that the brokerage’s balance sheet was more disastrous than had been thought, Mr. Lewis said that “we just thought it was in the best interest of our company and our stockholders, and the country, to move forward with the original terms and the timing.”

How nice. A company that’s been given tons of money from the government runs back for more money in order to complete a transaction that a prudent manager of risk would have walked away from. Mr. Lewis, it should be reminded, did not successfully land a plane (which included some of his employees) in the icy Hudson River.

Investors had almost become convinced that the banks had managed to pull themselves from the brink even as the U.S. economy nosed closer to the ledge. But with the banking sector still trying to remove itself from the chasm, the drumbeat of layoff announcements picked up this week, from the likes of Saks, Barnes & Noble, Advanced Micro Devices, Pfizer, and the liquidation of Circuit City, which was unable to find a buyer and instead will hold a fire-sale of DVDs and other items.