A new sign of the heavy stress on the banking system: Banks may be driving down the closely watched Libor measures of interbank lending rates by underreporting their borrowing costs. Why? Because, The Wall Street Journal reports, “they don’t want to tip off the market that they’re desperate for cash.” Though the Federal Reserve has put in place ample measures to ensure that cash-strapped banks and brokerage firms can borrow from the Fed in an emergency, it was only a month ago that Bear Stearns (BSC) collapsed following the mass exodus of its hedge fund customer base, and evidently that example looms over the market.

Of course, the notion that statistics are being played with is nothing new. There’s a long-running debate in the media and the blogosphere as to how badly the government distorts its unemployment data, for instance. But the fact that some people believe Libor rates are being artificially depressed is remarkable, because even the artificially depressed Libor has soared in recent months as the credit crunch has worsened. The spread between three-month Libor and the comparable U.S. Treasury note was 1.58 percentage points Tuesday, the Journal reports - more than five times as large as the average spread in the five years up to August 2007.

Yet Scott Peng, an interest-rate strategist at Citi (C), indicates that an accurately reported Libor number could be as much as 0.3 point higher, the Journal reports. He adds that “the long-term psychological and economic impacts this could have on the financial market are incalculable.”

Financial stocks resumed their swoon Wednesday, led by a 5% drop in Citi (C) after Oppenheimer analyst Meredith Whitney cut her earnings estimates on the banking sector. The selloff shows that even after stocks staged a rally in the wake of Monday’s Bear Stearns (BSC) buyout sweetener, investors remain worried about the health of the economy and the ramifications of the credit crunch. While many observers are still puzzling over how we got into this mess, Steve Waldman at Interfluidity offers up a strikingly simple explanation in his Credit Crunch for Kindergarteners.

By James Ledbetter (Colin is off for two days, so you’re stuck with me.)

On Tuesday morning, I asked the assembled financial wisdom at a Fortune.com meeting - this included Roddy Boyd, Allan Sloan, and Shawn Tully - if there was any scenario by which JPMorgan’s (JPM) bargain-bin deal to buy Bear Stearns (BSC) for $2 a share could fail. The answer came back a resounding no, for convincing reasons I will detail below.

Today, though, the answer seems slightly less clear. The Wall Street Journal reports that billionaire Joe Lewis - who owns some 12 million Bear shares - has filed with the SEC to register his dissatisfaction with the proposed deal. (On top of his already substantial holdings, Lewis added 569,000 shares on March 13 at the painful price of $55.13 apiece.) In language that nicely echoes Malcolm X, Lewis says that he and his crew “will take whatever action that they deem necessary and appropriate” to protect the value of their investment. That could mean, the Journal reasonably predicts, making an alliance with Bear employees - who own 30% of the stock - and other disaffected shareholders, like Bruce Sherman’s Private Capital Management, which last I checked owned more than 6% of Bear. Add that to Lewis’s 8% and it’s not impossible to see a majority of shareholder voting to reject Morgan’s shrewd offer.

Could it really happen? My understanding is that, in order to shun the JPMorgan offer, the company would have to declare bankruptcy, and in bankruptcy the shareholders have to get in line behind other creditors, thus by no means guaranteeing a better outcome than $2 a share. On top of that, as Roddy pointed out on Tuesday, such a move would spawn litigation that our grandchildren will still be writing about some day. Moreover, it was argued, it still wouldn’t restore the fundamental asset that Bear has lost, which is credibility: Even if Bear could rise from the dead, why would anyone want to do business with them at this point? Those remain powerful arguments. But even if their plan is a long shot, you could lose a lot of money betting against furious billionaires hellbent on protecting their assets.

By James Ledbetter

You remember the old line about the role of the Federal Reserve being to take the punch bowl away as soon as the party starts getting good? Well, the European Central Bank takes a different view: if you’ve had a little trouble with liquidity lately, don’t worry, there’s an open bar.

The ECB announced Monday it would make “unlimited” funds available at below-market rates to any European bank that might require them, in order to ease the unpleasant effects of the global credit crunch. This move, it is hoped, would make money cheaper for banks to lend to each other, which they’ve been reluctant to do because, as Peter Eavis pointed out last week, private-sector banks have all too clear an idea which ones among them might have a little liquid problem.

The Associated Press labels the ECB move “unusual”; the Wall Street Journal quotes an economist from Commerzbank who calls it “extraordinary.” Which it surely is: how can any bank guarantee an “unlimited” amount of credit? Leave it to the Brits, though, to quash this outbreak of Continental glee; the BBC news site story closes with this gem of understatement:

But some analysts say that until the banks reveal the true scale of their potential losses, the central banks will be unable to do much to ease the credit crunch.

Quite. As Eliot might say: Hurry up, please, it’s time.

By James Ledbetter

(Filling in today for Colin Barr, who’s more than earned a day off.) Financial turmoils that involve vast sums follow definite rhythms, and one predictable beat is the arrival of the subpoena. Yesterday Businessweek.com reported that federal prosecutors are investigating whether bankers at Bear Stearns (BSC) may have pulled their own money out of subprime-backed funds, even while encouraging the bank’s customers to continue to invest. This morning, the Wall Street Journal specifically names fund manager Ralph Cioffi as a target (indeed, the Journal says the sole target) of this investigation, claiming that he moved $2 million of his own money out of two funds just weeks before they famously imploded this spring.

Let’s be clear: no one has yet been charged with a crime, and there could be many explanations for Cioffi’s transfers if they did occur. Still, the tale has such a familiar ring, echoing the actions of dot-com boom bankers who touted stocks to customers while internally telling everyone the companies were dogs. For those who’ve watched the political careers of prosecutors like Rudolph Giuliani and Eliot Spitzer flourish on the backs of Wall Street investigations, however, there is one nagging question: who is Benton J. Campbell? Sure, he’s been the U.S. Attorney for New York’s Eastern District for, uh, two months, but why would his office - located in Brooklyn - have jurisdiction over alleged Wall Street malfeasance, as opposed to the Southern District, which was Rudy’s stomping ground in the ’80s? Anybody out there know?

First Marblehead (FMD) is the latest financial firm buffeted by fears that defaults will soar on all sorts of loans as the economy slows. Shares extended their recent free fall early Friday, dropping 8% after the student lender cut its dividend by more than half and said it won’t try to sell any securities backed by its loans this quarter. Earlier this week, Moody’s said it would review First Marblehead’s ratings; last week, Fitch cut its ratings on First Marblehead’s financial guarantor affiliate, on worries that the unit won’t have enough capital to sustain a sharp rise in defaults on First Marblehead loans.

Worries about the soundness of First Marblehead’s loans have sent the stock down 70 percent this year, in an arc resembling the plunges in financial intermediaries like MBIA (MBI) and Radian (RDN). But at the Motley Fool, Christopher Singley ventures that it may be time to buy First Marblehead. He says the lender has a first-class franchise in an area that’s got strong growth and may be somewhat more insulated from consumer spending worries than, say, car loans or credit cards - two areas where delinquencies have spiked lately. He also notes that at recent trading prices, the stock trades at a price-to-earnings multiple of about 6. “I don’t know about you,” he writes, “but to me, that sounds very, very cheap.”

Investors like Thursday’s bailout of E*Trade (ETFC) by hedge fund Citadel and asset manager BlackRock. Shares of E*Trade rose 4% on news of the $2.5 billion deal, which will give Citadel a 20% stake in the struggling online broker and relieve E*Trade of billions of dollars in toxic mortgage holdings.Supporters of the deal point out that Citadel’s Ken Griffin has an enviable record of buying distressed assets at the right time, and that E*Trade now has enough cash on hand that its continued existence is no longer in question. But  venture capitalist Paul Kedrosky, while acknowledging those positives, makes a crucial point: With the dilution from Thursday’s deal, and the flight of many lucrative customers as E*Trade appeared to be staring into the abyss, E*Trade’s earnings power is sharply diminished.The magnitude of the housing meltdown seems to have obscured that issue somewhat. With well-known outfits like E*Trade, Countrywide (CFC) and Citi (C) nearly running aground, the tendency has been to gape at the billions of dollars in writedowns coming down the pike. How much worse can it get, one repeatedly wonders.

Countrywide (CFC) doesn’t like Mondays. Shares of the struggling mortgage lender posted their third consecutive week-opening decline today, dropping 10% to $8.64 in heavy trading after The Wall Street Journal documented Countrywide’s increasing dependence on cheap Federal Home Loan Bank funding. Fortune’s Peter Eavis earlier noted a breathtaking - and, for taxpayers, deeply concerning - rise in lending by the FHLB to the government-sponsored mortgage investors, Fannie Mae (FNM) and Freddie Mac (FRE).

After Monday’s Journal story appeared, Senator Charles Schumer urged regulators to look into the sharp rise in FHLB lending to Countrywide. Schumer seems particularly concerned about the soundness of the collateral Countrywide has pledged to secure the loans, or advances, from the regional home lenders. The Journal reported that Countrywide has pledged $62 billion in collateral to secure $51 billion in advances — meaning Countrywide is getting about 82 cents on the dollar for the collateral it has surrendered to the FHLB.

We don’t know much what the FHLB took as collateral, beyond the dollar figure. But given that many nongovernment debt markets essentially have frozen up again in recent days, making just about any loan unsaleable at any price, it doesn’t sound like Countrywide is getting a bad deal. Whether the same can be said for John Q. Public remains to be seen.

Financial stocks are in free fall again. Round up the usual suspects: Fannie Mae (FNM) and Freddie Mac (FRE) were off around 8% amid the latest worries over their capital strength. E*Trade (ETFC) slid 10% as Wall Street decided a buyout of the mortgage-burdened online trader might not fly after all. Citi (C) shares fell 5% after CNBC reported Citi could cut as many as 45,000 jobs. Citi denies having decided on a layoff target but says it seeks to be “more efficient and cost effective to position our businesses in line with economic realities.” Economic realities are hammering other parts of the market as well. Banks continue to shy away from lending to one another, sending interbank interest rates such as Libor higher. The Fed, in turn, resorts to what David Merkel calls “half measures” such as a push to provide extra liquidity through year end. Merkel points out that the Fed doesn’t want to cut rates, because it would like to avoid further declines in the dollar and resulting inflation pressure, but the near panic in the market seems to suggest it won’t have much choice.

Three big-name economists have a distinctly gloomy view of the world this morning. In the Financial Times, former Treasury Secretary Larry Summers joins the crowd predicting the United States will tumble into recession under the weight of a spreading credit crunch. He says the Fed should ease rates further to stave off a deepening credit crisis, as “levels of the Fed funds rate that were neutral when the financial system was working normally are quite contractionary today.”

In the New York Times, Yale economics professor Robert Shiller warns the housing crisis is deepening. He calls for a fundamentally new approach to staving off foreclosures and keeping Americans in their homes, including changes to bankruptcy law and a rethinking of the role of institutions such as Fannie Mae (FNM). He calls the official response to the housing bust and related credit issues “anemic.”

And not to be outdone, NYU economics professor Nouriel Roubini says on his website that the 3.5% decline in American consumers’ average Black Friday spending shows that a U.S. hard landing and global slowdown are inevitable. He even calls for a stock market crash, saying, “Once the evidence of an economic hard landing is clear even to stock market investors – it is certainly clear to bond markets and to credit markets by now – you can expect a sharp fall in stock prices, a process that has already started in financial stocks, discretionary consumer stocks, retail stocks and housing related stocks.” Nothing like starting the week off on an upbeat note.