September 2008 Archives

The Wachovia model

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It appears that many Members of Congress who voted against the financial bill yesterday think they saved the taxpayers a lot of money. They need to think again. This is a case, to quote the old auto oil filter ad, of "pay me now or pay me later." The cost to the American citizenry will be high -- from direct costs of FDIC insurance payouts on failed banks and higher unemployment insurance to the indirect costs of what Steven Pearlstein warns may be "a decade of little or no economic growth."

As Pearlstein notes, the action is already shifting from Treasury to the FDIC. The Wachovia deal is a case in point. The New York Times ("In the Wachovia Sale, the Banking Crisis Trickles Up") describes the heart of the deal:

Citigroup will pay $1 a share, or about $2.2 billion, for Wachovia’s banking operations. Citigroup will assume the first $42 billion of losses from Wachovia’s riskiest mortgages and transfer to the Federal Insurance Deposit Corporation $12 billion in preferred stock and warrants. In exchange, the F.D.I.C. will absorb all losses above that level.

This action was precipitated by a different type of bank meltdown. As the Wall Street Journal ("Citi, U.S. Rescue Wachovia") explains:

Wachovia's motivating factor was not a run on the bank. While the bank and its regulators were nervous that depositors would start yanking their funds, it didn't happen; the bank was fully liquid and hadn't needed to borrow from the Fed.

The bigger problem was a prospective downgrade of Wachovia's debt by Standard & Poor's and Moody's, which representatives of the two ratings agencies had informed Wachovia could occur by Monday. That had the potential to sow greater fear among Wachovia investors and customers, not to mention increasing the bank's borrowing costs just as a batch of its debt was set to mature.

It was Wachovia's portfolio of toxic assets that was the problem. Or should I say presumed portfolio, because without a market it is next to impossible to determine what these assets are really worth. Thus, it was not a liquidity problem, but a credibility problem.

That sets up a different type of rescue operation that the standard injection of liquidity everyone is talking about. As the Financial Times ("Citigroup avoids missteps of other bail-outs") notes:

The Wachovia deal is notable because the government – in the form of the Federal Deposit Insurance Corporation – is taking much of the risk on Wachovia’s portfolio of toxic assets in return for a potential ownership stake in the combined bank.

In other words, the Citi-Wachovia deal accomplished the same end goal as the requested Troubled Asset Relief Program (TARP). Even the Wall Street Journal editorial board ("Pre-emptive Plumbing") -- a group I rarely agree with --liked the deal:

But the good news is that regulators are starting to take the initiative in forcing quick resolution at the most troubled banks, handing them off to stronger competitors and working creatively to contain the risk of contagion. It's a far sight better than the political gamesmanship that still consumes the adolescents on Capitol Hill.

What worries me, however, is that this was a rescue in an ad-hoc rather than systematic manner. With the collapse of the Paulson plan, ad-hoc may be all we have. We are already well down that road, as the following graph from Wall Street Journal ("Bailout Plan Rejected, Forcing New Scramble to Solve Crisis") illustrates:


So, pay now or pay later. And, as the auto mechanism in the ad implies, later is always more expensive.

A question of credibililty

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I don't know how the current financial crisis will work out after yesterday's House vote. I suspect, as I mentioned yesterday, that nothing will happen until the level of pain from the credit market meltdown is apparent on Main Street. Right now, the connection between the bailout and daily life is not seen by most Americans. Until that connection is made (which, of course, will be after the pain becomes intense and possibly far too late to prevent the worst of the pain), the plan will be see as an unfair reward to economic greed.

Compounding the problem is the complete lack of credibility on the part of the Administration. The ugly truth is that American people (and even members of the President’s own party) simply don't believe what the President and the Treasury Secretary are saying. And, sad to say, Secretary Paulson did himself no favors by starting out with a proposal that screamed of the Imperial Executive. I recognize that sometimes our legislation is far more complicated than it needs to be. But it was not the starkness of the 3 page Treasury position that got it into trouble. It was the explicit exemptions from any sort of oversight and accountability that grated so much.

One must be careful of drawing to much from historical analogies. But, as the saying goes, while history may not repeat, it often rhymes. In this case, that analogy is with 1932. I believe we may be in a similar situation as then -- not for the economic parallel but for the political. By 1932, the Hoover Administration had lost all credibility in fighting the economic downturn we would later call the Great Depression. But that did not stop President Hoover from advocating his policies, even after the election. Arthur Schlesinger, Jr.'s great work The Crisis of the Old Order: The Age of Roosevelt describes the moment. For five months (back then the Inauguration was not until March), outgoing President Hoover tried to get incoming President Roosevelt to commit to some of his (Hoover's) policies. Roosevelt steadfastly resisted until he had the reigns of government firmly in his grasp -- thereby insuring the his response was his and his alone, not compromised by have to have the previous Administration either craft parts of it or completely implement it. Part of what Roosevelt understood was the necessity of creating a strong foundation of credibility to address the problem untainted by the past. A new beginning, as it were.

Such will be the task of the next Administration -- either Obama or McCain. So I fear that the situation of governance, not simply the exigencies of politics, will prolong this crisis into January.

Things have changed since the days of FDR. In part, the Inauguration has been moved up two months. There is more of a sense that the incoming President can claim power (and is seen as responsible) immediately after the election. But it will still be a lame-duck President and a lame-duck Congress during those two months. And the credibility of a lame-duck is very weak.

Thus, I see no quick resolve to the underlying crisis of credibility. Until that crisis is resolved, we can't even begin to approach the financial and economic crisis confronting our nation. While this may not be a repeat of 1932, the rhymes are pretty strong.

What next?

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Now that the Congress (mostly GOP members) voted down the bailout, what happens next? I don't know. But a friend of mine reminded me that tomorrow is the last day of the 3rd quarter. Lots of financial things happen at the end of a quarter.

According to news reports, the House will go out for the Jewish holidays and reconvene on Thursday. That will give time for both the leadership to work on a new plan and for Members to gauge the thinking of their constituencies. It remains to be seen whether they are greeted with a "Holy S--t" reaction to the vote - or an "Atta boy". How much new pain emerges in the next few days may determine that response. And tomorrow's end-of-quarter maneuvering will have a lot to do with that.

Technology innovations awards - Wall Street Journal

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In other news, the Wall Street Journal has published its The 2008 Technology Innovation Awards. Check it out.

The heart of the matter

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Here is what I think is the best description of the heart of the bailout plan -- from Steve Lohr's column in the New York Times Bailout Is Only One Step on a Long Road:

The rescue package, if successful, would make the recognition of losses and the inevitable winnowing of the banking system more an orderly retreat than a collapse. Yet that pruning of the banking industry must take place, economists say, and it is the government’s role to move it along instead of coddling the banks if the financial system is going to return to health.

Japan’s experience in the 1990s is a cautionary example of the peril of propping up banks after a real estate boom ends. The Japanese government helped keep many troubled banks afloat, hoping to avoid the pain of bank failures, only to extend the economic downturn as consumer spending and job growth fell.

The Japanese slump continued for many years, ending only a few years ago, a stretch of economic stagnation known as Japan’s lost decade.

“The lesson from Japan is that tough love for the banks is what’s needed,” said Kenneth Rogoff, an economist at Harvard. “In the current crisis, you do want to get rid of the bad assets from the banks, to get markets working again. But the key is going to be in the details of how the bailout works. You don’t want it to be a subsidy in disguise that keeps insolvent banks alive. That would just prolong the economic pain.”

As I've noted before, there is going to be a fair amount of blood on the floor before this is over. The legislation attempts to deal with some of the past bleeding by allowing banks to take a tax-deduction on their losses on Fannie/Freddie stock -- Section 301 of the bill. (In the interest of complete disclosure, I own stock in a community bank that has had to write-off its investment in Fannie/Freddie). But clearly the work is only beginning.

So, to paraphrase Churchill, "while this may not be the beginning of the end, it may be the end of the beginning."

The innovation agenda

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Yesterday morning I was at the Information Technology and Innovation Foundation (ITIF) conference on Innovation Economics for the Next Administration. A lot of great discussion - much of which was based on two papers on the ITIF website: An Innovation Economics Agenda for the Next Administration and Economic Doctrines and Policy Differences: Why Washington Can’t Agree on Economic Policies.

The National Journal's Tech Daily summarizes:

One study describes how three traditional economics doctrines – conservative neo-classical (supply-side), liberal neo-classical (Rubinomics), and neo-Keynesianism – have dominated thinking in Washington. It explains how innovation economics, which is based on an explicit effort to understand and model how technological advances occur, should be the path of the future. A companion report argues that putting innovation at the center of U.S. economic policies can spur economic growth and raise standards of living.

ITIF offers eight policy ideas to drive innovation-led economic growth:

1) Significantly expand the federal research and development tax credit
2) Create a national innovation foundation
3) Allow foreign students receiving graduate degrees to get a green card
4) Reform the patent system to drive innovation
5) Let companies expense new investments in IT in the first year
6) Establish a federal chief information officer
7) Implement a national broadband strategy
8) Implement an innovation-based national trade policy

Bottom line of the conference was that innovation is a key part of our economic strategy - but that policymakers need help in both understanding it and making the political case. In that regard, I was especially struck by the comment of Mike Mandel (of BusinessWeek) early in the morning that the US has failed in innovation -- not that we haven't created new stuff, but that we have failed to turn innovation into job creation. Invented here; produced over there. That seems to be the problem.

Re-establishing the connection between innovation and employment/incomes needs to be a major part of the new strategy. It is also part of the problem discussed at the New America Foundation forum a couple of days ago of reconnecting the link between productivity and wages (see earlier posting).

Rather than try to capture the entire discussion, I want to cherry pick a couple of ideas. One was the issue of measurement of innovation. As Mike pointed out, we do a good job of measuring consumption, but not innovation. Professor Richard Lipsey made the excellent follow on point that even when we think we are capturing innovation -- in the form of total factor productivity -- we aren't because we can't separate out the innovation (I would say intangibles) embedded in out machinery and products.

The second point had to do with patents. Michael Katz made the useful distinction between stronger patents and broader patents. In the current debate, we tend to confuse the two. A patent that has more coverage (broader) is automatically assumed to be stronger, especially by the more-is-better crowd, since it extends patent rights. I think that we need to strengthen patents rights by making patents better, not broader. As Jonathan Baker pointed out, the recent trends in broadening of patent rights played almost no role in the rise of Silicon Valley, for example (as the broadening came after the creation of the innovations, not before). Other mechanisms of appropriability -- such as first mover advantage, speed to market, and tacit knowledge -- were far more important.

The importance of these other mechanisms should our focus -- if we are to truly understand the innovation process in the I-Cubed Economy.

Get ready for even worse economic news

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To add to all the drama, the latest numbers on the housing market are not good: sales of new houses down 11.5% in August. But that is not the worst part, as the Wall Street Journal explains:

The data show that the housing market was weakening even before the latest flare-up in credit markets -- which will likely depress activity further as potential buyers face more difficulty getting loans.
"Given the freezing up of the credit market, we do anticipate that the September and October data will be frightening," said Joseph Brusuelas, chief economist at Merk Investments in Palo Alto, Calif.

So get ready for more bad economic news in the future.

Price discovery

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In a posting yesterday, I noted how the key to the Paulson/Bernanke financial plan was price discovery (and how that is important in monetization of intangible assets as well). Today there have been a number of comments on price discovery. Here are a few.

Floyd Norris in the New York Times notes:

And how would that price be determined? Mr. Bernanke thought “auctions and other mechanisms could be devised that would give the market good information on what the hold-to-maturity price was for a large class of mortgage-related assets.” That strikes me as dubious at best. Auctions of disparate securities with one eager buyer and sellers of varying desperation may show something, but it is unlikely to be the “hold-to-maturity value.”

To estimate such a price, you need to make assumptions on how many defaults are likely, and how severe the losses will be, for each group of mortgages that was securitized. The correct answer will depend in large part on how long house prices fall, and how severe the recession is. If you think you know all that, then you can make a good estimate of value.

The nature of securitizations is that the losses arrive in lumps. A given security might meet all its payments if the mortgage pool backing it suffered losses of 5 percent, and be wiped out if the losses reached 6 percent. Change your assumption a little, and the value may change a lot.

But coming up with any kind of fair value was not the real objective. Instead, the goal was to recapitalize the banking system by placing a floor under the prices of securities that never should have been issued.

The Financial Times also notes the problems with this approach:

Furthermore, it is debateable how much information will be created by the price-discovery process in the government auctions.

Since each security is so different, investors may regard marks based on these government prices as meaningless.

For the plan really to work the government will have to devise an effective new vocabulary for standardising mortgage- backed securities.

This may sound simple but it has eluded the private sector for more than a year now.

I understand, but disagree. I think the Wall Street Journal gets it right:

Economists and market experts agreed that a government purchase of distressed assets would help reveal the extent of losses at financial institutions, a necessary step before the financial sector can rebuild itself.

Many financial firms are holding assets on their books at unrealistic prices, in part to avoid taking necessary write-downs that accounting rules require when an asset becomes impaired. Because the market has frozen for these assets, companies have been able to avoid reflecting their real value on their books.

. . .

With Treasury buying these assets in the open market, every institution, whether or not they participate in the program, would have to reflect market prices on their books.

"The market for many of these mortgage-related assets is so illiquid that there's very little price information out there," says Matthew Slaughter, an associate dean at Dartmouth's Tuck School of Business. "Once the government begins buying assets it will help the firms themselves, their investors, and their counterparties better understand their current balance sheets."

As Arthur Levitt and Lynn Turner argue in their op-ed (How to Restore Trust In Wall Street -

There is a direct line from the implosion of Enron to the fall of Lehman Brothers -- and that's an inability for investors to get sound financial information necessary for making sound investment decisions.

But, of course, simply restoring trust may not be enough. Paul Krugman argues that equity sharing provides the necessary compliment:

Why is that so important? The fundamental problem with our financial system is that the fallout from the housing bust has left financial institutions with too little capital. When he finally deigned to offer an explanation of his plan, Mr. Paulson argued that he could solve this problem through “price discovery” — that once taxpayer funds had created a market for mortgage-related toxic waste, everyone would realize that the toxic waste is actually worth much more than it currently sells for, solving the capital problem. Never say never, I guess — but you don’t want to bet $700 billion on wishful thinking.

The odds are, instead, that the U.S. government will end up having to do what governments always do in financial crises: use taxpayers’ money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably have done this by buying toxic waste for much more than it was worth — and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that’s what the equity sharing is about.

Bottom line: I continue to believe that price discovery is an important part of the process. But it is one that will leave a lot of blood on the floor before it is over (as everyone finally writes down these assets). Thus, the Paulson/Bernanke plan is just the start. The next President and the next Congress will have a lot more work to do.

Using auctions to price hard-to-price assets

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Here is good description of how an auction for hard-to-price assets might work -- from
Economists Look at Ways to Structure Auctions -

Auction experts say the best solution would be for the government to bring experienced buyers into the auction process so it wouldn't be the sole buyer. Absent that, there are techniques the government could use to force sellers to disclose what they believe the appropriate prices are, said University of Maryland economist Lawrence Ausubel.

He said he thinks the government should hold an auction in which it announces its intention to buy some of the amount outstanding of a security -- perhaps half. It would then start the process by setting a relatively high price for a security at which presumably all the firms that hold it would want to sell all they own. Then the government would set the price progressively lower until the holders, either by dropping out or reducing their bid sizes, were willing, overall, to sell no more than half of what they own.

The "winners" of the auction would get to sell, but the losers, who were unwilling to sell cheaply, would benefit as well, because the price the government paid in the auction would help establish what a reasonable price for the security is, helping to re-establish the market for such securities. "Once the government establishes some liquidity, the private market may finish the job," said Mr. Ausubel.

Key is price setting. In essence, this is what the OceanTomo IP auctions have been doing for patents. The systemic benefits from these auctions extend far beyond simply serving as a clearinghouse for IP transactions (as important as that is). The auctions give the rest of the market a starting point for private transactions by providing price data. That is not to say that negotiations don't take place without price data. But once a generally accepted reference point has been established, the negotiations run a lot smoother and with less transaction costs.

So, Mr. Ausubel is exactly right. Set up a way to get some generally accepted price points and the market will start to work again. After all, a major cause of illiquidity is the lack of confidence - and that lack of confidence is due to uncertainty - on both price and the ability of your counterparty to fulfill their obligations. Reduce the price uncertainty and you can help reduce the illiquidity.

Buffett and Morgan - part 2

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In a couple of earlier postings, I raised the question of whether Warren Buffett could play to the old role of J.P. Morgan in calming financial markets. Well, the answer is a qualified yes. Yesterday, the markets did not turn around on the news of Buffett's $5 billion investment in Goldman Sachs, but they did stabilize somewhat on that news. Obviously, the current Wall Street rally (up almost 250 point as of this writing) is due to the announcement of a pending deal on the financial package. But the Buffett action may have boosted confidence enough to set the stage for the current rally. In the current financial situation, that may be good enough.

What financial crisis do to people's thinking

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At yesterday's New America Foundation forum on (see earlier posting), some one quipped that "just like there are no atheists in foxholes, there are no libertarians during financial panics."

Today' that statement was reinforced with the following editorial in Investor's Business Daily (IBD) - It's Time To Act advocating for the bailout -- oh, excuse me -- the "rescue."

For those who don't know, IDB's editorial page usually makes the Wall Street Journal look absolutely pinko. I guess you're ideological position really does depend on who is getting "rescued."

Why we need Freddie/Fannie like institutions

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From Bernanke's comments today in front of the Joint Economic Committee:

Mortgages that are ineligible for credit guarantees by Fannie Mae or Freddie Mac–for example, nonconforming jumbo mortgages–cannot be securitized and thus carry much higher interest rates than conforming mortgages.

In other words, without someone like Fannie or Freddie offering a guarantee, the mortgage securities market isn't happening. That may be fine with the uber-critics of securitization. But the truth is that the basic vanilla model of securitization has served us well (including through lowering rates). It has been the abuses that have done us in -- the over the top, "covenant-lit", "we-don't-understand-the risks" deals.

The same lesson holds true for intangible assets. Where there is sound underwriting, there will be sound deals. And having an institution to provide credit guarantees based on sound underwriting -- similar to the conforming mortgage requirement -- will open up the sound and safe monetization of intangible assets.

Setting the value on junk

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Yesterday, Ben Bernanke also answered I question I poised earlier: how are they going to value these assets? The answer: expected cash flow. The reason for using this method (often referred to as "hold-to-maturity") is to inject more liquidity into the system (so banks and other holders of this toxic debt don't have to write it off almost completely as they would under "fire-sale" prices). (For an explanation, see today's FT, "Bernanke squares virtuous circle".) The problem is, of course, that using these higher prices means that the losses to the taxpayer will be greater.

However, while expected cash flow is a tried and true method (and potentially even an appropriate methodology if the government is really going to hold the underlying 30 year mortgages to maturity), it may be rather difficult in cases where the financial instrument is the second derivative of a potentially useless warrant on a loan with an undeterminable probability of default. Martin Wolf reminds us, "these assets are illiquid precisely because they are so hard to value."

So I think my question remains: how will they value these illiquid or thinly traded assets? The answer will come through trial and error, I'm afraid, as the process unfolds. The answer will also potentially have, as I noted before, a large impact on how we value intangible assets.

Cash is King ... and intangible are targets

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Everyone knows that in a downturn, cash is king. And the king of cash right now (other that Hank Paulson) is Warren Buffett. So, what is Buffett buying? Goldman Sach -- to the tune of a $5 billion investment. And why Goldman Sach?. As the Washington Post explains:

Buffett has long touted the value of investing in well-known brand names such as Coca-Cola and Kraft because they can charge premium prices for their products and services. Goldman Sachs is no exception.

In other words, Warren Buffett knows the bottom line value of intangibles. Brands are powerful because they sell more products and more expensive products. As I have long argued, intangibles are not some separate factor out there -- they are part and parcel of economic life. Intangibles have power because they are connected to the goods and services we buy everyday. Intangibles are either used to somehow make those goods and services more valuable or they are useless. An unused intangible has no value until and unless it is put to work. And all work embodies some intangibles. Thus, it fair to say that the entire economy is the Intangible Economy.

Economic Turmoil

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I spent much of yesterday at the New America Foundation forum on Confronting Economic Meltdown – a timely meeting and one that was one hearing room over from the Paulson/Bernanke show in the Dirksen building.

The general mood of the meeting I was in was probably more optimistic than next door. That may sound a little odd, given that almost every one of the forum participants agreed that the cost of the plan would be greater than the $700 billion price tag and that there was genuine skepticism that it would even work. As Leo Hindrey pointed out, there are a lot of other credit problems out there beyond bad mortgages.

The collateral damage is also expected to be high: higher Federal debt; higher interest rates; less funds for other important government spending; higher inflation; lower dollar; and greater reliance on foreign sources of capital.

The optimism in the room came from the shared sense that the age of de-regulation and anti-government was over. So while there was a feeling that the country is in grave trouble, there was also the feeling that something could be done about the situation. Most agreed that the Paulson plan was not enough. Sherle Schwenninger called for a more robust recovery program (see also his paper An Economic Recovery Program for the Post-Bubble Economy). Tom Gallagher noted the need for “non-traditional policy responses”. Others, including Ralph Gomery, called for a realignment of corporate interests with the national interest and for a reconnection of the linkage between productivity gains and wages. There were also calls for a strategy to re-vitalize manufacturing. Bruce Stokes called for a new trade strategy based on reciprocity rather than MFN (most-favored-nation) status – meaning that you cut deals with specific countries based on how they treat your companies and products.

Two comments especially caught my attention with respect to the I-Cubed Economy. Harold Meyerson mentioned the role of unions in building social capital. The example was Las Vegas versus Reno. The Vegas workforce is highly unionized – and much better paid and more productive – compared to those working in the same industry in Reno. One of the reasons is that the unions work at skill upgrading. When I talked to him afterwards, he referred me to his piece in The American Prospect - "Las Vegas as a Workers' Paradise", which explains:

When workers apply for employment at the Vegas hotels under contract with Local 226, they go to the union hall for a skill assessment. If they have no experience, or wish to improve their skills, they are referred to the local's Culinary Training Academy. There, they are offered free courses in every nonmanagerial aspect of hotel work. The academy is funded entirely by employers, who in the latest contract with the union agreed to pay 3.5 cents per worker per hour to fund the training, with a curriculum developed jointly by management and labor.

Here is a perfect example of the type of action we need in the I-Cubed Economy: one that invests in intangible assets!

The other comments were from my friend Pat Choate on the importance of intangible assets (although he referred specifically only to intellectual property). Over twenty years ago, Pat wrote a prescient book on the future potential of the US economy, The High-Flex Society. Unfortunately, over the past two decades we have failed to implement Pat’s recommendations and consequently have failed to create the workplace and workforce we need for the 21st Century.

He also talked about the need for reforming and strengthening the patent office. While I disagree with him on some of the specifics of patent reform, Pat clearly understands how the economy has changed and the importance of intangible assets.

The final part of the meeting was a talk by former Senator Ernest “Fritz” Hollings, highlighting his new book, Making Government Work

While I don’t agree with all of the Senator’s policy positions, I always enjoy listening to him. His work on technology and economics was groundbreaking, including the creation of the Manufacturing Extension Partnerships (MEP). These are rightfully called the “Hollings” centers. I am looking forward to reading the memoir. It should give an insightful look at the workings of Washington and more than few tidbits of wisdom on how we should confront the I-Cubed Economy.

Almost hidden away in the meeting was announcement of another way to prepared for the I-Cubed Economy. New America Foundation is launching a new program to under take a SWOT analysis of the United States. SWOT stands for Strengths, Weaknesses, Threats, Opportunities - and is a basic first step in preparing a strategic plan. It was noted throughout the meeting that other countries act strategically in their own interests with respect to their economic policies. Yet, the US steadfastly refuses to do so.

The need to think strategically about the US economy and to understand the economic changes is a core belief here at Athena Alliance. Four years ago, proposed the creation of a Commission on the Future of the US Economy. Based on our analysis of the new competitiveness challenges, the mandate of the Commission would be

to analyze the current economic environment and competitive challenges facing the U.S. workers and companies; review the strategies of other nations for responding to the competitive challenges of the new economic environment, and analyze the impact of those strategies on the future of the U.S. economy; and formulate specific recommendations on a broad range of issues related to the development of the nations’ skill-base and innovative capacity within the private and public sectors of the U.S. economy.

We hope this new initiative by the New America Foundation will set us on the path to accomplish the same goals.

Part of the fix

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Martin Baily and Bob Litan at the Brookings Institution have released a new paper, A Brief Guide To Fixing Finance. While it is an analysis and a set of suggestions on the mortgage mess and the general financial meltdown, there was one proposal that caught my attention as relative to intangible assets: "For asset-backed securities: public reporting on characteristics of the underlying assets."

Amen to that -- and to more. Since the vast majority of company value is in intangibles, we need public reporting on the characteristics of all intangible assets - whether underlying an asset-backed security or underlying the economic prospects of a company.

Mandated such disclosure for asset-backed securities will move us a step closer to greater disclosure of all intangible assets. If the characteristics of intangibles underlying existing intangible asset-backed securities are required to be disclosed, then a template will be de-facto created for the disclosure of the characteristics of all intangible assets. Such a de-facto standard will go along way to regularizing the role of intangibles in the corporate and financial systems.

Financial re-arrangements

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It is more than ironic. While the neo-cons are mounting a full court press to burnish the Bush legacy on foreign policy grounds, events have conspired to create a situation where the Paulson/Bush economic policy has potentially a more lasting impact. The financial meltdown and the government interventions already implement by Treasury Secretary Paulson have re-arranged the landscape -- to say nothing of Friday's proposed massive buyout of toxic assets. Already the investment bank model has disappeared, practically over night, as Goldman Sachs and Morgan Stanley converted to commercial banks (see Washington Post, Financial Times: Goodbye investment banks, Goldman and Morgan Shift Marks End of Era in Finance -, and Wall Street Journal. The new authority proposed for the Treasury to deal will the mortgage-related securities mess is extremely broad (see Legislative Proposal for Treasury Authority To Purchase Mortgage-Related Assets - and Treasury News Release: Paulson Outlines Comprehensive Approach to Market Developments). Left unsaid in this proposal is the next step: the comprehensive set of regulations to reconstruct the broken system. It is unclear whether we will see the outline of these regulations come out of the Bush Administration (other than what Sec. Paulson has already proposed - see earlier posting). And while those new rules are a necessary parallel to the funding proposal, there is simply not enough time to build the needed consensus, especially at the end of a contentious election process. Conceivably, Congress could come back in a lame-duck session -- but the new Administration will probably want a large say in any such fundamental changes. So the architecture of the new financial regulatory system will wait until next year.

In the meantime, all eyes are focused on the short term fix. Key to making that fix work will be the process used to determine value. As the Financial Times notes:

Until now there has been no real transparency in how any of these now toxic securities have been valued, despite pages of tortured explanations in Wall Street quarterly reports.
The combination of actual trades, dealer estimates and models with varying inputs has resulted in subjective judgments with little consistency across firms.

Treasury would like to use market mechanisms, such as reverse auctions, to set the price. But, since the entire reason for the plan's existence is the failure of these market mechanisms, it is likely that alternatives will be needed.

For the future monetization of intangibles, this may be a blessing in disguise. The mechanisms that Treasury will eventually come up with may be applicable to the thinly traded asset class of intangibles as well.

When the new Congress and the new Administration take over in January, one of the first orders of business will be those new financial regulations. As they undertake this task, we need to make sure that the system created recognizes the role of intangible assets and is set up for the 21st Century - not the 19th.

Reconstituting lending standards

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Louis Uchitelle's column in today's New York Times describes the main street fallout from financial meltdown (Pain Spreads as Credit Vise Grows Tighter). As the credit crunch works its way down the economic chain, the result "will force businesses and consumers to cut spending more than they already have."

Lenders of all types had already been raising the bar for borrowers, turning away all but the best customers. This week, they became even less willing to part with their money, further crimping budgets and family spending.
. . .
“With marginal lenders in trouble, we have more people than ever coming to us for loans,” said Brad Rock, chairman of the Smithtown bank. “So all of a sudden, we can be much pickier in deciding what loans to make and how much to lend.”

Smithtown is an example of the type of lending that will survive:

The winners so far are the Brad Rocks of America, the bankers who have emerged unscathed, their capital intact and with enough retained earnings to support lending, on their terms. A residential mortgage from Bank of Smithtown requires 20 percent down and clear evidence of adequate income to repay the loan, as well as a good record of paying down debt.

Bank of Smithtown specializes in small businesses — the stationery stores, pizza parlors and pharmacies of eastern Long Island with annual revenue of $2 million or less, regularly in need of bridge loans, for example. During the credit boom, Mr. Rock said, many of these business owners went to lenders who required, as he put it, nothing more than a tax ID number to qualify for a loan.

“Now many of these lenders are gone,” Mr. Rock said, “and the small-business borrowers are coming to us, and we are doing good old-fashioned underwriting, and the result is that fewer people are getting loans.”

Old fashioned underwriting is exactly the way things are going. But, even more so. As the reoccurring problem of credit lock up shows, the system has a tendency to swing the other way -- from lend on nothing to don't lend at all.

Key to a functioning credit system is the underwriting standards Mr. Rock implicitly refers to, such as 20% down and a verified income stream. However, a reversion to “good old-fashioned” lending standards is likely to be as inappropriate for coming decade as the "anything-goes" standards of the past decade.

The reason: the rise of intangible assets. More and more economic value is based on intangibles. But intangibles are normally not considered "assets" for purposes of collateral. Yet, many intangibles are bought and sold and have income streams associated with them. There is no reason why they should not be used to back a loan.

Utilizing intangibles in the financial system will not be easy - as the call will be for a return to hard economic assets based on economic "sanity" and reality. Many will undoubtedly not see intangibles as "real" assets - regardless of their demonstrable value and past practice (note, patents have been used to secure loans since at least 1837 when the first trade secrets case in the United States involved the debt on a bond secured in part by a secret chocolate-making process. In 1884, Ara Shipman loaned Lewis Waterman $5,000 to start a pen-manufacturing business, secured by Waterman’s patent.) In large part, this is because there are no acceptable standards for classifying and valuing intangibles or for lending against them. Each deal is essentially a one-off, as we continue to re-invent the wheel.

As we reconstitute good old-fashioned lending standards, by all means, let us make sure that those standards are based on economic reality. But let us make sure that this is the reality of the 21st Century not that of the 19th Century. Creating underwriting standards for intangibles is the first step in embracing this new reality.

Reputation - continued

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In previous postings, I've discussed the concept of reputation as an intangible asset. Over at Intellectual Asset Management, they have a timely posting on Reputation as risk: a lesson from the financial markets. The entry highlights a soon to be published article by Nir Kossovsky, executive secretary of the Intangible Asset Finance Society and CEO of Steel City Re, and New York intellectual property attorney Jorge Torres on the linkage between reputation and stock price volatility. It should come as no surprise that reputational risk is highly correlated with volatility.

While the financial services industry (which strongly relies on trust as an operating factor) is especially vulnerable, the issue is widespread. As my friend Nir notes in a separate comment:

“Ironically, Lehman Brothers was felled by the same vortex of forces that a year ago, turned Barbie’s accessories into toxic waste and knocked off $2 billion from Mattel’s market cap. That vortex was created by the complex forces at play in Mattel’s business network, ie, its supply chain. Today, flat and lean organisations, like Mattel, that outsource non-core functions, are unencumbered by physical assets and are instead rich in intangible asset value. Their superior returns on assets are highly dependent on complex business networks. Mattel depended on offshore suppliers who, in turn, depended on offshore factories. Lehman depended on a global network of banks and other organised sources of capital. That network’s crisis of confidence and its resulting failure to supply the required liquidity mortally wounded a storied investment firm.”

In a comment on the posting, Mary Adams notes that:

"Perceived" is the operative word. The lack of good information about the strength of intangibles is a barrier to transparency and appropriate pricing of public firms. Lack of transparency and confidence in the available information about intangibles means that any indication of trouble will lead to a dramatic reaction by the market in the logic that "where there is smoke, there must be fire." The market is always valued on perceptions. So the question is how perceptions and reputations can be improved.

I agree - to a point. Reputation and brand is built on something; perceptions are based somewhere in reality, admittedly sometimes distorted. In the case of a distorted reality (malicious rumor etc), transparency and information flow is important. But, a company that sells toxic toys is going to have problems, no matter how well the reputation is managed. A bank that bases its capital position on risky assets is going to have problems. Transparency in these cases shows that there is a problem. The key factor then becomes not transparency, but how quickly the company recognizes and corrects the problem. The ability to "make things right" maybe the key intangible capability operating here.

So perception management and the capability for operational improvement need to married if reputational peril is to be avoided.

July trade in intangibles - and major revisions

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Catching up on last week, the overall trade date from BEA showed a worsening of our trade deficit, increasing from $58.8 billion in June to $62.2 billion in July. The higher price of oil imports accounted from most of the jump.

Our intangibles surplus increased by $232 million in July to a level of $12.8 billion.

The big bad news on intangibles, however, is the significant revisions to the data for the first half of the year. The level of intangible exports was revised significantly downward, the level of business services imports was revised significantly downward and the amount of outgoing royalty payments (imports) was revised significantly upward. As a result, the intangible surplus was $900 million lower than previously reported. In fact, in January and February 2008, the surplus actually decreased, rather than rising as previously reported.

Clearly, more work needs to be done on improving the collection of services trade data.

The other bad news was a dramatic increase in Advanced Technology Products deficit, which grew from $3.9 billion in June to over $7 billion in July. The change was due largely to a drop off in aerospace exports and a surge in information and communications technology imports. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

Intangibles trade for July  08

Note: we define trade in intangibles as the sum of "royalties and license fees" and "other private services". The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees - Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term "royalties" generally refers to payments for the utilization of copyrights or trademarks, and the term "license fees" generally refers to payments for the use of patents or industrial processes.

Other Private Services - Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term "affiliated" refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise's voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

National economic resilience as an intangible

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Last week I was at the Intangible Asset Finance Society annual meeting. The theme was "Reputational Peril." A key topic was business resilience (specifically supply chain resilience) as an intangible asset (see earlier posting).

This week, the concept of resilience is being applied at a much higher level: the national economy. For example, the story in today's Washington Post about the economic fallout from the financial crisis is titled A Test of Resilience: Financial Crises Have Slowed But Not Halted U.S. Economy. Yesterday's Financial Times ran a Special Report on Business Turnrounds. The lead story opened with this startling observation:

A new battlefront is opening up between the world’s economies. After a decade in which labour cost, labour mobility and creativity were crucial determinants of success, restructuring capacity is poised to become the new decider.
It went on to claim that:
Governments have realised that in today’s globalised, freer markets, the ability quickly to rescue and restructure troubled companies is central to economic competitiveness.

Clearly, on either level - microeconomic (firm) or macroeconomic (nation) -- resilience is a key intangible capability. I use the term capability rather than asset very deliberately. There are attributes to economic systems (macro or micro) which are not separable assets but abilities. These intangible capabilities are just as important as assets -- and include things like innovation capability as well as resilience. Over the past few years, our attention has been on the innovative capability. With, as some might say, our financial innovation capability run amok, resilience has grabbed center stage.

As the financial chaos works itself out, policy makers will have to think about how to strengthen our national intangible capability of resilience. They may think they are working on economic and financial regulatory policy. But they are really talking about economic resilience policy. And about yet another important attribute of the I-Cubed Economy.

Focus on the past - and looking at the future

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Catching up on stories from last week, there is this piece by Tom Friedman on Making America Stupid where he wonders:

Why would Republicans, the party of business, want to focus our country on breathing life into a 19th-century technology — fossil fuels — rather than giving birth to a 21st-century technology — renewable energy? As I have argued before, it reminds me of someone who, on the eve of the I.T. revolution — on the eve of PCs and the Internet — is pounding the table for America to make more I.B.M. typewriters and carbon paper. “Typewriters, baby, typewriters.”
As he goes on to say:
Unless we make America the country most able to innovate, compete and win in the age of globalization, our leverage in the world will continue to slowly erode. Those are the issues this election needs to be about, because that is what the next four years need to be about.

Amen. I hope both campaigns are listening (but I don't hold out much hope that this will really be at the heart of the debate for the next 7 weeks).

But, while it may not be at the heart of the campaign rhetoric, both campaigns have written about these issues. My friends over at the Information Technology and Innovation Foundation have produced report Comparing the Candidates’ Technology and Innovation Policies. Both campaigns have generally embraced S&T as an economic driver.

It remains to be seen whether the next Administration will be able, however, to take the next step and go beyond the S&T agenda to create a broad innovation agenda. That is the fundamental task, no matter who wins in November.

Financial market melt down and the monetization of intangibles

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As we watch the financial markets descend into a form of Dante's Inferno with one rolling crisis after another, what does this mean for the future of monetization of intangible assets? At first blush, it would seem to mean that the use of intangibles assets in financial markets is doomed. Intangibles are in that category of "exotic" assets -- and right now the rush is to safety. (Of course, at one time there was nothing safer that mortgages backed by Fannie and Freddie or AAA corporate paper - both of which are now suspect). However, there are lessons to be learned from the chaos.

The first lesson is that asset quality matters. Today's Washington Post (A New Architecture For the Financial World) summed it up succinctly:

Financial firms have expanded vastly in the past decade, hiring tens of thousands of bright business school graduates to engineer new financial products, find ever more complicated ways to manage other peoples' money, and dream up new ways to combine, divide, and recombine corporate America.
Some large portion of that work, it now appears, wasn't really creating any value for the company's clients or for the U.S. economy. No matter how many times crummy mortgage loans are recombined into clever packages, they're still crummy.

Our first task, therefore, is to make sure that loans backed by intangible assets aren't crummy. The valuations need to be real and the cash flows from those assets need to be real. This all points toward further work on asset standards. As we noted in our report Intangible Asset Monetization:

Intangible assets have no standardized financial tools to capture their value. Each intangible asset financing deal seems to be a unique, one-off event employing differing models to determine the assets’ value. The associated perceptions of risk—in some cases exacerbated by actual events, such as the subprime mortgage meltdown—have greatly hampered the utilization of intangibles in capital markets.

The current crisis also points the way (as described in our report) for the need to continue to develop a healthy primary market in intangible assets. Activities such as the OceanTomo auctions are steps in the right direction. Patent reform to strengthen the quality of patents is another (after all, how can I trust in a patent when a court might rule that my patent is either not valid or infringes on someone else's patent). A fresh look at government technology transfer policies (aka Bayh-Dole) is also called for -- as many critics claim the current system tends to lock up technologies rather than push them into the market place.

So, while the markets are reeling in their uncertainty, today is the time to start the rebuilding process. That process should include a transparent and grounded market in intangible assets. Let me suggest a beginning point -- not on Wall Street but on Main Street. The financial markets are not likely to accept intangibles as an asset until the bankers do. After all, the entire process of securitizing mortgages didn't begin until there was a solid system for underwriting mortgages in the first place (a system that broke down in the sub-prime market). Getting banks to recognize, value and lends against intangibles might be our best first line of attack.

Here there is a positive role the government can play. I would propose that the Small Business Administration be tasked with analyzing its rules and regulations concerning the use of intangibles as collateral on SBA loans. Furthermore, the SBA should work with the private sector to develop standards to be used for underwriting such intangible-asset based loans.

Such action is warranted on two grounds. First, small businesses (especially intangible-rich businesses) are most likely to be hit by the ongoing credit crunch. Since these businesses are a major engine of economic growth, finding new ways to enhance their access to credit is an important public policy concern. They are the collateral damage of the financial meltdown, not a contributing factor. Therefore, stemming that collateral damage before it severely impacts these growth sectors should be an important part of limiting the contagion of the financial crisis.

Second, the creation of such standards is a public good in and of itself. The economy has shifted to an intangible asset basis. It is not going back, no matter what happens on Wall Street. The incorporation of intangibles into the financial system will happen sooner or later - and potentially in ways that are unsafe for the overall financial system. Doing it the right way now will be better (and more effective and less expensive) than fixing the problem later. If we have learned anything from this crisis, it is the danger of our financial innovation getting ahead of our understanding. Let us work now to increase the understanding of intangible assets so that we don't repeat the situation we are going through today.

See you in a few days

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After the successful IAFS meeting (see previous postings), the Intangible Economy is taking a few days off. See you next week.

Lost Knowledge

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Another session at the IAFS was a discussion by David DeLong about Lost Knowledge. The term refers to the tacit knowledge within a company that gets lost as workers retire, quit or otherwise leave the company. In case after case, companies have found that a key piece of knowledge resides with one or two employees. How to capture and even recognize that knowledge is a key element of any social capital system. The area of knowledge management is supposed to go after this problem. But part of the real problem is auditing the company to understand what are the key piece of information. In most cases, the importance of the information is not apparent until the system fails: the 50 cent seal on a machine that really needs to be changed every 6 weeks rather than every three months that the service manual calls for.

For my point of view, this problems is one of worker involvement. The lost knowledge issue deals with risk of important tacit knowledge disappearing. It is about preventing bad things from happening. The flip side is how to spot and exploit opportunities based on that tacit knowledge. What is need is what we used to call "high performance work organizations." This organizational structure stresses teams and worker participation. In doing so, it helps share tacit information.

That should be to goal - sharing tacit knowledge. HPWO and knowledge management are steps in the process.

Supply chain management

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I am blogging from the meeting of the Intangible Asset Finance Society annual meeting, which this year is on "Reputational Peril." This morning's panel is on supply chain management.

Reputation as an intangible assets is something I have commented on before. But supply chain management has also become an important intangible assets. According to the speakers, capital markets are beginning to recognize the value of good risk management. For example, the credit rating agencies are now looking at how well companies manage their supply chain risk. Given the number of examples of companies who have taken big financial hits because of problems with their supply chains, this makes sense. If a company's revenues drop because they can't get their product to market because a fire at the factory of a key sole-source supplier, investors are rightfully going to ask "why didn't you have a more robust supply chain." Revenue loss is something the markets understand and analysis. Thus a company's market value takes a hit as well. So market players are beginning to look at whether or not the company has a risk-mitigation strategy in place. Financial markets are more willing to extend credit, possible at more favorable rates if the company has addressed their supply chain risks.

In addition to direct revenue impacts, there is the indirect impact on reputation. If bad things happen because of a supply chain problem (think Mattel), not only are short term revenues hit but long term reputation is at risk as well.

So add supply chain management as another key intangible asset.

More on valuing intangibles

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Last week, I posted an entry on an article by Denise Caruso on the Real Value of Intangibles. On her blog at The Hybrid Vigor she mentions some other sources, including her colleague, Mary Adams -- who blogs regularly on intangibles. Worth checking out.

The value of gold

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The Sunday Washington Post runs a column that celebrates the smart-aleck answer called Three Wise Guys. This past Sunday they answered the all important question: How much gold is there in an Olympic gold medal? The answer is, not much, because they are not solid gold, but gold plated. However, they also continued as follows:

Let it be noted that an Olympic gold medal's six grams of gold were worth about $165 at the Opening Ceremonies on Aug. 8. As of last week, they're worth about $160. Funny how the gold in Michael Phelps's eight-medal haul is materially worth $1,280, yet he's making tens of millions off its symbolism.

Not really so surprising. If you think about it, much of the value of many things nowadays is really based on their intangibles. A car is worth a lot more than the value of the metal (and plastic). A factory is the sum of multiple intangibles: the skills of the workforce, the organization, the knowledge that went into the layout of the factory, the knowledge that is embedded in the machinery, etc. etc. etc.

So, it should come as absolutely no surprise that the value of those medals is not in the gold but in the intangibles. Three Wise Guys, welcome to the I-Cubed Economy!

August unemployment jumps

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This morning's BLS Employment Situation Summary for August was dismal: unemployment jumped from 5.7% to 6.1% and non-farm payroll dropped by 84,000. One piece of good new, if you can call it that is that he silent employment problem did not get worse. As the BLS stated, "the number of persons who worked part time for economic reasons was essentially unchanged at 5.7 million."

Coming after the Fed's beige book report of continued slow economic activity, the past report of a 3.3% GDP growth looks more and more like a mirage.

The automakers loan and sharing technology

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Yesterday's column by Steven Pearlstein in the Washington Post ( The Road to a Bailout They Don't Deserve) about the pending loan to the automakers contained a suggestion that echoed my earlier call for technology sharing:

The government should insist that its loans get first priority and be used only for investment in new technology that can be shared with competitors, or in new plants and equipment that could be sold to other car companies in the event of a bankruptcy.

I also liked Pearlstein's answer to the question of how to do this during yesterday's online discussion:

Washington, D.C.: Steven, I really like your idea that any technology coming out of the program should be shared. But given the current state of intellectual property rights and government rules on IP, how can this be done? Should there be an automatic patent pool, for example?
Steven Pearlstein: Yeah, something like that. There is already such an agreement among the Big three, which have received technology grants under programs dating to the Clinton administration. They formed a joint venture called US Car or something like that, and it morphed into something like Freedom Car under a subsequent Bush program. So there are mechanisms to do this, if the will is there.

I was around when US Car was formed, so Steven is right: we have the mechanisms, we just need the will.

Liability and reputation

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The ongoing situation of the Simplicity baby bassinet recall illustrates an important point in managing an intangible asset: the difference bewteen liability and reputation. Liability is a legal responsibility to the customer; reputation is how the customer views your product. You would think that it is easy enough to distinguish between the two. But they routinely get tangled. The Simplicity case is highlighted in a story in today's Washington Post: Recall Highlights Liability Questions.

Simplicity for Children has had problems recently with its bassinets, with numerous recalls over the past few years. The company was bought in April by SFCA, an affiliate of Blackstreet Capital Management. The deal was supposed to shelter SFCA from the liability issues. As the Post story relates:

At the time, SFCA was aware of Simplicity's recall of 1 million cribs and voluntarily set aside resources to continue carrying it out. A May news release from Blackstreet said: "The Simplicity brand is well known for its exceptional value, innovative design and unparalleled focus on safety."

Clearly, this was a strategy to deal with the issue and move on.

However, a few weeks ago, the Consumer Product Safety Commission issued an order removing the bassinets from the stores. Here is the kicker as the Post story tells it:

SFCA had refused to issue a recall, saying it gained the right to sell products under the Simplicity brand but that it did not assume the liability of products already on the market, said Rick Locker, an attorney for SFCA.

Now, technically Mr. Locker may be right. SFCA bought the assets at auction and the liability may not confer with the sale. But the reputation does. It looked like those bassinets were coming off the market one way or another. By not being part of the recall, SFCA attempted to draw a distinction between those products and themselves. This may be a good tactic as part of asserting no liability. But from a reputation point of view, it doesn't appear to be a successful. Those products say "Simplicity" on them. Not dealing with the reputational threat to the brand weakens the brand, maybe fatally. Blackstreet back in May all but said they were buying the brand. Rather than attempt to bolster the brand by moving quickly to correct what was seems as a major problem, Blackstreet now appears to want to be moving away from the brand as quickly as possible. And if the owners don't stand behind the brand, what is it worth in the eyes of the consumer?

Bottom line, Blackstreet's strategy for deal with the liability issue may have dealt a death blow to the brand's reputation.

Value of intangibles

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There is a great article on "The Real Value of Intangibles" by Denise Caruso in the most recent issue of Strategy + Business. Notwithstanding that I am quoted extensively in the piece, it is an excellent summary of the problems with measuring intangibles and current state-of-play. She ends with a reference to our recent NAS conference as a sign of hope:

This is not to say that government should try to make these massive changes on its own. But in active collaboration with all stakeholders and interested parties — including corporate executives, institutional investors, banks, statisticians, and setters of accounting standards — agencies like the BEA must take the lead in defining and implementing the standards that would grant intangible assets the status they deserve. In the process, they would return some credibility to both U.S. economic data and, eventually, to the financial statements of U.S. corporations.

A first step in that direction may have just taken place. In June 2008, the National Academies’ Board on Science, Technology, and Economic Policy; the Committee on National Statistics; and the BEA convened a public meeting to discuss intangibles. Its agenda included what government statistical agencies are doing to gather data on intangibles and what government’s role should be in supporting markets and promoting investment in in­tangibles. With the right people and organizations in attendance and a rallying of political and institutional will, the gathering may have breathed new life into this languishing but critically important issue.

We all need to work to make that a reality.

Future of Capital (and intangibles) - Rotman Magazine

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The Fall issue of the University of Toronto’s Rotman School of Management magazine is devoted to the The Future of Capital, including discussions on intellectual capital/intangible assets. As Rotman Dean Roger Martin states in his introduction:

By the dawn of the 21st Century, a revolutionary change had taken hold in the realm of value creation: physical and financial assets were no longer the key factors of sustainable competitive advantage. Instead, leading companies like Dell, GE and Procter & Gamble depended on the superior human and knowledge assets for their competitive edge.

The key advantage conferred by such firm-specific ‘organizational capital’ is the fact that these resources are mainly tacit: they are difficult to codify or directly transfer to other organizations. As the knowledge economy has expanded, so too has our definition of capital, to the point where the most valuable assets of leading innovation-based firms have no actual physical presence, nor a home on a traditional balance sheet.

These ‘intangible’ assets – which include reputation, brand equity, sustainability, security and customer relationships – are receiving increased attention, and for good reason: according to a study by the Brookings Institution, they now comprise between 60 and 80 per cent of S&P 500 companies’ market value. In some firms, the gap between book value and market value is modest, but in others it can be significant, leaving investors guessing as to how much this ‘unseen wealth’ is worth.

Financial reporting systems have failed to keep up with the changing nature of value creation, leaving us with the equivalent of an abacus for measuring the actual value of corporate assets (hence our cover image.) In this issue of Rotman, we aim to expand your understanding of today’s most valuable forms of capital and how they contribute to the bottom line

The issue contains number of great articles from a number of perspectives from thought leaders such as including Baruch Lev and Nir Kossovsky. These interviews/insights cover a number of perspectives from accounting to social capital and from brand equity to reputation. It also contains an interview with me on the I-Cubed Economy (on pages 84-86).
(Note: the link is to a PDF of complete edition of the magazine)

Well worth the read.

Copyright and cooking

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This weekend's restaurant column in the Financial Times has the reviewer worried about copyright (Nicholas Lander - Cooking with a small ©):

From the moment I was handed the single sheet menu at A16, an extremely fashionable and popular restaurant on Chestnut Street in the very cool Marina district of San Francisco close to the Golden Gate Bridge, my eye was caught by its very last line. This reads “© 2008 All rights reserved A16 restaurant” – the very first attempt that I have ever come across by the owners of an independent restaurant to copyright their menu.

. . .

One of the distinctive features of the restaurant business internationally is that in contrast to so many others, industrial espionage does not seem to exist and there are few trade secrets, if any. Recipes were shared even before the internet and head chefs welcome “stagiaires”, young chefs on a placements, with commendable enthusiasm. Could all this hugely beneficial sharing of information soon hit the legal buffers, I wondered?

Fortunately, my concerns were dismissed during a conversation with Cecily Engle, a highly respected London-based copyright lawyer. “I certainly don’t know of any cases in the UK relating to the copyrighting of menu descriptions or layout. The law in the UK is very clear about this and no artist, whether painter, writer or musician, needs to affix a small c to their work, as the copyright automatically belongs to them. In the same way the originality of the design and layout of a menu automatically belongs to the restaurateurs. Take the menu at The Wolseley, for example. As long as its owners have bought the design outright from whoever created it, then that menu is theirs. I’m sure that there is a fair amount of copying of menu ideas but every industry has its different attitudes towards this type of thing and it can probably be resolved without going anywhere near a court of law.”

I'm not sure that Mr. Lander should take comfort from this. US law is the same -- copyright exists automatically. The copyright symbol is just a devise to remind other of this fact and to warn off any possible infringers.

The key is what Mr. Engle notes: the attitude of the industry. There have been a couple of notable cases of copyright suits -- for example in New York about Pearl Oyster Bar versus Ed’s Lobster Bar (see earlier posting). But in that case, the copying was more than just the menu but the entire operation. And the case was settled out of court.

Cooking may be one of those areas that benefits from the "negative space" concept of IP (where sharing of ideas is controlled in ways other than from heavy IP (for more on negative space, see earlier postings on fashion and magic). Success is a combination of both ideas and skill in implementation. I can have the recipe in front of me, but coming up with the same thing as I would get in a top restaurant is another matter. Then there are all the other intangibles of atmosphere, service, etc. So I'm not sure that copyright will take over the restaurant industry.

I will note that the case which raised Mr. Lander's concern was in Northern California - where there is a great concentration of IP lawyers.

Innovation in a "basic" industry

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When we think of innovation, we generally think of high-tech industries. But innovation is just a possible in what we often refer to as "basic" industries. Here is a case in point from the steel mill/ship building example. It comes from a story in the Economist (Steely logic) about the possible take over in Korea of Daewoo Shipbuilding & Marine Engineering (DSME) by the steel company POSCO. POSCO is the world’s fourth-largest steelmaker and DSME is the world’s third-biggest shipbuilder. Part of this is backwards and forwards integration. POSCO is also looking to buy iron and coal mines.

But this is more than one large heavy industry buying upstream manufacturing. It is also premised on taking advantage of the ability to create innovation from the combination. As the story mentions:

“In building a ship, the less you weld the less you spend,” says Lee Ku-taek, POSCO’s chief executive. “If we can tailor our ship plates to a specific ship, then costs can be saved.”

Changing the nature of ship building with customized plates looks like a great innovation to me.

    Note: the views expressed here are solely those of the author and do not necessarily represent those of Athena Alliance.

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