October 2008 Archives

OceanTomo has sent out the following analysis of the Bilski ruling and its affect on State Street:

Bilski Decision Unlikely to Alter Business Method Patents Value

The Federal Circuit’s en banc decision in In re Bilski, while closely watched, is unlikely to substantially change the scope of subject matter eligible for so-called business method patents or to alter the value of business method portfolios. The Court, relying on a detailed analysis of Supreme Court precedent, articulated a “machine or transformation test” for patentability. Under this test “an applicant may show that a process claim satisfies §101 either by showing that his claim is tied to a particular machine, or by showing that his claim transforms an article.” However, because the claim at issue in Bilski was admitted to be “not limited to operation on a computer,” or to carrying out the process by “any specific machine or apparatus,” the Court expressly declined to consider the contours of the machine implementation alternative. “[I]ssues specific to the machine implementation part of the test are not before us today. We leave to future cases the elaboration of the precise contours of machine implementation, as well as the answers to particular questions, such as whether or when recitation of a computer suffices to tie a process claim to a particular machine.” (Emphasis added).

The Court also made clear that the “transformation” test is broad. For example, it noted that a claim direct to the “transformation” of the depiction of a physical object on a visual display meets that test. Perhaps of greatest significance, the Court overruled the “useful, concrete and tangible result” test established in State Street, holding that it was “insufficient to determine whether a claim is patentable subject matter under §101.” But while this test is no longer the law, the new test will likely not alter the ultimate answer to the question as applied to particular business methods.

“Business method patents” commonly claim implementation by computer. Accordingly, the Court’s refusal to consider “whether or when recitation of a computer” is sufficient to render a process claim patentable means that the practical impact of Bilski should be limited. Absent development of further case law which squarely addresses this point, Bilski does not appear to materially change the business method patent landscape, or alter valuations of these patents.

I'm sure we will see more analysis over the next few days.

Steve Pearlstein does an "I told you so" -- Hank Paulson's $125 Billion Mistake:

It was only a few weeks ago that most right-thinking economists and left-leaning bloggers were jumping on Treasury Secretary Hank Paulson for his plan to jump-start the markets in asset-backed securities by having the government buy them up at auction. Much better, they argued, to use the $700 billion to "recapitalize" the banking system, just as Gordon Brown was doing in Britain. Even the Federal Reserve thought that a better idea.

So Paulson changed course, called in the nine biggest banks and "forced" them as a group to accept $125 billon in new capital. The critics patted themselves on the back for having been right all along.

Now, many of the same people are shocked -- shocked! -- to discover that the banks aren't using the money to make new loans to households and businesses, as they had assumed, but are using it to maintain dividend payments to shareholders, pay this year's bonuses to executives and traders, or squirrel it away for future acquisitions.

I hate to say it, but I told you so. Sprinkling money around a highly fragmented banking system when markets were panicked and everyone was scrambling to reduce leverage was always akin to shoveling sand against the tide.

I think it may be a bit premature to call the direct infusion process a mistake. But I continue to believe - along with Pearlstein - that the best course of action is to buy up the assets:

Paulson's first mistake was in allowing himself to be diverted from his original strategy, which stood a good chance of establishing reasonable and credible market prices for asset-backed securities -- a necessary first step in attracting other buyers back into those frozen markets. That would take tremendous pressure off all banks, insurance companies, hedge funds and bond insurers, most of which now can't raise capital because nobody can even guess what the assets on their books are worth, forcing accountants and auditors to assume the worst. It also would get liquidity to those institutions that most need it.

As I understand it, that program is still being set up. I hope it gets up and running soon.

From the Wall Street Journal - Court Limits Issuance of Patents on Methods of Doing Business

The U.S. Court of Appeals for the Federal Circuit upheld a ruling made by the Board of Patent Appeals and Interferences, which denied a patent for a method of hedging risks of sudden changes in energy costs. While patent law specifically allows the patenting of processes, the court ruled today that this protection doesn't extend to all abstract strategies of doing business.

The court, in a 9-3 decision, wrote that in order for a process to receive patent protection, it has to either "transform [an] article to a different state or thing" or be "tied to a particular machine." The risk-hedging strategy, the court ruled, did not fall into either category. Wrote the court: "transformations or manipulations of…business risks, or other such abstractions cannot meet the test because they are not physical objects or substances…"

The plaintiffs, Bernard Bilski and Rand Warsaw, had developed a hedging strategy used by several utilities to smooth out revenues in a sector where prices often gyrate. Messrs. Bilski and Warsaw argued that the utilities should have to license the right to use the method, citing 1998 court decision which largely allowed so-called "business method patents." Yet, the patent office denied their request and the plaintiffs appealed.

But in today's ruling, the court largely disavowed the highly controversial 1998 decision, State Street Bank v. Signature Financial Group. That case had granted protection to a system for managing mutual fund accounts. The State Street decision was widely cheered by the financial-services and software industries, among others. But ever since its issuance, the State Street case has been a lightning rod among patent practitioners, with detractors largely arguing that it led to a glut of weak patents.

This changes a lot.

For more background on the case (not the ruling) see Patent Law Blog (Patently-O): Bilski: Full CAFC to Reexamine the Scope of Subject Matter Patentability, Why In re Bilski will see the US move closer to Europe - Intellectual Asset Management and United States, Intellectual Property, Federal Circuit To Re-Assess Standards For Patent-Eligible Subject Matter - Fenwick & West LLP - 07/04/2008, Patent.

Mike Mandel commenting in Business Week on the global economic meltdown (It's Not a Crisis of Confidence) blames the problem on three flows: technology and industrial know-how to emerging economies; goods from those nations back to the developed world (read: "US"); and, flow of capital back to the emerging nations to pay for those products.

This tri-flow worked as long as everyone believed that American consumers could finance their debt. But here's the problem: At the same time Americans were borrowing, their real wages were falling—and not just for the least educated. By BusinessWeek's calculations, real weekly earnings for college grads without an advanced degree have dropped every year since 2002.

You can't pay back rising debt with falling wages; something had to give.

So, what should we do? According to Mandel:

Policymakers should stop talking about investor confidence as if it exists in a vacuum. Instead, they should focus on the real goal of stimulating the creation of innovative new goods and services that the U.S. can produce and sell on global markets. That would reduce the amount of borrowing the country has to do, and help create a sustainable global economy.

In other words, attack our underlying international competitiveness problem that got us into the financial quagmire.

I agree - to a point. I think the financial collapse came before the effects of the competitiveness/trade deficit problem could be felt. Everyone assumed the economic crisis would start with a drastic drop in the value of the dollar - as other nations stop lending us funds. But in the current situation, the opposite has occurred. The flight to safety has meant a flight to US Treasuries.

So the world has not yet given up on lending to the US. But, at some point, it will. To prevent that next catastrophe from happening we need to follow Mandel’s advice and use this opportunity to rebuild our economic competitiveness. Or the next time will even worse.

New York Times' DealBook has a summary of the SEC hearing on mark-to-market. There was an interesting back and forth between to witnesses. Accounting Professor Ray Ball, University of Chicago Graduate School of Business noted that part of the problem in Japan was that banks “were allowed to keep financial instruments on their balance sheet at historical costs for a very long period of time so that investors in the capital market did not know what were the strong banks and which were the weak banks.”

William Isaac, former chairman of the Federal Deposit Insurance Corporation, argued the opposite:

He said he favors a return to accounting methods that allowed banks to judge for themselves what an asset is worth and not be forced to value it using models marked to current prices.

What is interesting was Ball’s rejoinder about the current mark-to-market rules:

“It probably, of all the accounting standards written in recent decades, brings more judgment into the accounting than any other,” he said. “You can use prices, indexes or you can use basically judgment estimates of future cash flows” to value an asset.

Maybe that it is the real problem -- too much judgment. I think Mr. Isaac's position on letting the banks be the only judge of value is a step in the wrong direction. It would be fine if there was complete transparency, including methodology. But that isn't the case - as the earlier posting on Fannie Mae illustrates. It would also make accounting statements useless -- since the numbers would be based on whatever the bank wanted them to be.

As Alice found out, in Wonderland:

'When I use a word,' Humpty Dumpty said, in a rather scornful tone,' it means just what I choose it to mean, neither more nor less.'
(from Through the Looking Glass)

We need to avoid Wonderland accounting.

The BEA advanced estimate of 3rd Quarter GDP shows a decline of 0.3%.

Only 0.3%. That is actually somewhat good news. It is not a big a decline as expected. The Wall Street Journal reports that "Economists surveyed by Dow Jones Newswires had projected a drop of 0.5% during July through September."

As I said before, the US economy has been in a recession for some time. The coincident indicators have been steady or declining for a year. If we get by with a flat economy, rather than a deep drop, we will be very lucky.

Having said that, today's data is only the beginning. Based on what has happened so far in October, the 4th quarter looks bleak.

Here is a reason why we need better transparency in company books. According to a story in the Washington Post, Fannie Mae is writing off almost half of its capital base. Why, because that capital was in the form of deferred tax assets, i.e. credits against taxes on future profits. Fannie has decided that it is unlikely to make a profit in the near future, so the tax credits are essentially worthless. That is a write off of $20 billion of a $47 billion capital base. According to the Post story:

In the months leading up to the companies' takeover, the firms and their federal regulator cited the capital positions in an effort to allay fears about their financial security. But during a summer probe of the companies' books, government officials grew concerned about whether the financial cushions were sufficient. In particular, the deferred tax assets drew scrutiny.

Government-appointed Fannie Mae chief executive Herbert M. Allison Jr. and Freddie Mac chief executive David M. Moffett are reviewing a range of accounting policies at the company. At Fannie Mae, Allison decided the company had to be more forthright in how it reports information about the liquidity of certain assets.

Let's hope that this is the start of a trend toward better disclosure of assets -- including intangible assets.

Today's Financial Times has this interesting story about man versus machine -- in the financial area - Faith in trading floor returns:

Investors have responded to market turbulence by routing a rising proportion of trades on the New York Stock Exchange through people rather than computers, reversing the recent trend toward automated trading.

The explosive growth of electronic trading had resulted in an ever-shrinking role for NYSE "specialists", who match buyers with sellers in particular stocks, and floor brokers, who execute buy and sell orders.

But the 105-year-old maple trading floor of the NYSE has roared back to life as market volatility has reached unprecedented levels and investors have sought out prices quoted by human intermediaries.

. . .

One trader noted that in recent weeks, there have been several trading glitches and erroneous orders in all-electronic markets - including so-called "dark liquidity pools", off-market trading venues that have grown in popularity this decade. He said human traders could have spotted such problems.

"The combination of hi-tech and high touch has been shown in recent weeks to be the best model," the trader said. "People are becoming a little suspicious of dark pools where at times like these there really is not enough transparency."

. . .

Todd Abrahall, vice-president for specialist liaison at the NYSE, said: "At no other point in history has the investment community needed this building more. The combination of automated trading with brokers on the floor has recently been an indispensable part of the market in terms of price discovery, aggregation of volume and dampening of volatility."

High-tech; high touch. That is one of the characteristics of the I-Cubed Economy. Apparently even in the stock market.

GM Chairman Rick Wagoner was in Washington yesterday to press the case for immediate aid to the automaker. As I noted yesterday, car companies are looking for help from TARP as well as the loan program.

At the same time, there was this gem - Chrysler ends hybrid adventure before it can begin - Los Angeles Times:

Before it even started selling them, Chrysler is spiking its hybrids.
The troubled automaker said Tuesday that it would discontinue production of its Dodge Durango and Chrysler Aspen hybrid sport utility vehicles at year-end, when the company shuts down the Delaware plant that makes the two trucks.

What!!!! The loan program for the companies was specifically tied to new energy-efficient technologies. And now they are closing plants that build hybrids?

In fairness to Chrysler, it appears that they are still going ahead with hybrid and electric models for 2010. But still ...

Is someone at Treasury and the Energy Department paying attention? Yesterday I said that TARP funds should be used to help auto credit purchases. But, with this news, we need to add new criteria: any funds from TARP need to be tied to the same criteria as the loan program -- namely, new energy-efficient technologies.

For another take on the pending merger, see Steven Pearlstein column today - Detroit Bankruptcy Beats a Bailout. I'm not sure that I agree with Steve that bankruptcy might be the better way to go. But if the government aid is going to end up moving automakers in the opposite direction of where they have to go on new energy technology, then we should start considered the "b" word.

The answer to that question is a qualified "we don't know." Today's Wall Street Journal
notes - "Much Bank Aid May Not Go to Loans":

The federal government's bank-rescue plan will spread more than $15 billion among 10 regional banks, those companies announced Monday. But some banks acknowledged that perhaps only a small chunk of the money would be funneled into loans.

. . .

Nearly $35 billion in capital infusions have been disclosed since Friday, led by the $7.7 billion in cash that PNC Financial Services Group Inc., Pittsburgh, is using to buy National City Corp. for $4.69 billion in stock.
. . .

Several banks said Monday they plan to use their new capital to make loans and possibly buy weakened rivals. Others suggested a substantial increase in loan volume is unlikely as long as the U.S. economy is troubled, since that is likely to worsen loan delinquencies and charge-offs.

In the meantime the Journal also reports that the "Rescue Plan Faces Delays In Hiring Asset Managers":

Several hurdles have arisen, including concern over the fees the government will pay asset managers, as well as a lack of manpower at Treasury, said people familiar with the matter. The delays have contributed to investor uncertainty about how effective the rescue plan will be.

So it goes. It will be an interesting time when the Treasury comes back to Congress for the second $350 billion tranche of funding for the TARP.

Yesterday, the Treasury Department announced that US automakers are eligible for financial assistance under the TARP program. As the Washington Post reports:

"The law grants the secretary broad authority to purchase troubled assets that he deems important to improving financial stability," said Treasury spokeswoman Jennifer Zuccarelli.

Ford and General Motors are eligible because they are both chartered as thrift holding companies, so they can establish banks to make car loans nationwide. Other businesses, such as General Electric, Nordstrom, John Deere and Macy's, are chartered in the same way to issue credit cards or make loans to their customers. Chrysler would also be eligible, Treasury officials said.

Another option under consideration is to tap a $25 billion loan program that Congress just created to help the auto companies modernize their plants. A third option would involve going back to Congress, immediately after the Nov. 4 election, for authority to spend funds aimed specifically at the auto industry. But officials have not yet decided how much assistance to provide or how to structure any aid program.

Under the TARP program, the funds would likely go to the automakers' credit arms to financial new car purchases. Under the Congressional loan program, the money was supposed to go to production of new energy-efficient vehicles (see earlier posting). Those are two very different activities with two very separate outcomes.

Maybe we need to do both - given the vastly different targets. TARP was created to get credit flowing again - so maybe helping make auto loans is an acceptable use of the money. But the loan program was targeted at the future of the industry. Unless US automakers start producing the products we need, no amount of credit will stave off their decline.

The loan program came with strings attached. When we were giving such aid to other countries (either directly or through the IMF and World Bank), we used to call that "conditionality." People would complain - but we would insist. Now it is time for US recipients of government aid to get a taste of some of the same medicine.

Give the auto companies the aid. But force them to live up to their side of the bargain. And by the way, let me repeat my other condition: the US taxpayers get a part of the intellectual property. If the taxpayers are going to assume the risk, the taxpayers should reap some of the benefits -- both financially and in the introduction of new technologies.

Allan Sloan's column in today's Washington Post - Don't Blame Mark-to-Market Accounting:

Mark-to-market is a business rarity -- an accounting term that draws reactions from people who don't know spreadsheets from bedsheets. Mark-to-market, which we'll call MTM, evokes images of Enron's made-up profits and the other corporate scandals that marred the first years of this decade. Not pretty.

Now MTM -- which means valuing marketable securities at market prices -- is a hot item again, but for the opposite reason. This time financial companies and their allies are claiming it's too strict. They argue that marking the value of complex, illiquid securities to artificially low market prices has unnecessarily crippled the U.S. and world financial systems by creating billions of illusory losses on perfectly fine (albeit illiquid) securities, such as collateralized debt obligations linked to mortgages. Markets for these things, the argument goes, are depressed way below true economic value.

. . .

Credit markets have been frozen much of the past 15 months largely because banks haven't trusted the balance sheets of other banks and have thus been afraid to lend to them. I can't imagine that confidence problem being resolved by changing MTM.

There are problems with MTM: It's relatively new, and parts of it seem arbitrary. But its problems have been exaggerated. It's easier to blame accountants for your problems than to admit you made your institution vulnerable by overleveraging its balance sheet and buying securities you didn't understand. Ironically, many of today's whiners adopted MTM a year before they had to, partly because of an arcane provision that let them count as profit the decline in the market value of their publicly traded debt.

The bottom line: Despite MTM's flaws, blaming it for the world's financial problems isn't the answer. Neither is shooting the messenger -- or, in this case, the accountant.

Now, tell me again how "cooking the books" is going to make things better?

In this weekend's edition, the Financial Times published a short bit on "America's best assets":

At the end of last year, there were $1,580bn of assets on the government's balance sheet. The fact that printing presses can be switched on at any time makes the number pretty arbitrary. Still, the near-trillion dollars of inventories, property, plant and equipment is real enough, of which almost 70 per cent is defence-related. Obviously, the US is not about to sell its uranium stockpiles but, according to the Government Accountability Office, the government - including the Pentagon - has "many assets it doesn't need".

That is only the half of it. Not even included on the balance sheet are the properties, land and heritage assets held in stewardship. How to value the Constitution is anyone's guess. But neither is a monetary value placed on the 28 per cent of the US landmass owned by the government. Selling national parks (or Alaska) for mineral resources would be controversial but many environmental studies conclude wilderness areas are no better managed under state ownership than they are privately.

I would disagree that we should think about privatizing these assets; what part of the word "stewardship" does the FT not understand.

However, the piece indirectly raises a different point when it asks about how to place a monetary value on the Constitution. The US government has a large collection of intangible assets that do not show up on the books. Like any organization, the Federal government needs to manage those assets well.

A first step would be to know what we have. In the past, I have called for a review of how much the government spends on developing intangible assets. An intangible asset budget would help tell us how we are doing in fostering the development of intangibles within the larger economy. We need an inventory of government-owned intangibles as well. That inventory would give us the baseline for better internal management. Both reviews would help bring the government into the I-Cubed Economy.

I was at an event this morning where the subject of so-called "patent trolls" came up (see also an earlier posting). Trolls are creatures who live under bridges and demand payment from travelers who wish to cross the bridge. Patent trolls are companies and/or individuals who buy patents for the purpose of making money off of infringement claims (rather than for the purpose of marketing/developing the invention). As such, trolls are a subcategory of (and take the organizational form of) the patent holding company. A good example of a patent holding company is Royalty Pharma, which makes its money off of the royalty stream. However, defining a troll, and differentiating it from a holding company, is sometimes tricky.

At the conference this morning someone made the analogy of patent holding companies and rental car companies. The rental car companies don't operate those cars -- just like patent holding companies. The cars, in fact, sit around, not being utilized, for periods of time -- just like the patents being held by those companies.

Interesting analogy, but incomplete. I have no problem with holding companies serving an important market-making function of essentially renting out patents - just like an airport rental car company. I agree with the argument that patent holding company provides a valuable service (see IEEE Spectrum: Hooray for the Patent Troll! - which unfortunately equates trolls and patent holding companies).

But the analogy quickly breaks down. I don't have a problem with rental car companies, of course. But I would have a problem if that rental car company parked their cars in such a way as to block all of the entrances to the airport and said that the only way into the airport was to rent one of their cars, at whatever price they wanted to charge you -- and by the way, if you got out of your car and walked, you would be trespassing and they would shoot you dead.

That is the business model of the patent troll.

Here are a couple of references to new ideas in education. The first is a policy paper from the Brookings Institution on
Changing the Game: The Federal Role in Supporting 21st Century Educational Innovation:

To resolve dramatic disparities in educational achievement and ensure future American workers are globally competitive, the federal government needs, as it has in the past, to change the game in public education.

A robust new federal Office of Educational Entrepreneurship and Innovation within the Department of Education would expand the boundaries of public education by scaling up successful educational entrepreneurs, seeding transformative educational innovations, and building a stronger culture to support these activities throughout the public sector.

The second is a slide show in Business Week on Disruptive Education Technology: Helping Kids Learn:

A growing number of education technologies, many of them distributed over the Web, are upending traditional approaches to education.

New approaches should certainly be welcome in the I-Cubed Economy.

It looks like Larry Summers will be the new Assistant to the President for Economic Affairs and head of the White House National Economic Council (NEC). The NEC is the President's economic coordinating body. As the head of the NEC (the President is the actual Chair, but Assistant to the President chairs the meetings in his absence), Summers will be a major voice on economic policy. Given this role, I though we should go back to what he wrote a month ago in the Financial Times:

Economists do not understand what drives productivity growth very well. However, we know these facts: productivity grew rapidly after the second world war and then sometime between the late 1960s and mid-1970s it slowed dramatically only to re-accelerate to record levels in the mid-1990s. Unfortunately, even before the downturn, underlying productivity growth appeared to be slowing.

The most plausible explanation is that an array of transforming investments and technologies – the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period. Eventually their impact dissipated and, as energy costs rose, growth slowed until the information technology revolution kicked in during the 1990s. Unfortunately, the IT supply shock that powered the economy in the 1990s and early part of this decade appears to be diminishing.

So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.

I had a chance a couple of weeks ago to ask Summers about this. In his answer it became very clear that he understood the need to action on the microeconomic level to boost innovation and productivity. Of course, it may have helped that this occurred at the National Academy of Sciences - where he was taking over as the Chair of the Board on Science, Technology and Economic Policy (a position he will now have to give up).

So I am optimistic about the innovation and productivity agenda. President Obama's economic team will have to confront our immediate economic crisis. But if Summer's earlier words are any indication, the short term action should help feed long term solution.

The Financial Times alerts us to the next crisis in its review of a new book, The Brand Bubble:

It is conventional wisdom now that because brands deliver superior market share, margins and "loyalty" (repeat purchase), they represent a secure source of superior future cash flows that is naturally reflected in the owners' share prices. Brands should, therefore, be a haven for investors in today's crisis-ridden markets. But they may not be, warn the authors of The Brand Bubble .

Over the past few decades financial markets have consistently pushed up the stock prices of brand-owning companies, say John Gerzema and Ed Lebar, both senior executives at the WPP-owned advertising agency Young & Rubicam. But, they warn, over the same period consumers have been "falling out of love" with brands.

The authors have tracked consumer perceptions of 2,500 US brands since 1993 as part of their "brand asset valuator" (BAV) research programme. Back then, consumers said they trusted 52 per cent of the brands researchers asked them about. In the latest round of research the trust level had fallen to 25 per cent. This "precipitous" decline in brand trust is mirrored by other metrics. Product quality ratings have declined by 24 per cent over the same period and brand "esteem" - whether the brand is seen as reliable and is highly regarded by the respondent - has fallen by 12 per cent. Brand awareness has dropped by 20 per cent.

"While Wall Street has been bidding brand values ever higher, consumer perceptions towards brands are substantially eroding . . . Financial markets think brands are worth more than the consumers who buy them," say the authors, who, writing before the latest crash, estimated the size of the "brand bubble" to be $4,000bn, much bigger than the size of the subprime mortgage market.

Interesting. But a bit overblown, I think. I have always had a problem with what I consider hyped values of intangibles. (See my paper Measuring Intangibles for an overview of the various metrics.) So I'm not sure I buy the $4 trillion figure. And (as the reviewer points out) this bubble may have burst already in that the stock value of these brands probably has already dropped with the overall market.

A year ago, the International Standards Organization (ISO) formed Technical Committee 231 to begin a project on brand valuation standards. I don't know whether this project is still on going. I believe that the US is not participating in the project. As I said when the project got started, the development of valuation standards is an important undertaking but I'm not sure that ISO is the right venue for this exercise. We will see whether this new book - and the continuing bubble mania - pushes us closer to a set of understandable and widely accepted valuation methodologies for intangibles - including brands.

By the way, the FT reviewer had this to say about the entire book:

The Brand Bubble is worth reading just for the salutary first few chapters that outline this argument. The rest of the book is disappointing. The authors have access to one of the richest longitudinal marketing databases in the world. They could have used these data to add many extra levels of chapter and verse, throwing a detailed spotlight on different "stellar" brands and underperformers.
Instead, they use the second half as an extended advertisement for their agency's proprietary research and brand-building methodologies ...

I would be interested in hearing what others have to say about the book and the issue of brand valuation.

As I noted before, there are technical problems facing the Fed as it undertakes its financial stability actions (I would call it a plan, but it seems to be a series of improvised actions -- which may be for the best). One of those is that the Federal Reserve Act requires the Fed's lending to be backed by collateral. They have been finding ways around the technical problems, such as with the new mechanism for lending to money-market funds.

But, what if they start looking further at things like intangible assets as collateral? Is the industry ready? Are the identification, valuation and structuring processes in place? Yes, there have been deals done in the past, but nothing like the volume that the Fed is playing with now. My fear is that a large volume of intangible-backed deals being done for the Fed could overwhelm the system. That opens the door for bad (meaning widely varying and uncertain) valuation estimates and poorly structured deal. Such a negative process could result in the tainting of intangibles as a new toxic asset class.

As the Financial Times notes (Practicalities the only limit on Fed action), operational problems are now becoming a concern:

The problem is that, as it lends money in ever more ways to an ever larger range of institutions against an ever broader range of assets – or in the case of the commercial paper programme, the underlying credit of the borrower – the complexity involved expands exponentially. At some point the Fed will have to stop because it will exhaust its capacity to make the basic credit judgments involved.

As we argue for increased monetization of intangible assets, we need to make sure we don't overstrain those operational capacities.

Here is an update on my earlier posting on political campaigns and copyright, from Larry Lessig's op-ed in today's New York Times Copyright and Politics Don’t Mix. He argues that copyright has become a tool of political censorship:

A recent dispute in a race for New York State Assembly is a perfect example. A Democrat, Mark Blanchfield, is challenging the Republican incumbent, George Amedore, in the Assembly district that includes the upstate New York city of Schenectady. Last month, Mr. Blanchfield released television and radio advertisements that included a clip from a video interview with The Albany Business Review in which Assemblyman Amedore said, “I don’t look at the Assembly position as a job.”

Mr. Amedore complained that the ads took his remark out of context, and the newspaper’s lawyers sent Mr. Blanchfield letters calling the ads “an infringement of our client’s exclusive copyright rights” (redundancy in the original), and threatening Mr. Blanchfield if he didn’t cease using the material. Never mind that Mr. Blanchfield’s use couldn’t possibly have harmed the financial interest of The Albany Business Review. Whatever the newspaper’s motive, the result is the censorship of Mr. Blanchfield’s campaign.

This problem isn’t limited to New York Assembly races. It has directly affected the presidential campaigns. Last year, Fox News ordered John McCain to stop using a clip of himself at a Fox News-moderated debate. Last month, Warner Music Group demanded YouTube remove an amateur video attacking Barack Obama that included its music, while NBC asked the Obama campaign to pull an ad that included some NBC News video with Tom Brokaw and Keith Olbermann. No doubt, these corporations are simply trying to avoid controversy or embarrassment, but by claiming infringement, they are effectively censoring political speech.

I would note that that if today's copyright laws had been in effect a hundred plus years ago, the Thomas Nast's heirs might have been able to force the US government to stop using the image of Uncle Sam on anything they politically disagreed with - along with barring the GOP from using the elephant and the Democrats from using the donkey (since Nast can lay claim to the copyright over all of those).

Clearly, something needs to be done to better balance copyright and the right of free speech. As Lessig says:

It would be far better if copyright law were narrowed to those contexts in which it serves its essential creative function — encouraging innovation and ensuring that artists get paid for their work — and left alone the battles of what criticisms candidates for office, and their supporters, are allowed to make.

From Washington Post editorial Blaming the Bean-Counters:

Markets not only need transparent financial reporting, they need consistent financial reporting. To suspend or abandon mark-to-market now, in the middle of a panic, would simply deepen the confusion and suspicion that are already crippling the financial system. No, today's financial meltdown is not some accidental byproduct of misguided technical rules. It happened because too many firms made too many bad financial bets with borrowed money. Pretending otherwise won't solve anything.

From the Corporate Reporting Users Forum in Europe - a group of investors and analysts (story and letter in the Financial Times):

We would oppose any steps by the European Commission to undermine this position and diminish investor confidence in corporate reporting by establishing further carve-outs from IAS 39 [which calls for mark-to-market] or adopting its own standards. Now especially, investors need comparability and transparency, not further uncertainty and inconsistency.

The Conference Board released its latest set of economic indicators. The good news is that the index of leading indicators -- which is supposed to predict future growth -- rose in September. The bad news is that "the coincident index decreased sharply in September and it has declined or held steady since October 2007."

In other words, economic activity has been flat or declining for the past year.

In last Friday's Financial Times, Jagdish Bhagwati wrote about the dangers of financial innovation in "We need to guard against destructive creation":

In each case, the assumption was that financial innovation was like non-financial innovation. When the personal computer was invented, the economy profited without upheaval. The typewriter became obsolete – an example of what Joseph Schumpeter famously called “creative destruction”. But with financial innovation, the downside can be lethal – it is “destructive creation”. We have to work hard at defining the downside scenarios.

The failure to think about the downside results from what I call the “Wall Street-Treasury Complex”. Robert Rubin went from Goldman Sachs to the Treasury and back to Citigroup. Hank Paulson went from Goldman Sachs to the Treasury and will doubtless return also to Wall Street. This network shares the optimistic scenarios that Wall Street spins. Mr Rubin was in charge of the Treasury during the Asian financial crisis, whereas Mr Paulson was among the five major investment banking chief executives who persuaded the Securities and Exchange Commission not to extend prudential reserve requirements to their companies.

We therefore need a truly independent commission of experts to look closely at each financial innovation and work out its potential downside. Keynes once wrote that the inevitable never happens, it is always the unexpected. This commission would be charged with trying to narrow the range of the unexpected. We do not have to be blindsided by downsides just because we lazily surrender to the euphoria of the Complex.

I guess I don't know whether to laugh or cry. First of all, that Professor Bhagwati blithely assumes that technological change is not disruptive, always positive and always beneficial betrays a woeful ignorance of both history and a huge body of knowledge. True that most technological change works slowly, so there is not the cataclysmic disruption that happens in financial panics. But to say that technological change happens “without upheaval” is either naïve or uninformed.

The second point is about re-inventing the wheel. Maybe a group of "wisemen" vetting financial innovation would be helpful. But again, the idea of analyzing the pluses and minus of innovation has a long history -- which has fallen out of favor. It is called "technology assessment".

In fact, for 23 years until 1995, Congress had its own Office of Technology Assessment (where I once worked). It was closed by the new GOP Congressional majority who, I guess, felt such activities were not needed. Over the past decade, a number of people have called for the re-creation of this function, if not the actual organization. Maybe Professor Bhagwati, once he studies the history of innovation, might want to also join in this call.

I have said a number of times that even with the emergency financial package, there will still be a lot of blood on the floor before this is all over. This will be due, in part, to the write-downs that the financial institutions will need to take to get the toxic assets off their books (which will not be as bad as it might have been thanks to TARP).

The other part of the bleeding will come from the shakeout in the rest of the economy. It is not only financial institutions that have gone overboard. Today's editorial in the New York Times does a great jobs of explaining what is next and what needs to be done -- The Bubble Keeps On Deflating:

By now everyone knows that reckless and even predatory mortgage lending provoked the financial meltdown. But bad lending did not stop there. The easy money also fed a corporate buyout binge, with private equity firms borrowing huge sums to buy up public companies and pay themselves big dividends.

The process was much like a homeowner who borrowed big for a house and then refinanced to pull out cash. In corporate buyouts, however, the newly private company was left with the fat loan, while the private equity partners got the cash.

In keeping with the mania of the era, banks lowered their lending standards as they competed fiercely to make buyout loans. Lenders also did not worry much about being repaid, because they made money by slicing and dicing the buyout loans and selling them off in pieces to investors.

All of this means that the country needs to brace for yet another round of trouble: a potentially sharp increase in corporate bankruptcies. This time, government officials and Congress must not be taken by surprise.

So far relatively few companies have gone bust. But that is not necessarily a hopeful sign. Instead, loose lending has very likely allowed many troubled companies to postpone a day of reckoning — but not forever.

Under the lax terms of many buyout loans (deemed “covenant lite”), borrowers could delay payments, say, by issuing i.o.u.’s in lieu of payment or adding the interest to the loan balance rather than paying it. But when the loans come due and need to be repaid or refinanced, terms will no longer be so easy. The likely result will be defaults and bankruptcies.

A rash of corporate bankruptcies would obviously be very bad news for employees and lenders, and for stockholders at troubled public companies, like the carmakers. It could also rock the financial system anew.

As with mortgages, huge side bets have been placed on the performance of corporate debt via derivative securities, like credit default swaps. Derivatives are unregulated, so no one can be sure how widely a big or unexpected default would reverberate through the system.

Various measures indicate elevated default risk at a range of businesses, including retailers, media companies, restaurants and manufacturers. A survey released this month by the Federal Reserve and other regulators is especially sobering.

It looked at $2.8 trillion in large syndicated corporate loans held by American banks at the end of June. Compared with a year earlier, the share of loans rated as problematic had risen from 5 percent to 13.4 percent.

Regulators must continue to monitor possible bankruptcies. Even if they cannot prevent a failure, they can soften its impact by ensuring that it does not come as a shock, further spooking investors.

Congress must prepare to deal with higher unemployment from corporate failures. In the coming lame duck session, lawmakers must extend jobless benefits for people who have exhausted their previous allotment. The next Congress and the next president need to upgrade the nation’s outmoded system of unemployment compensation to cover more Americans.

Congress must also be prepared to investigate large or particularly disruptive bankruptcies to identify both possible unlawful activity and regulatory lapses.

So far, inquiries into the collapses of Bear Stearns, Lehman Brothers and American International Group have been little more than public hazings of corporate executives. What is needed is a serious effort to determine accountability and figure out what reforms are needed to make sure these disasters don’t happen again.

You can't say we haven't been warned.

Treasury's Rescue Plan Hits Technical Snag - washingtonpost.com

Banking regulators are working today to resolve accounting roadblocks that would hold up the government's plan to revive financial markets by investing $250 billion in the nation's banks.
The problem is this: Under existing rules, banks cannot count the Treasury Department's investment as part of their core capital, the foundation of money that supports a bank's operations.

So, none of those "experts" who have been screaming for the direct injection model figured this out?

Here is one accounting rule I would be willing to suspend -- at least temporarily.

Speaking of the Presidential campaign, here is an interesting bit on political campaigns and copyright -- McCain Fights for Right to Remix on YouTube - Bits Blog - NYTimes.com:

Internet issues have taken a back seat in the presidential campaign. But this week, even as John McCain unveiled his new economic plan, he also introduced a new position on copyright law.

Trevor Potter, the general counsel for the McCain-Palin campaign, sent a letter on Monday to Chad Hurley, the chief executive of YouTube, complaining that the video service, now owned by Google, has inappropriately removed McCain commercials from its site.

The commercials incorporated snippets of television news broadcasts. Using provisions of the Digital Millennium Copyright Act, the news organizations demanded that the commercials be removed from YouTube because they violated the organizations’ copyrights.

The piece notes that Senator McCain supported the Digital Millennium Copyright Act.

If nothing else, I hope this raises awareness of this issue of "fair-use" -- something that we need to confront as we move forward in the I-Cubed Economy.

Here is another analysis of the Presidential candidate's proposals on "innovation" - from the New York Times If Elected ... - Rivals’ Visions Differ on Unleashing Innovation - Series.

My only complaint -- and this is directed at the New York Times, not the candidates -- is that the entire article is about high-tech. The writers fail to break out of the mindset that "innovation" = "high-tech."

Maybe some day, someone will write about innovation. But, sadly, not today.

Last year there was a lot of talk about London taking over world leadership in the financial industry. One reason given for the shift was the perceived over-regulation in the US.

What a difference a year makes. No one is talking about over-regulation. And the financial meltdown is having an unforeseen impact on the New York/London rivalry due to, you guessed it, regulation. As the Financial Times reports, New York reaps reward from hedge fund fears:

London has suffered a setback in the battle with Wall Street for leadership of what remains of the financial world as hedge funds move billions of dollars to New York banks because of worries about the UK bankruptcy regime.

The issue has to do with how quickly Lehman assets can be liquidated. The London, the process may be slow—leaving investors and counterparties high and dry. As a result, hedge funds are moving assets from London branch of the remaining large investment banks to the New York operations. As the FT notes:

This week, a group of the biggest US hedge funds warned that London banks would suffer if clients’ assets were not returned quickly by administrators as confidence suffered.

“This could be disastrous for UK plc,” wrote Richard Baker, chief executive of the Managed Funds Association, in a letter appealing to the Bank of England to intervene.

It is not just US hedge funds that are worried. “It is potentially a problem for London both because of the bankruptcy law and the parallels with the legal structure used by the other US investment banks,” said Andrew Baker, deputy chief executive of the Alternative Investment Management Association, the London-based hedge fund trade group. “If you take away the investment banks [London’s financial sector] will atrophy. There’s no doubt about it.”

Interesting.

Speaking of valuing assets (yesterday's topic), a special section in the Financial Times last week (Managing IT assets can bring big rewards) asks an important question:

Most organisations can, with a fair degree of accuracy, calculate how much their warehouses, manufacturing equipment or company vehicles are worth. Some have become adept at placing a financial value on assets less tangible, such as brand and intellectual property.

So why are so few able to provide an accurate figure for the software applications, hardware and networking equipment that power their core business processes?

The answer is shockingly simple: managers don't think of IT as an asset but as an expense.

The article goes on to state:

Soumitra Dutta of Insead, the business school, believes it is a matter of focus. He says many organisations continue to account for technology on the basis of cost alone: "Rather than focus on value creation, they see IT as an expense item to be minimised."

In research commissioned by Micro Focus, a software tools company, in late 2007, Prof Dutta found that almost two-thirds of chief financial officers and chief information officers did not know the size of their core software assets, for example, and a third do not know what they spend on these assets each year.

"We have been doing ourselves a great disservice," admitted one executive responding to Prof Dutta's research. "We have created an enormous base of intangible assets and then we have largely elected to ignore it."

This is a good example of the trap intangible assets often fall into: they are not seen as real assets. It is also an illustration of the trap that those of us who think we understand intangibles fall into: limiting our vision as to what is an intangible asset. We need to continue to remind ourselves that Intangibles are much, much more than intellectual property.

Here again, misunderstanding of the intangible asset affects the bottom line. The article describes the problems with using net book value (NBV - essentially the amortized costs approach I complained about earlier) versus residual value:

One client, for example, had estimated the NBV of equipment at £60,000 but, with the help of Morse [a systems integration company], demonstrated a current residual value of £280,000 - which it was then able to offset against the cost of a complete refresh of its estate, priced at £2m.

That is a 10% savings on the new system. Simply by paying attention to an intangible asset and getting the valuation right!

Speaking of mark-to-market, here is part of the announcement from last week by the SEC -- SEC Commences Work on Congressionally Mandated Study on Accounting Standards; 2008-242; Oct. 7, 2008:

Under legislation enacted last week to help stabilize financial markets, the SEC is required to conduct a study of "mark-to-market" accounting. The study is to be completed by Jan. 2, 2009, in consultation with the Secretary of the Treasury and the Board of Governors of the Federal Reserve System. Under the terms of the EESA, the study will focus on:

1. The effects of such accounting standards on a financial institution's balance sheet
2. The impacts of such accounting on bank failures in 2008
3. The impact of such standards on the quality of financial information available to investors
4. The process used by the Financial Accounting Standards Board in developing accounting standards
5. The advisability and feasibility of modifications to such standards
6. Alternative accounting standards to those provided in [Financial Accounting Standards Board] Statement Number 157

Floyd Norris makes a great point in his blog today -- The Problem Is the Assets, Not the Mark:

The CFA Institute, the organization of certified financial analysts, distributed a questionnaire to its members on Thursday, and so far has received more than 5,000 responses from people whose job it is to review financial statements and make investment recommendations.

It should come as no surprise that they are more concerned about banks overvaluing assets than about the possibility that mark-to-market accounting is causing assets to be valued at unreasonably low levels.

So, remind me again why it is a good idea to keep cooking the books?

A story in today's Washington Post describes the story behind the story of Paulson's Change in Rescue Tactics:

Treasury officials were probing deeper into the books of the nation's banks and concluding that there were so many troubled assets that simply using government cash to buy them up -- the strategy Paulson had pitched -- wouldn't be enough to jump-start the markets. The troubled bank Wachovia alone had $312 billion in such assets.

. . .

Federal Reserve Chairman Ben S. Bernanke had privately urged that approach [of direct injection] for weeks, but he vigorously endorsed Paulson's rescue package in part because he knew it left Paulson enough flexibility to change direction.

. . .

during the debate over the rescue bill, Paulson told lawmakers he was reluctant to inject capital into banks in part because direct investments smacked of big-government nationalization. Aside from his free-market inclinations, emphasizing that option could have led some Republicans to vote against the bill.

Moreover, if he had called attention to the provisions in the bill that made cash injections an option, stockholders in banks could have concluded that the government was about to wipe them out, as it had investors in mortgage firms Fannie Mae and Freddie Mac and insurance giant American International Group, driving stock prices down and making the need for a bailout all the more urgent.

I realize that this direct injection is the preferred method of many economists. But it is not without risks as well. As the Post story points out:

Through asset purchases, the government has considerable power to control exactly which assets get bought and which don't. With injections of preferred stock, the government has no explicit authority to ensure that banks use the new capital to increase their lending to ordinary families and businesses. There is a risk they could become "zombie banks," technically solvent but unwilling to make new loans.

The response:

Government officials said they have been deeply worried about that risk and intend to use their regulatory power to lean on the banks to take advantage of their new capital by making new loans.

I'm not sure these regulatory are a strong enough tool to prod zombies. Some are concerned that the Treasury plan doesn't go far enough in giving the US a shareholder vote through common stock. As Nobel laureate Joseph Stiglitz was quoted in the Wall Street Journal, "As we pour money in, they can pour money right out. We don't have a veto." I'm not sure that I would support Treasury voting common stock or sitting on the Board, ala the European plan. But I would like to see some clear "anti-zombie" provisions.

I would also like to have seen the banks pledge their intellectual property as collateral. I know this might seem an added complication to the process -- but we need to start thinking like we really are in the 21st Century.

Finally, we still have to deal with how to get the bankers' books cleaned up. No wonder Wachovia was in trouble -- with $312 billion of toxic assets on its books that the outside world didn't know about. It is examples like that which reinforce the hording instinct. So the sooner the TARP auctions are set up to start buying those assets, the better.

Many congratulations to Paul Krugman for winning the Nobel Memorial Prize in Economics.
I have not always agreed with Paul (especially on his early thoughts on competitiveness
- see Peddling Prosperity: Economic Sense and Nonsense in an Age of Diminished Expectations)

But his work on trade and economic geography are truly path breaking. Here are a few references to some of that work:

Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy

Strategic Trade Policy and the New International Economics

Geography and Trade (Gaston Eyskens Lectures)

Development, Geography, and Economic Theory (Ohlin Lectures)

In the search for solutions to the financial mess, some politicians and pundits have latched on to the rules for "fair value" or "mark-to-market" accounting as the villain. They claim that these rules cause financial institutions to fall into a situation of undercapitalization because of low asset valuations.

Yes, I will concede that there is a danger of valuing these assets at fire sale prices.

But the old way of accounting was simply wrong. Based on amortized costs, at best it was an ostrich-head-in-the-sand approach. At worst it was just another way to cook the books. As was noted in an earlier posting, one of the reasons why banks are afraid to lend to one another is that they know the types of accounting games that came be played -- and they simply don't trust their counterparties' books.

Well, it looks like in Europe at least, the politicians have partly won. But according to the Financial Times, at least Gordon Brown is raising the voice of sanity - (Fair value accounting rules eased):

The issue has stirred up a political storm with French and Italian leaders, among others, pushing for an easing of the rules. However, Gordon Brown, UK prime minister, said in a press briefing: “Some people are looking for a get-out-of-jail-free card and an easier way of registering their financial position than is the truth.”

He warned that changing the accounting was not a quick solution. He said the world had to find “a level playing field” and not just offer “a breathing space”. “It’s just a lot of money put on one side of the accounts to make things look better.”

Brown is absolutely right. We need to find a level playing field to deal with hard to value assets -- and not just with the current troubled assets. As we move further into the I-Cubed Economy, all sorts of other intangibles assets will need to come into play. We will need transparent and reliable methods for valuing these assets.

There are other methods. As Susan Woodward, a former SEC Chief Economist, points out, Fannie Mae has accurate models for valuing mortgage assets (Rescued by Fannie Mae?):

Some argue that Fannie is discredited for this work because it, too, has losses on riskier mortgages. But Fannie's losses arose from a failure to reserve adequately for losses that were anticipated by its models. Fannie's business people overrode the risk managers when making the decision to keep reserves too low. The models were right.

We need to explore and officially adopt these models. The old head-in-the-sand approach is responsible for getting us into the mess we are in. It will not help us get out. Nor will it help us prosper in the future.

The Dow may have rallied yesterday, but we are still a long way from an economic turnaround. If you want a clear explanation of what happened in the financial meltdown and the consequences, I would recommend this presentation from Sequoia Capital, one of the premier venture capital funds: “RIP: Good Times” (thanks to the blog VentureBeat). This presentation was given by Sequoia to the companies it invests in. Not a pretty picture.

Even as we search for solutions to the financial crisis, the search for the "why" is also underway. Congressional hearings are planned. Politicians have already pointed the finger (as have some average citizens using the middle finger). While it is important to understand the "why", it is interesting how the answer is influenced by ideological and political filters. The Republicans and the right are blaming the crisis on housing loans to poor people; the Democrats and the left are blaming greedy Wall Street speculators.

This rush to find scapegoats is part human nature. That does not mean it is correct. Understanding the "why" will take more than playing to the current political climate. So, come on guys and gals: what part of "systematic" in "systematic crisis" don't you understand?

For all the pain and anxiety and drama associated with the financial meltdown, the crisis is only a part of the overall picture. Overshadowed are the problems with underlying economic fundamentals. For years, people have been comparing our situation to the frog in the pot. Put a frog in a pot of boiling water and the frog will try to jump out. Put a frog in a pot of water and slowly turn up the heat, the frog will boil alive. The slow build up economic problems is like that frog sitting in that pot: the gradual increase in the heat isn’t enough to cause action.

Now, it is as if someone took a sharp pin to that slowly boiling frog. The pin will cause the frog to jump, while the slow boil will go unnoticed until it is too late. Solving the credit crisis won’t turn down heat. But we can hope that the sharp pin shocks the frog enough to cause it to jump out of the pot.

Easy credit is what kept Americans afloat for the past decade. With stagnant wages and families already relying on two incomes, the only recourse for many was borrowing. Borrow on easy terms to get that house you otherwise would not be able to afford; borrow on your house’s equity; borrow on your credit cards to do your patriotic duty, as the President stated after 9/11, to go shopping. And easy credit made up for the hemorrhaging of international accounts as money flowed out to other nations to pay for our trade deficit. (In some ways, we may have the last laugh as all that financial paper we sold them in return for goods and services may turn out to be worthless.)

Solving the financial crisis won’t solve the trade deficit, for example. I won’t go into the long litany of economic issues and problems. I will mention one: wage stagnation. Productivity gains – which have kept this economy going – used to be broadly shared. Somewhere over the past couple of decades the linkage between wages and productivity snapped. As a result, while the economy has grown, wages have not. If we are to put the country back on the right track, that needs to be fixed. Overcoming the financial crisis is the first step. But we also have to keep the frog jumping straight up and back into that pot. Otherwise the frog will be back where it was, boiling alive.

Here is exactly the problem (from Floyd Norris's column today in the New York Times):

Each bank knows the games it has played in valuing assets — or at least could have played — and is loath to believe the balance sheets of other banks. That suspicion has chilled the interbank lending market.

The financial crisis has long moved beyond the realm of economics; it has become all about psychology. Specifically, it is about the psychology of uncertainty. Hence the need for clear information – not new attempts to cook-the-books.

As Norris goes on to say:

The government could be selective in deciding which banks get the cash, and it could impose conditions on those that seek the money. Those banks could be required to come clean about the risks that they have taken in dubious assets, and to write those assets down to what a willing buyer would pay now.

With that information, the government may decide to let some banks fail. But the others, in which the government does invest, would have a government seal of approval that was backed up by cash.

Coming clean about their books -- that would be the right thing to do.

BEA announced this morning that the trade deficit for August improved somewhat. The deficit dropped to of $59.1 billion from the July figure of $61.3 billion, revised. Both exports and imports declined -- a clear sign of economic slowdown. The improvement in the deficit was imports declining more than exports. The decline in imports was helped by lower oil prices. But, as the New York Times notes, “the politically sensitive deficit with China increased as imports from that country hit a record.”

Our intangibles surplus also decreased in August to about $11.7, from $12.8 in July. Both receipts (exports) and payments (imports) of royalties increased in August – payments jumping by over $900 million. Exports of business services decline slightly while imports grew slightly.

Trade in Advanced Technology Products returned to normal after the anomalous jump in the deficit in July to over $7 billion, as aerospace exports returned to there normal level in August. The technology deficit in August was $3.2 billion – similar to previous months. 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.

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.

From the blog Vox comes this posting by Marco Pagano, Professor of Economics, University of Naples on simplified information for investors yesterday, catastrophic uncertainty today:

By simplifying the information they transmitted to investors, banks managed to expand the market for the structured bonds that they issued. But this has also led to a catastrophic uncertainty that paralyses markets and even affects policy choices. The choice of opacity by issuers and rating companies has been socially harmful and should have been constrained much more tightly by regulation. Until today, though, few believed that transparency could be worth as much as 5% of US GDP.

In other words, issuers didn't want to give investors complex information:

by simplifying the information transmitted to the market, banks managed to expand the market for the structured bonds that they issued: providing detailed and complex information would have kept away from the market many unsophisticated investors, who would have been at a disadvantage compared to those capable of processing this information.

The result is market crushing uncertainty. And so why do some want to go back to the old days of cooking the books and a regulatory system that promotes less accountability?

Just in case you are interested, here are the rules for the New York Stock Exchange Circuit-breakers (from the NYSE website):

CIRCUIT-BREAKER LEVELS
FOR FOURTH-QUARTER 2008
In the event of a 1100-POINT decline in the DJIA (10 percent):
Before 2 p.m. -1-HOUR HALT
2-2:30 p.m. - 30-MIN. HALT
After 2:30 p.m. -NO HALT

In the event of a 2200-POINT decline in the DJIA (20 percent):
Before 1 p.m. - 2-HOUR HALT
1-2 p.m. - 1-HOUR HALT
After 2 p.m. --MARKET CLOSES

In the event of a 3350-POINT decline in the DJIA (30 percent), regardless of the time, MARKET CLOSES for the day.

NYSE Circuit Breakers
In response to the market breaks in October 1987 and October 1989 the New York Stock Exchange instituted circuit breakers to reduce volatility and promote investor confidence. By implementing a pause in trading, investors are given time to assimilate incoming information and the ability to make informed choices during periods of high market volatility.

Rule 80B
Effective April 15, 1998 the SEC approved amendments to Rule 80B (Trading Halts Due to Extraordinary Market Volatility) which revised the halt provisions and the circuit-breaker levels. The trigger levels for a market-wide trading halt were set at 10%, 20% and 30% of the DJIA, calculated at the beginning of each calendar quarter, using the average closing value of the DJIA for the prior month, thereby establishing specific point values for the quarter. Each trigger value is rounded to the nearest 50 points.

The halt for a 10% decline would be one hour if it occurred before 2 p.m., and for 30 minutes if it occurred between 2 and 2:30, but would not halt trading at all after 2:30. The halt for a 20% decline would be two hours if it occurred before 1 p.m., and between 1 p.m. and 2 p.m. for one hour, and close the market for the rest of the day after 2 p.m. If the market declined by 30%, at any time, trading would be halted for the remainder of the day.

Under the previous Rule 80B trigger points (in effect since October 19, 1988) for a market-wide trading halt, a decline of 350 points in the DJIA would halt trading for 30 minutes and a drop of 550 points one hour. These trigger points were hit only once on October 27, 1997, when the DJIA was down 350 at 2:35 p.m. and 550 at 3:30, shutting the market for the remainder of the day.

From a story in today's Wall Street Journal - Wachovia Talks Snag Over Division of Its Assets:

After burrowing deeper into Wachovia's books, Citigroup and Wells Fargo have been surprised by the concentration of assets they regard as low-quality, these people said.

In other words, we don't have a clue as to how wide and deep (or narrow and concentrated) this problem is. Which is why we need better information on what the financial institutions are holding -- not new attempts to essentially "cook the books."

The Detroit Free Press is reporting that GM is looking to borrow money based on it signature Renaissance Center HQ building:

GM paid off its debt on the Renaissance Center in May and is now assessing its options for monetizing the buildings, said spokesman Dan Flores.

Raising funds with its headquarters building could generate more than $500 million in cash at a time when GM is working to cut $10 billion in costs and generate another $5 billion by selling some assets and borrowing against others.

Given that GM probably has a large patent portfolio, I wonder if they have looked into using that for borrowing purposes as well. In an earlier posting, I suggested that the auto companies should put up their IP and other intangible assets as collateral for the large government loans they will be getting. I still think that is a good idea.

Martin Wolf is spooked. In today's column in the Financial Times (It is time for comprehensive rescues of financial systems), he states:

The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago. But unjustified panic also causes devastation. It must be halted, not next week, but right now.

At this point, I agree that the do everything approach may be needed. But even there, Wolf is only part way to the “everything” that needs to be done.

There are three interrelated problems. First is the financial system meltdown: the credit lockup and the huge uncertainty of the fiscal status of banks -- leading to a shareholder run on financial stocks. The second is the stock market meltdown as that shareholder run drags everything else down. The third is the underlying weakness in the economy. This weakness both helped precipitate the financial meltdown (as the housing bubble burst as mortgage payments were missed and foreclosures rose) and has been, in turn, fueled by the financial crisis. As the Wall Street Journal reports:

The relentless slide in home prices has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults -- the very misfortune that touched off the credit crisis last year.

Most of the actions by the various governments worldwide are aimed at addressing the first two problems: the financial markets problem directly and the stock market problem indirectly by addressing the financial market problem. At some point, the third issue of the weak economy must be addressed. And addressed in a way that goes beyond just the housing portion of the problem.

Right now, the various governments need to stop the panic. As Vikas Bajaj writes in the New York Times, Forget Logic; Fear Appears to Have Edge:

The technical term for it is “negative feedback loop.” The rest of us just call it a panic.
How else to explain yet another plunge in the stock market Tuesday that sent the Standard & Poor’s 500-stock index to its lowest level in five years — particularly in the absence of another nasty surprise?

Crafting the larger economic package will be the task of the new Administration and the new Congress. What that package includes will likely be the subject of intense discussions between the incoming Administration and the leadership of the new Congress -- starting November 5.

So stay tuned.

In other news, chip maker AMD announced it would spin off its manufacturing facilities to a new company called Foundry Co. As the Wall Street Journal reports:

The strategy -- variously called "asset light" or "asset smart" by AMD officials -- mirrors strategy changes that many companies have gone through to cope with rising costs and fierce price competition in the industry. Texas Instruments Inc., for example, has given up developing new processes for creating digital chips, though it still runs factories based on older, analog technology.

Instead of owning their own plants, most companies that design chips now rely on companies known as foundries that operate chip manufacturing services. The new AMD venture is expected to join the ranks of such foundries.

While this has been the trend in the semiconductor industry for years, I worry about this "asset light" strategy. Yes, intangible assets, such as the design capability, are at the heart of the value-added process. But the linkage between the product development and production processes is often important in the innovation ecosystem. By not keeping a tight linkage, a company runs the risk of getting locked into simply making the same old thing -- and not taking advantage of new opportunities and information coming out either product or process developments.

Now, granted, ownership is not the only way to maintain that coupling. In the new collaborative business models, the information flow and working relationship is much more important. And common ownership/management does not prevent the old silo effect where design and production never talk to one another. But the arms-length distance between spun-off companies may make the silo issue even worse -- if management has not put in place systems to overcome that problem.

Time will tell whether AMD's strategy will work. In the short run, it looks like a mechanism to infuse capital into the very capital intensive portion of the process (the chip foundry) without having to sell off part of the company as a whole. The outside investors get a stake in Foundry Co., not in AMD. In the long run, we will have to see how it affects AMD's ability to move into new markets -- or survive as solely a chip designer.

It should be clear to everyone by now that the current economic meltdown has become a matter of lack of confidence. What began as a financial problem of dealing with bad loans has turned into a full scale crisis as credit markets have locked up. Investors fear runs on financial institutions -- not on their deposits but on their stock value.

Today was a little bit better than yesterday. The Fed announced that it will purchase commercial paper - which should loosen the credit markets a bit. And the stock market got a bit of a bounce.

But, as I have said before, there is still the possibility of a lot of blood on the floor before this is all over. Those toxic assets still need to be gotten off the books - and how ever that is done, it will not be pretty.

So, in these times I offer two simple words of wisdom from Doug Adams, that great philosopher and author of The Hitchhiker's Guide to the Galaxy:

as chatter spread around trading floors that Mitsubishi-UFJ could abandon its agreement to take a stake in Morgan Stanley. The buzz sent Morgan shares sliding roughly 30% and helped cause a broader rush out of stocks. Morgan Stanley later issued a statement saying that the deal remained on track, helping stanch the selloff, but its shares were still down by more than 22% in afternoon trade. Rivals like Merrill Lynch and Barclays also were sharply lower, falling 27% and 19%, respectively.

Peter Boockvar, equity strategist at Miller Tabak, said the "noise" surrounding Morgan Stanley had put the entire market on edge. "Everybody's nerves are completely fried," he said "On the slightest chance of a reversal, everyone runs for the doors."

Tom Palley has offered what I think is one of the clearest explanations of why we need to craft a new regulatory policy for the so-called shadow banking system (which he calls the parallel system). The essay ("Why Federal Reserve Policy Is Failing") is available on the Financial Times or Palley's website. Core of his argument is the different situations facing the traditional banking and the parallel system:

First, traditional banks are significantly funded by customer deposits. Ironically, such deposits can be withdrawn on demand and are in principle even more insecure than short term roll-over funding. However, they stay in place because of federally provided deposit insurance.

Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans. These loans are therefore priced by auditors on a mark-to-realization basis. However, if they were securitized their market value would be significantly lower owing to current disruptive market conditions.

The bottom line is that the banking system is in better shape not because of its virtues, but because of policy. Deposit funding is safe because of deposit insurance. Banks are spared mark-to market losses because of different accounting rules. And the Federal Reserve is providing banks with massive liquidity infusions through its discount window and its various emergency auction facilities.

Policy has therefore ring-fenced traditional banks. But in the meantime it has left the parallel system in the cold, leaving a gaping hole in the policy dyke.

This policy stance reflects the Fed’s continuing attachment to an antiquated view of the system whereby it takes responsibility for traditional banks and nothing else. Such a policy makes no sense and will fail. The Fed encouraged development of the parallel system, and that system undertakes many of the same activities as traditional banks. Meanwhile, failure of the parallel banking system will continue putting downward pressure on asset prices and lender confidence.

The Treasury’s proposed $700bn asset purchase program will help put a needed floor under asset prices. However, it does nothing to tackle the parallel banking system’s roll-over funding crisis that is crimping lending and pushing firms into bankruptcy. That is causing distress to spread far beyond the mortgage market, undermining the ability of any asset purchase program to put a floor under asset prices.

The urgent implication is the Fed (and other central banks) must extend its safety network to include the parallel banking system. Just as the traditional banking system needs liquidity assistance, so too does the parallel system. That assistance can be provided through such vehicles as the discount window and Federal Reserve auction facilities, and it should be allocated to qualified firms able to post appropriate collateral.

I'm not sure Palley's recommendations go far enough. But they do underscore the fact that the current situation is a result of policy failure as well as market failure. Similar to the S&L Crisis, policy changes did not keep up with market changes and in part drove market behavior. To cope with the current situation, we will need a more comprehensive re-look at the financial system -- not just the regulatory process.

Unfortunately, history shows that we are not very good at such comprehensive undertakings. We tend to muddle through, putting out fires as we go. That would lead me to predict more fires -- big and small -- as we go forward, rather than a large scale fire prevention program.

Let us hope I am wrong.

The Wall Street Journal blog Real Time Economics has a great piece - Is Debate Over Mark-to-Market Just a Waste of Time?

The posting summarizes both sides of the debate and ends with the following:

In an excellent post on the Curious Capitalist blog, Justin Fox makes a point that may make the whole debate moot. “Investors and regulators and reporters and corporate executives need to learn not to take any financial reporting numbers, whether marked-to-market or not, at face value. The health of a bank or any corporation can never be adequately measured by a single bottom-line number. Understanding the assumptions and uncertainties inherent in accounting numbers is crucial to understanding how to use them,” he writes.

In the current environment, everyone seems to be taking Fox’s advice. That may be one reason why these markets are frozen in the first place. Even if mark-to-market rules are suspended immediately, it won’t change the makeup of a company’s balance sheet. Investors have decided that these assets are toxic and no matter how a bank accounts for them in its books, that sentiment isn’t likely to change unless investors see some proof that the instruments are actually undervalued. So far, there’s been little to suggest otherwise.

This lack of information about what is on the books is, for me, a major part of the problem. The Real Time Economics piece quotes Brian Wesbury's WSJ op-ed How to Start the Healing Now:

A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.

Yet, a recent article by But a recent article by Joe Stiglitz in The Economist’ Voice We Aren’t Done Yet: Comments on the Financial Crises and Bailout implies that most of these assets are toxic and doubts whether they can be valued properly. As an expert on asymmetric information in economic transactions, his warning can not be ignored. Stiglitz also argues that a number of other measure need to be undertaken, such as also getting warrants from the banks in exchange for buying the assets and addressing the underlying housing foreclosure problem. I completely agree. But we also need to figure out how to clean up the books so that everyone knows what is going on – and normal financial exchanges can resume.

In about 2 hours, when the House finishes voting on the package, we will know if we have taken this first step. But the title of Stiglitz’s article is right on point: We aren’t done yet.

And as Fox’s comment underscore, the mark-to-market debate is partially irrelevant. The idea that there is a single number that will give us all the answers about these complex financial instruments is ludicrous. So, the issue should not be focused on solely what the “mark” is – but should revert back to the old math exam requirement: “show your work.” That should be the core of any movement to greater transparency.

Normally, the news from BLS that employment dropped by 159,000 would be the stuff of headlines and move financial markets. This is especially true since the numbers were worse than expected (see New York Times and the Wall Street Journal). But the September job numbers -- usually one of the politically most important pieces of economic data, since it is the last look at employment before the election -- was overshadowed by other news. Wall Street (and the nation) is holding its breath to see what happens to the Emergency Economic Stabilization Act. All eyes are also on the Fed. And politically, the biggest show was to see whether a VP candidate would melt-down or revive. Even the fast pace of events has us surprised, such as the news that Wells Fargo is acquiring Wachovia rather than the government-sponsored purchase by Citigroup. Even with the bad numbers, the stock market opened with the Dow up over 100 points.

In other words, this morning's employment numbers were almost irrelevant. They didn't tell us anything we really didn't already know.

That statement, in and of itself, should be an indicator of the extraordinary times we are in. Scary, real scary.

Our friends over at the economics blog The Big Picture make an excellent point in their recent posting Understanding the Significance of Mark-to-Market Accounting:

Now that the garbage is on the books, no one wants to admit the original error of purchasing this class of assets. Its not just that the trade has gone bad, its the original buying decision was so flawed even if the trades were not such giant losers.

Recent actions of corporate titans in the financial sector are essentially an admission that their business model was deeply flawed. No one would invest any capital for a ROI of 50 bps per year. They of course knew this -- so they leveraged up that 50 bps 35X or so, creating the false appearance of more attractive returns. This higher risk, potentially higher return paper was part of that misleading process.

Suspending FASB 157 amounts to little more than an attempt to hide this broken business model from investors, regulators and the public. Its not just getting through the next few quarters that matters; Rather, its allowing the market place to appropriately reallocate this capital to where it will serve its investors best. That is what free market capitalism is, including Schumpeter's creative destruction. (A WSJ OpEd today get this issue precisely wrong).

They go on to say:

If FASB 157 is suspended, I would advise our clients and the investing public that owning any financials that failed to disclose their holdings accurately were no longer investments -- they were pure speculations.
(Emphasis added)

Not the way to restore confidence in the markets.

GillianTett's column in today's FT point out a contrubuting factor to today's mess -- Seeds sown in murky finance (published in hard copy under the better headline of "The yawning information gap between bankers and the rest"):

More specifically, during most of this decade, bankers have assumed that it was not just acceptable but also entirely normal to have a situation where 99.9 per cent of people had absolutely no idea how money really flowed round the world. Twenty-first century bankers, in other words, have been acting like a BlackBerry-toting priestly class that assumed that only people who spoke the equivalent of advanced financial Latin should be allowed to attend mass.

Meanwhile, politicians and voters, for their part, have been shockingly lazy in trying to understand finance – or even just asking why they were suddenly finding it so easy to get access to cheap cash. Much of the media has been remiss too: most mainstream outlets all but ignored the fact that a revolution was under way in finance during the first seven years of this decade.

Which is why I recommended mandatory disclosure of information on intangible assets in corporate financial reports (see Reporting Intangibles) and I support financial literacy programs as a necessary part of the I-Cubed Economy.

There is a reason I really like Steven Pearlstein -- he has a way of cutting through to the heart of the matter. In today's column (No Silver Bullets Here), he looks at the alternatives to the Paulson financial plan. Two proposals have concerned me: ending mark-to-market and direct recapitulation. On recapitalization, I don't understand how simply throwing money at the banks will help. As Pearlstein says"

Given the widespread fear of lending to or investing in banks until the full extent of their lousy lending becomes clear, there's a good chance that injecting large amounts of government capital wouldn't do much to attract additional private capital, or even get banks to begin lending again.

Getting to the heart of the matter, the issue is not really liquidity but confidence. As long as the banks' capital base is suspect -- presumed now to be full of toxic assets -- the distrust will remain.

This brings me to the point of mark-to-market. I fully understand the concern of some that mark-to-market will undervalue hard-to-price assets, turning what could be good assets in the long run into toxic assets in the short run. (For more background, see the AP story Banks want to suspend accounting rule in bailout and the New York Times story S.E.C. Move May Relax Asset Rule, among just a few of the many stories on this subject).

The SEC and FASB has issued an interpretation that re-stated the fact that:

When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.

My problem with this approach is that it does not necessarily give investors a clear idea of what is going on. I have long argued for a "safe-harbor" for the disclosure of intangible assets - that would allow management to estimate value. But that has to be tied to a clear and transparent -- and generally accepted -- methodology for making those estimates. Here again, Pearlstein has an interesting idea:

There is an easy compromise here: Require banks to disclose market prices right alongside their own estimates of "fair value." Let the investors decide which to rely on.

As Lynn Turner (former Chief Accountant at the SEC) notes in today's Financial Times (Banks want to shoot the messenger over fair value rules):

Transparency is critical to gaining investors' trust in markets. Unless information is accurate and reliable, investors will not trust it. When investors are given misleading or incomplete information, they rightfully steer clear of investing in the markets because all too often it leads to losses.
. . .
To bring back investors to the markets, they must once again be convinced they are getting reliable information upon which to base informed, not misinformed decisions.

Suspending mark-to-market doesn't get us there. Allowing banks to continue to hold and hide toxic assets doesn't get us there. Creating better mechanisms for understanding and then cleaning up the mess on the books is what we need.

Hopefully, the bill that passed the Senate last night will move us in that direction.

Otherwise, it is really time to worry -- big time.

Here is a resource I ran into recently. The London School of Economics' Information Systems and Innovation Group has a video archive of some of its seminars. Some of these are a little dated - but still of interest.

David Leonhardt's take on the root casues of the financial mess - in today's New York Times "Economic Scene" column Lesson From a Crisis: When Trust Vanishes, Worry:

As a young academic economist in the 1980s, Mr. Bernanke largely developed the theory that the loan officers’ lost knowledge was a crucial cause of the Depression. He referred to this lost knowledge as “informational capital.” In plain English, it means that trust vanished from the banking sector.

The same thing is happening now. Financial markets are global, not local, today, so the problem isn’t that the failure of any single bank locks individuals or businesses out of the credit markets. Instead, the nasty surprises of the last 13 months — the sort of turmoil that once would have been unthinkable — have caused an effective breakdown in informational capital. Bankers now look at longtime customers and think of that old refrain from a failed marriage: I feel like I don’t even know you.

And that is why I am worried.

Here is a classic example of how our laws and regulations mess up when it comes to intangibles. The Federal Aviation Administration (FAA) wants to auction off airport landing slots in the New York area (as part of a plan to ease airway congestion). However, yesterday, the Government Accountability Office (GAO) said the FAA lacks the authority to do so. Aviation Week explains:

FAA argued that slots are intangible property that it owns and may lease. The GAO disputes this claim. "An examination of [applicable] statutes read as a whole, however, makes clear that Congress was using the term 'property' to refer to traditional forms of property... It was not referring to FAA's regulatory authority to assign airspace slots, no matter how valuable those slots may be in the hands of the regulated community." GAO says related case law confirms its conclusion.

In other words, GAO, backed by case law, apparently believes only tangible property is property.

Regardless of the merits of the auction plan, this is a very bad precedent. It highlights the inconsistent treatment of intangible assets in our laws and regulations. That needs to be changed.