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?

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.

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.

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.

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?

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.

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."

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.

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.

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.

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."

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 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.

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.

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.