Failure Without Context

Will history make much of the financial volatility we’re seeing? Will September 15th, 2008, achieve a legendary nickname, like Black Monday, or Black Thursday?

I don’t know. And, despite the huge amount of opining facilitated by the internet, nobody else knows, either.

The Dow Jones Industrial Average dropped about 10% in a day or two. But not straight down a steady slope. Few seem to have perspective that the Dow is only 30—albeit huge—corporations out of 7000+ companies regularly traded in the USA.

One of those 30 in the DJIA, American International Group, was the most recent to “fail” in the current market. Again, not overlooking the far-reaching effects that the banking and insurance industries have on all sectors of the economy, remember this current spate of turmoil is centered on the financial sector. Manufacturers, retailers, basic materials, non-financial services, energy, etc. are not “failing”.

Why do I insist on putting “fail” in quotes? Because after reading the common-man and political blogs, and listening to Obiden and McPalin issue statements, I’ve realized most people don’t really know what these failures entail. Nor do they have any useful definition for what constitutes a “bailout”.

I certainly do not know in any professional-level detail. But I have looked into it, deeper than necessary for rhetoric. Deep enough to challenge my feelings and test my biases. The banks that have failed are considered so because of their balance sheets.

The balance sheet of a bank includes non-physical assets and liabilities that most experts don’t understand. Which is, in simple terms, why they failed. The liabilities are now being more properly valued. Physical assets, like your house, are still standing. Nothing real, in the common-man sense, has been destroyed. Some assets have lost some value, like your house (unless you live in large swaths of Texas and the mid-South, where real estate has not been declining). But the underlying physical stuff is still there, and still useful.

So the “hard” asset side of the balance sheet is O.K. Not great, but O.K. It is the liability side, where bankers and insurance companies figured out how to isolate and bet on the riskiest part of the national loan pool, which has collapsed. The experts were wrong. Or, probably more true, the experts just didn’t spend much time measuring and verifying the risk profile of the national loan pool.

In double-entry bookkeping, every liability is somebody else’s asset. On some balance sheets the liabilities, which are now recognized to be huge, translate to be assets now worth zero. These are “soft” assets. Not houses, factories, machines or intellectual property like software and databases. The stuff we all use to make more stuff is still there and still at work.

If banks and insurers are unable to make loans and mitigate real risk, it is harder for business to expand and in some cases, continue operating. But there is still demand for what they do. The world most folks live in hasn’t changed. The labor force hasn’t forgotten how to provide for the needs the market demands. Business managers just have to figure out how to reshuffle their cash and short-term promises of payment. Providing that service, keeping money liquid and moving, is something banks do. That part of their business is still sound, in demand, and profitable.

Thus, these bank failures don’t seem to be the kind of total failure most folks take it to be. Perhaps we have a problem of specialized vocabulary in finance sharing the same words as common language. The same words have different meanings in different context. Context is essential. And context is lacking as folks pontificate and opine about what went wrong and what their candidate will do to fix it.

Next, I'll offer my take on whether the Federal Reserve’s assumption of AIG’s assets is a bailout or nationalization. First, one must look into what those terms mean. I hope to get that out before this whole situation is eclipsed by the next “crisis”.