Categories and Systems

Probably early humans benefited more from thinking in terms of categories than in terms of systems. "Is that food, or not?" and "Is that my friend, or not?" being two important categorizations.

And so we still seem to define categories and compartmentalize more than we make connections and think about systems, let alone "systems of systems".

The "interesting" events in the financial world are an example of categorizing more than systematizing. Many institutions have been playing the game of "subprime" lending for years. The way these games are presented is in terms of "markets" where a market is treated more as a category than as what it really is: a system. And the relationships *between* markets is repeatedly overlooked. The Japanese financial crisis of a decade ago or so hit Portland, Oregon somewhat hard, but only after the local business analysts declared the result would be otherwise because Japan is "over there" and Portland is "over here".

For quite a while now the headlines have been presenting the problems with subprime loans and defaults on them. The subprime market (category) was in trouble. "No problem. So what if some low-wage earners can't pay their debts and some lower-tier lenders take a bath? I'm not in that category."

Recently the problems secondary effects on other markets have been presented as problems of "confidence". That's probably true, since all markets are ultimately based on confidence. But that's not the real problem, since all markets are ultimately related, and in many cases far more closely related than the institutions would want investors to believe.

"Our current system of levered finance and its related structures may be critically flawed..." Uh-huh. From the International Herald Tribune...

The result has been a freezing up of markets for many securities that, it turns out, were critical to the free flowing of credit in recent years.

"Our current system of levered finance and its related structures may be critically flawed," said Bill Gross, the chief investment officer of Pimco, a mutual fund company. "Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment."

The basis of the system has been a belief that securities backed by bad credits could be very safe - so long as there were other securities that would suffer the first losses that came from defaults in pools of subprime mortgages, or of loans to highly leveraged companies.

Even the people playing the system are finding out they've been playing a misconception of the true system. The true crisis of confidence is now about finding out what the true system is, and how it works, in order to find some solid ground for building up confidence. No confidence: no credit. No credit: no business.

One of the bases of confidence has been the credit rating system. That turns out to be based on a system that does not truly exist. Or at least not in the form used to establish the bases.

"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating," the French bank said.

Added to the problem is that the questionable securities now are widely owned, and sometimes have been repackaged to form the basis of other securities.

Gross compared the problem confronting investors to a game of " 'Where's Waldo' - Waldo being the bad loans and defaulting subprime paper."

Suddenly, some fear Waldo is everywhere. European banks and funds own paper tied to subprime mortgages, and it is not clear who else does, or how investors will react.

"You have to believe that in the hedge fund and mutual fund complexes, there is a decision that is building that says, 'I want to hold some Treasuries to have a cushion if I see redemptions,' " said Robert Barbera, chief economist of ITG.

We need better tools and more awareness of the systems we live in. This crisis is a problem due to lack of systems thinking. We've enjoyed the credit ride fueling the economy for the last seven years or so, flying high, smooth sailing.

Meanwhile, hold on. Monday could get a bit bumpy, and there could be a fair bit of turbulence ahead during the search for solid ground. And we may be running out of gas.

If the current panic is just that - unreasoning fear - then... cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need for them to sell them. As they eventually turn out to be good, the loans can be repaid and all will be happy.

On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.

But the central banks still confront significant challenges. The new financial system, with its credit expansion through securitization, made it possible for questionable borrowers to keep borrowing at very low rates even as the Fed was tightening.

Now, the combination of market reaction and new regulations on mortgage lending have drastically tightened credit on many borrowers...

The new financial system is not the one the Fed was created to deal with, but it is the one it must try to handle.