This post was originally published on my blog at www.marktomarket.typepad.com.

For the past two weeks, we have constantly heard opinions, analysis and perspective from many people on the historical chain of events currently taking place within the financial markets. It seems everyone has an opinion and regardless of the financial and economic variables at stake, the issue has not surprisingly been politicized to no end. As such, I have taken most of what I’ve heard with a grain of salt, but I am confident there are some viewpoints that are worth further consideration by everyone involved. Similarily, Steven Levitt, author of the NY Times’ Freakonomics blog, made a smart move by going to a pair of economists whose insight is actually worth something in this discussion, unlike most people you will hear talking about the situation on CNBC, Bloomberg or any other network. Click here to read Levitt’s full post.The Freakonomics author talked to Anil Kashyap and Douglas Diamond, two well respected economists from the University of Chicago and the Chicago School of Economics. I admitedly am not as familiar with the research of Kashyap, but Diamond is someone whose research I have become well acquainted with in recent months, in that one of my graduate school classes was practically formed around the framework by Diamond and Phillip Dybvig that models bank runs in modern financial systems. So, Diamond literally wrote the book (or paper) on why bank runs occur; as such, I’m thinking we should listen to what he has to say about the current chain of events taking place within our financial system.

Here are a few of Diamond and Kashyap’s points that I thought were especially pertinent …

The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression. […]

This is a pretty significant comment, considering economic downturns and recessions are fairly cyclical, so numerous economic crises have come and gone since the 1930’s; however, the best economists out there are saying this situation is turning out to be the worst since the Great Depression. That’s scary, especially considering the fact that we’re technically not even experiencing an actual recession yet.

This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. […]

I thought this was interesting, because the authors completely ignore the original source of the current economic downturn, which began more than twelve months ago. Further, they neglect the fact that another long-time financial firm completely died earlier this year. But, I guess this makes sense, because what is happening in today’s markets is happening because of Lehman, Freddie/Fannie, Merril/BofA and AIG. Bear Stearns, Countrywide and the other firms that have been sucked down by the housing crisis and general economic challenges are beside the point … right now, at least.

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government.

I thought this last comment was interesting, because it struck up some thoughts going back to the conversations that I recently had with some of my grad school colleagues and Professor Laurence Harris, who is Director of the Center for Financial and Management Studies (CeFiMS) at SOAS, University of London, which also happens to be where I am a masters student, studying financial economics.

Earlier this week, we discussed whether or not the failing banks are the result of a liquidity crisis or full-fledged insolvency. Quite a few of the pundits and commentators on Wall Street keeping saying that this isn’t a situation of illiquidity by these banks, because they indeed have significant capital reserves. It’s a situation of insolvency, according to many of the commentators. These folks go on to say that this is more of a moral hazard issue, or worded differently, the problem has been mismanaged debt.

Firstly, I do indeed agree that moral hazard plays a distinct role in this credit crisis. The debt that has emerged on the balance sheets of large financial firms leaves even the most skilled market analysts and economists speechless. It’s honestly baffling.

However, I think some have underestimated the role that illiquidity is playing in these events. Let me also point out the theory that there really is no actual distinguishing factors between illiquidity and insolvency. For the central bank to interject capital via the credit window, this is a solution that takes place over a relatively short span of time. As such, monetary policymakers do not have the time to adequately conclude whether or not the firm is insolvent or suffering from illiquidity, or both.

When you look at the balance sheets of Lehman Brothers (as well as that of Bear Stearns before they were acquired and Freddie/Fannie before their bailout), you will see what looks like adequate amounts of capital reserves. Like I pointed out above, that is why most conclude moral hazard is to blame for the runs on these banks. However, if you look deeper at the debt instruments on these balance sheets, one could easily question the liquidity that these firms have/had. For instance, with Bear, it was agreed by Bear’s management and regulators from the Fed that if they did not act before the markets opened in Asia, then the firm would likely not have the liquidity to cover all of its liabilities. Therefore, a run on the bank ensued.

I think a similar scenario was acted out this past weekend. While I would love to have been a fly on the wall during the discussions that were taking place between Bernanke’s people and the top execs from Lehman, Merril, BofA, AIG, etc, I would argue that the issue of liquidity played a a prominent role in these discussions.

One of my grad school friends asked why did these events happen so quickly; could they not have dragged these out longer, in order to seemingly better evaluate what exactly would be the best solution? Well, I believe it the issue of liquidity was the reason they could not wait. I think it was like the situation with Bear Stearns, where if the markets opened before something was done, then some of the largest financial institutions in our system would collapse without the cover of Chapter 11 (or some other ‘bailout’ solution). Bottom line, they couldn’t prevail on their own and I believe liquidity was one of the prime reasons for that. Of course, moral hazard played a key role, but when it came down to it, Lehman, Freddie/Fannie, AIG, and the others did not have adequate protection to shield them from what the markets would deliver the following trading day.

Further, I believe this was definitely the situation when it comes to AIG, which the Fed just paid $85 billion to bailout. Diamond and Kashyap had the following to say about AIG …

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging. Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

Moving on, though, I think the issue of Freddie and Fannie should be addressed separately from the others, and it was Diamond’s comments that have sparked these thoughts. Here’s the thing when it comes to Freddie/Fannie … how could we not expect the housing-centered GSE’s to succumb to an economic crisis? Let me put it more clearly: Freddie Mac and Fannie Mae were organizations responsible for guaranteeing mortgages. When the housing market went south, you have to know these organizations would be some of the first to get hit. Quite frankly, I’m surprised these organizations have lasted this long.

And finally, we cannot conclude this issue without addressing the political situations that have developed throughout this chain of events.

Greg Mankiw references a quote from House Speaker Nancy Pelosi (D-CA) today, which was published in the Wall Street Journal:

“Why does one person have the right to grant $85 billion in a bailout without the scrutiny and transparency the American people deserve?”

Now, in this quote, Pelosi was questioning Fed Chaiman Ben Bernanke’s ‘right’ to bailout AIG with an $85 billion bailout, without approval from Congress, or at least I assume she would have preferred Congress to grant such approval.

Well, Madam Speaker, Chairman Bernanke’s ‘right’ to grant such a bailout comes from the President of the United States and the US Congress, in that the authority to make such an injection of capital via the Fed’s credit window resides with the Chairman of the Federal Reserve. Perhaps the Speaker’s people should refresh her on the process of monetary policy in the US, because her question has a very clear and simple answer, which I would hope she would be familiar with as Speaker. Needless to say, her comments were very inappropriate, not to mention assenine and insanely clueless.

With that said, however, the situation with AIG does bring up some questions for me, which have nothing to do with Bernanke’s authority to inject capital, regardless of the amount. In fact, one of the tenants of the central bank’s role as a provider of liquidity is that it must be prepared to allocate any amount of capital when liquidity is necessary. Moreover, this is Bernanke’s authority and role to make such a decision, and the Congress plays no role in this process, regardless of the fact that fiscal policymakers believe they should have the final say on everything.

My question is aimed more at the ‘macro level’ of the situation; specifically, why did AIG get bailed out, while Lehman was allowed to fail? The simple (and most common) response that I have received to this question from experts is that Lehman was not rescued, because the Fed had to draw a line somewhere, and Lehman was the ‘fall-out boy’ for the Fed to prove its point.

I understand that response, and perhaps agree with it … to a point. But, why did AIG receive such a hefty bailout? Indeed, it cost the government $55 billion more to rescue AIG than it did Bear Stearns. Further, one could easily argue the solvency of Lehman compared to the illiquidity and thus insolvency of AIG by the poor management of illiquid assets on AIG’s balance sheets. Now, I’m not advocating that Lehman should not have fallen, based on its poor management; however, I am also not sure why AIG was rescued over Lehman.

When Bear was rescued, the Fed created a new lending facility to help provide bridge financing to other investment banks. The new lending arrangement was proposed precisely because there were concerns that Lehman and other banks were at risk for a Bear-like run. Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night. Once the Fed had made these changes and determined that it and the others in the market had an understanding of the indirect or “collateral damage” effects of a bankruptcy, it could rely on the protections of the bankruptcy code to stop the run on Lehman, and to sell its operating assets separately from its toxic mortgage-backed assets.

I am sure there are numerous explanations as to why the events have transpired the way they have; however, I am just not convinced by anyone’s story as being totally accurate just yet, mostly because everything we’ve heard (until now with Diamond’s analysis) has been misinformed and uneducated speculation, based on sketchy bits of information. Indeed, Diamond and Kashyap go into detail specifically answering this very question, and I agree with it, based on what we know at this point. I just am still not convinced we have all of the information to speculate on this matter, especially seeing that the best detailed explanation out there essentially says that Lehman failed because the Fed did not want to contradict the lending facility established after Bear’s fall. If that’s the ultimate reasoning, then that was quite an expensive outcome of the Fed ‘sticking to their guns.’

In closing, I think Diamond and Kashyap concluded their thoughts with an appropriate topic. In answering the question of ‘when will it all end,’ they said:

The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.

Now, you don’t have to be a tenured economics professor at the University of Chicago to understand that, but this simple point is so important for all of these people I see on a daily basis (literally) speaking on CNBC and Bloomberg saying we’ve hit a bottom and it looks like we could see things turn around. If you’ve read my material before, you’ll know I am not a fan of the ‘gloom and doom’ school; however, let me be clear of one thing: we are not out of the woods. In fact, we are nowhere close to being out of the woods. Just because the markets gained 400 points today doesn’t mean anything, except that some people may have gotten an adequate chance to cover on some of their positions. Other than that, we can only expect to see more losses in the near future.

The reason for this is because there is still a significant amount of bad debt out there. Just go look at analyst ratings of the remaining large financial firms and look at their balance sheets. You will see that they are not in a position to turn around any time soon. Even Goldman Sachs (GS), the firm that was considered immune to a good portion of the financial crisis, is experiencing the impact of large amounts of poorly managed debt on their books, and they don’t even have exposure to residential mortgage debt.

The fact that many people out there are still arguing the crisis has been fixed tells me they’re either 1) so naive and clueless that they haven’t even looked at the numbers and balance sheet exposure; or, 2) they’re efforts to be eternal optimists as a means to positively influence market agents has become borderline ridiculous. I imagine its a little of both, but the fact that just earlier today, another bloke was on CNBC talking about how we ‘could see things start turning around for financials’ continues to make me wonder.

Again, I don’t subscribe to the ‘end of the world’ mentality, not even if this is the largest financial crisis the US has experienced since the Great Depression. However, I am trying to ‘keep it real,’ so to speak, something which I don’t believe Cramer or the folks on CNBC are doing.

Overall, I believe we will continue to see further declines. I have argued for a while now that if recession does come, it will likely hit sometime in early to mid 2009, and based on what we have seen in the past few days/weeks, I am more confident that this will happen. As such, the gains we saw today are merely temporary, and we can be confident that we’ll see further gains/losses as we hit the bottom, and then bounce along the bottom, until a real turnaround can be achieved.

With the negative viewpoint expressed, though, let me also say that I see a great deal of potential for this market. While I think the people saying ‘I think we’re going to see things turn around soon,’ are borderline crazy, I do believe there’s always value to be found in any market (even if I am pretty much short the entire financial sector right now).

And further, although I have no specific recommendations for where the value is (I don’t make recommendations, see my disclaimer), my personal feeling is that the Q2 2009 will be when we see things start to make a real move for the better, and by ‘real move,’ I am referring to a permanent or long-lasting turn around in the markets.

I believe this is when we’ll see the housing market start to change directions, and in order for that to happen, we must see the following things happen first: 1) the bad mortgage-related debt on the books of financial firms must be cleaned out; and, 2) the current supply in the housing market must decline, to which right now, we are seeing about a nine month lag in market-wide inventory. This will stimulate some sense of equilibrium between supply, demand and prices in the housing market, to which much of the other market challenges are dependent upon in this current crisis. Further, this will give us time to get other macroeconomic factors under control, such as inflationary/disinflationary repercussions of potential rate cuts and other monetary policy scenarios that will likely occur after we move past the fall-out from the current situation with Lehman et al.

So, have we figured it all out yet? Of course not; even Doug Diamond hasn’t totally gotten there yet. But, the cure to this crisis is time. I have to agree with Cramer (which I don’t often do) that a panic ensuing will (needless to say) not help this situation. We need keep the issues simple and realize we have a long ways to go yet. But, at least the stuff that has been avoided for so much time is getting out there, and we’re addressing it one way or another. More power to Ben Bernanke and his decisions. He has so far handled the largest financial/credit crisis in over a half-century and we’ve still yet to have a quarter of negative economic growth. So, take that Nancy Pelosi.

We’ll see where this takes us tomorrow and I’m sure we’ll have to re-evaluate then. But, at least we’re starting to make sense of it all … or at least some of it.