Synthetic Derivatives -What are They and Who Cares?

A few weeks ago, the Senate interrogated the guys from Goldman Sachs, a Wall Street so-called "Investment Bank" The argument was about regulating Synthetic Derivatives. HUH? What are those and why does it matter anyway?

Here’s the easiest way to think about it - there is a real Football league made up of real football teams. In each game played there is a winning team and a losing team. And, in each game players do good or bad.

Then we have a Fantasy Football League, made up of the same teams but with the players on each team made up of peoples' "dream team" - players taken from any team and put together (only on paper). Based on how each player and the REAL TEAM he plays on does each week, these made up teams are ranked. People actually bet on these MADE UP TEAMS- "FANTASY TEAMS"- which are DERIVED from the real teams. A Fantasy League is a DERIVATIVE.

Now imagine a second "Fantasy Football League" made up of the same players and BUT instead being based on the outcome of the Real Teams, it’s based on the outcome of the FANTASY TEAMS and ranked according to how the players and the FANTASY TEAMS do each week. This is a Synthetic Derivative - it’s a bet about how well another bet will do! Will Pete win or lose on his bet on Fantasy Team #1. That’s what is being bet on.

A SYNTHETIC DERIVATIVE IS A BET ON A FANTASY FOOTBALL TEAM BASED ON A FANTASY FOOTBALL TEAM

Here's an example of REAL Derivatives and Synthetic Derivatives:

A bank (we'll call it "Bank 1") puts 10 mortgage loan together and creates what is called a "Collateralized Debt Obligation" abbreviated to "CDO". In this case, Bank 1 sells the CDO to an investor, possibly another bank called "Bank 2". Both Bank 1 and Bank 2 can actually see the collateral; go from house to house to be certain that the loan has collateral enough, that the houses are worth enough, to assure payment in case of a foreclosure (This is the way the "secondary market" used to run, but that was 20 years ago).

The key here is that while Bank 2 bought a "security", the pool of loans, called the CDO, it could actually see the collateral and was paying Bank 1 for the CDO (the 10 mortgage loans) based on reality. This was not a gamble but a true investment.

Now, let' take the CDO Bank 2 bought and make it part of a large pool of CDOs, maybe 100 of them, that a mortgage Bank puts together, a place like Goldman Sachs. . Now we have 1,000 mortgages comprising a "Mortgage Backed Security" ("MBS" for easy reference), spread out over a large geographic area. We have something that no one can really examine - the collateral is spread out over maybe 5 states, and there are 1,000 houses. It becomes a MBS because no one bank or institution bought this bunch of 1,000 mortgages as mortgages. Keep in mind that if each mortgage loan was originally for only $200,000, the MBS has a "value" of $200 million!

The MBS that was created by Goldman Sachs (in or example), is sold in pieces (of the $200 million MBS) to investors. For instance, a Mutual Fund that wants to provide a stream of income to it's customers who might be employees with a 401K or and IRA etc, might buy $10 million of the MBS. Another mutual fund might buy $20 million etc.So far, everything seems simple. Bank 1 puts 10 loans together and sells then to Bank 2. Bank 2 sells the loans, for a profit to a Mortgage Bank which is buying 100 of the CDOs like the one that Bank 2 bought and sold. The Mortgage Bank now has 1,000 mortgages (100 CDOs) and it calls them a "Mortgage Backed Security" or "MBS". THIS MBS IS A DERIVATIVE.

The MBS itself is nothing more than a security, something for sale which is DERIVED from the value of the mortgages that make it. Once the MBS is created no one thinks about looking at each house. Because of the number of loans, investors in the MBS are just betting that there will be an average number of mortgages defaulting and going to foreclosure. This is a gamble based on historical trends. Go back 4 years and think about what you considered the safest investment in the world - the value of your house!!

Now comes the weird part. There is a market for "investors" who will bet that the MBS will pay 100% of what it should and "investors" who figure that something will go wrong and the people who bought the MBS will get back only 80% of their investment. These Bets based on another Bet are bought and sold.

The price to buy one of these bets on a bet is based on hundreds of factors, like the disaster in the Gulf, the number of jobs created in a month, the value of the Euro in relation to the Dollar, the state of the war in Iraq, the problems in the Middle East as they can affect the oil supply, North Korea's testing of a missile, and on and on and on. These Bets on Bets are Synthetic Derivatives. Basically it is a bet placed on whether someone else's bet will pay off 100% or if it will pay only 80%.

That is what Congress is trying to regulate; the whole process that led to our economic collapse!

Maybe we should bet on whether Congress will get it done or not. I bet it won’t!!!

Author's Copyright by Richard I. Isacoff, Esq, June 2010

rii@isacofflaw.com

http://www.isacofflaw.com/

Better Now Or A Year Ago?

Now that all of the drama of the Goldman Sachs vs Congress (actually Sen. Carl Levin) is over, what did it all mean. More importantly, WHO CARES? (well, I actually do but it's my job to care).

The reality is that regardless of who caused the financial crisis most of us just want to know when it will end and how will we survive until it does. Will knowing what a "Synthetic Derivative" help? NO, and it's not something you add to your cars oil or take out of it for that matter! If the crisis is over, if we have turned the corner on the recession, if the economy is improving, why is the unemployment rate still at record or near record levels, after adjusting for those who have fallen off of the rolls because benefits ran out, and deducting the Census workers?

The answer is easy, well at least explainable, or at a minimum, less confusing than Synthetic Derivatives. The term "Recession" is a technical economic word that rarely intersects everyday life. It deals with the number of consecutive calendar quarters that the "gross domestic product' declines. And when most TV types discuss the economy getting better they are really talking about the stock market, which a world unto itself.

For real people - are you better or worse off financially than you were 1 year ago? That's far from scientific and can be misleading, but it isn't a bad way to gauge the problem.

Foreclosures are still way up. April's figures showed fewer foreclosure sales but more actual cases where the lender has actually taken possession of the properties it foreclosed against months ago. And, the number of borrowers in default is not leveling yet. And the modification programs are still not really working. And people have so little left from their paychecks that they cannot afford to file bankruptcy using a lawyer, or even a document preparer (which is worse than filing themselves anyway).

In my office, we are taking payments for months from clients who want the expertise of a lawyer but can only pay $50 or $100 per month. The extra part-time job is gone; the overtime hours aren't available. Money is tight.

HOWEVER, at this point it doesn't appear that "the economy" will get any worse. This may not help every individual but it is an indication that we may have bottomed. How long we stay down is any one's guess.

Synthetic Derivatives? Think of a fantasy sports league based on a fantasy sports league, based on a real sports league! - (Next time I will try to explain in fewer than 5000 words)

Author's Copyright by Richard I. Isacoff, Esq, May 2010
rii@isacofflaw.com
http://www.isacofflaw.com/

Good News/Bad News - Is There a Difference?

Foreclosures are up 23% from the end of the 3rd quarter last year. Foreclosures are up 5% from the end of the second quarter this year. If the numbers continue, this year will have more foreclosures than any before. THAT'S THE GOOD NEWS!

With all of the money given (loaned) to banks, and with the likes of JPMorgan Chase having a profit for the last quarter of $3,600,000,000 ($3.6 Billion), having doubled the amount of money it has planned on for loan losses, you might think that there would be money for you to borrow to refinance your house (after all your credit is good ), or borrow for your business. WRONG - THINK AGAIN! Banks are bracing for the next wave of losses; commercial real estate mortgage backed securities failing because the loans that make up the securities are defaulting. Additionally, because of the financial crisis we are still in, the "normal" way of making loans will not work.

In the April 13th posting (and several others), the whole issue of securitization was explained. The basics: agree to buy a large number of mortgages so that the value, on paper, of what the security maker controls is huge, like $1 Billion. Rather than holding the loans in any Bank, and risking borrowers not paying the mortgage regularly, sell the loans in a package (pool) to investors on Wall Street; investors like mutual funds, individuals, pensions, and of course the Federal Government. So now the $1 Billion portfolio is owned by thousands of people, plans etc. The security eliminates the risk of loss for all of the banks involved in making the loans, because no bank owns one of the actual mortgages - not one. Investors, not lenders/banks, each own a small portion of the pool. Again, they own a security, that acts like a corporate bond, but not a mortgage.

Because of the recent losses and the enormous rise in foreclosures, no one wants to buy these mortgage-backed securities ("MBS"). If no one will buy them, then they will not be created, because the creator does not want to get stuck with a long-term investment (pooled mortgages). If they are not being created, the banks will not lend; even to good borrowers. THIS IS THE BAD NEWS.

There will be no real recovery until credit is available again. The government's mortgage lenders FannieMae and FreddieMac, FHA, have new and very strict guidelines. If you have a blemish on your credit report, NO LOAN.

Businesses use borrowed money all of the time to keep operations running, to buy new equipment, and to expand. If banks won't lend to them, the business shrinks and dies. More jobs are lost, and not just at that business. if people lose work, then they cannot spend money and other businesses fail. That is the cycle we are in for unemployment. And more unemployment means more defaults on mortgage payments, and that means more foreclosures.

The new Bank regulations that will require banks to keep more money set aside for bad loans, and the fact that only the Federal Government will buy the existing MBS and not new ones, means that Banks will not make loans, except to the very best customers. The noose gets tighter and tighter. The recent run-up of the stock market is not a reflection of consumers’ and "Main Street" types’ (us) confidence. The profits are being made by traders, Wall Street professionals, and companies like JPMorgan Chase.

So, the very kinds of investments, the MBS or pools of mortgages, that allowed the housing boon, has led us to the housing boom - it’s imploded. Breaking the cycle we are in will take time; actually a great deal of it

They're Back!!! (With a Vengence)

Our favorite charities are back in business, but this time not asking for handouts - just taking the money from us. CitiBank/CitiFinancial/CitiGroup (well, you get the idea), Bank of America, JPMorgan Chase, Goldman Sachs, Smith Barney (whatever the full name is now), and a cast of other "BANKS", reported huge profits for the 2nd quarter or 2009. That must mean that the financial crisis that threatened life on the planet is now past! Well, yes and no or maybe, but we are not at all certain yet.

It is true that there were record earnings at some of these banks and they all did great, but it is where that got there profits that is disturbing, more so than the fact that after pleading for a bailout, they are ready to give out huge bonuses again. Little of the profits came from "banking" as consumers and small to mid-size businesses understand the term. Bank of America and CitiXxx had huge one-time profits from the sale of assets and from "investment banking". Ah ha you say - "banking is how they made money"! Not so quick grasshopper.

"Investment banking" is to "banking" (as most of us understand the word) as Burger King(R) is to a cooking a barbecued hamburger in your back yard. Char-broiled but to a different scale. Buying and selling securities, selling short, trading in commodities, dealing in derivatives, buying other businesses - and selling its assets at a profit, is what investment banking is. Making loans to small and mid-size business, or to people (unclean) is what it IS NOT.

Keep in mind that Goldman Sachs was one of the top firms that put mortgage loans into packages (securitization) and sold them at huge profits. When the value of mortgage-backed securities (MBS) began to crash Goldman "sold short. They "gambled" that the price would go down FAST and that they would fill the order to sell MBSs at the lower price. They made a small fortune while the rest of us lost millions in our 401Ks, IRAs, and had all credit stopped.

So, almost none of the money received from the government and from other financial incentives given during the crisis, went to new home mortgages, was used to modify existing mortgages to stop foreclosures, was used to keep the "mom-and pop shops" in business, or was loaned to small and mid-size firms to help them through the cycle so they would not have to lay-off 50% of their staffs, creating a nearly 10% unemployment rate. The rate of job losses is slowing, but still increasing in numbers.

The promised home loan modification process is not yet functioning. Mortgage modifications are more difficult to get than they were a month ago. Businesses keep laying-off workers because they have no business because other companies have had to minimize operations and they have reduced staff which has caused more foreclosures which has killed the building trades which has caused bankruptcies which has prevented many companies from being paid which has...

There are those economists and financial types who say now - "see, the free-market system is working". They were many of the same experts who cried foul at the bailout of AIG and Bank of America and Citi. The "free-market system" needed some help because of the lack of regulation in the late '90s and through 2007 that led to the crash from which we are trying to recover.

We have reached the point that we now know you cannot put CheezeWiz(R) back into the can.

Author's Copyright by Richard I. Isacoff, Esq., July 2009

http://www.isacofflaw.com/
rii@isacofflaw.com

How Money is Derived from Derivatives Called "Mortgage Backeds"

The Chart above shows how Mortgage Backed Securities "MBS" come into existence.
(Chart author/designer unknown)

Terms used - (Green = $$$):
a. Originator=Lender
b. Arranger=the "putter together" of the mortgages
c. Trust=Holder of the MBS money
d. AAA-Purple=the MBS itself
e. Investors= buyers of the
MBS/I.O.U.s
f. Manager= Loan servicer
g. Houses= collateral for the MBS)

Hopefully, you have some idea of what a "Derivative" is and that a "Credit Default Swap" is really a kind of "Derivative". Further, that "Mortgage Backed Securities" are just sophisticated I.O.Us, where the "Arrangers" of the MBS say to the investors (mutual funds, banks, of just retail investors) that the "Arranger" wants to borrow money and will pledge mortgages as collateral. But, rather than pledging a mortgage at a time, the creators group thousands together and sell them as one big I.O.U. The pieces may be $1,000, $10,000 or $10,ooo,ooo (Think of a large pie sliced into some large and some tiny pieces).

Here is a restatement of the past posts about these topics:

1. Thousands of mortgages are put together.

2. The creator of this pool of mortgages offers to sell the right to receive income from the pool at a pre-determined rate of interest.

3. An investor can buy up to 100% of the pool.

4. The investor will be paid interest on the amount of the pool he/she buys

5. No one actually is buying any of the mortgages that make up the Pool, just the right to receive income from the Pool, based on the average of the interest rate for all of the mortgages in the Pool, after all costs, losses, and profits are deducted

6. The creator of the Pool/Mortgage Backed Security will sell the investor the I.O.U. based not on the actual cash received from mortgage payments, but merely on his/her/its promise to pay. (It's not like all of the money gets collected and someone divides it up into a thousand or two thousand little piles).

7. In case all else fails, IN THEORY, there is collateral for the Creator of the Pool, not the investors. The collateral is the homes that are mortgaged. The Creator of the Pool can liquidate homes that are the collateral for the mortgages that default, and use that money to pay the investors each month.

8. The Creator/Seller of the MBS, is selling the right to receive an I.O.U. which pays interest to the "Buyer" of the I.O.U. (Investor) based on the hopeful profit from the mortgage payments.

THIS NEXT PIECE IS WHERE I MIGHT LOSE YOU (if I haven't already) - IF THAT HAPPENS, READ 1-8 AGAIN PLEASE!

9. The right of the Investor to receive the money for the I.O.U. is DERIVED from the Mortgage Backed Security, which has the right to collect money DERIVED from the underlying Mortgages, which is DERIVED from the Mortgagor's (the original borrower/homeowner) I.O.U. to the Bank/Lender. All of this is based on the sale value of the real estate that has been mortgaged by the Homeowner.

If you are still confused, refer to the chart at the top of the post. If you are still confused, join the ranks of MOST lawyers, accountants, stock brokers, and most of Congress.

The next post will deal with the Administration's first step to getting some of the BAILOUT mortgage money to regular homeowner-type people.

Author's Copyright (Text Only) by Richard I. Isacoff, Esq, April, 2009

rii@isacofflaw.com

http://www.isacofflaw.com/

"Credit Default Swaps" - Insuring Against Oblivion

We were dealing the the issue of DERIVATIVES. Okay - So I put too much into the last posting. Let's start this one in the middle; without the preamble.

Let's get an example that most of us understand more easily - LIFE INSURANCE. When you buy a life insurance policy, you are betting an insurance company that you will die before you have paid more in premiums than the policy will pay to your beneficiaries. The Insurance Company takes the BET, because they know that on average, very few policy holders dies before either paying in more than the death benefit, or simply let the policy lapse after many years of paying. The insurance company, having hundreds of thousands,or millions of other people buying and dying, have sophisticated mathematicians (actuaries they are called) who prepare statistics on the probability of someone dying.

For example, if you are healthy and 30 years old, and do not race cars, and want to buy a $25,000 policy, the company will say "fine" and charge you a modest monthly premium. They can do this because they have statistical proof that very few 30 year old healthy people die. If you are 70, the chances of death before paying a lot of premiums is far greater, so the payments are much higher.

REGARDLESS OF THE SITUATION, YOU ARE BETTING THE COMPANY YOU WILL DIE WHILE YOU ARE INSURED AND BEFORE YOU HAVE PAID A FORTUNE, AND THEY ARE BETTING THAT YOU WON'T. That is gambling/betting/buying chances... The company can do this because they sell hundreds of thousands of policies and the statistics prove them right enough of the time. Basically, you and hundreds of thousands of others pay premiums, and the Insurance Company pays relatively few claims. They get to keep the profit!

To be certain that the Company has guessed correctly, it will bet another and bigger insurance company that the insurer might be wrong. The bigger company which has even more statistics takes the bet and collects easy money. It has bought a derivative - a bet not on the life of the insured, but a side bet on whether the first company will have to pay the claim. This second bet is DERIVED from the first bet -the insurance policy itself. It is equivalent to the bet on Tiger's golf game (see the prior post - great analogy & reading).

BUT, what would happen if a disease struck all of the 30-40 year olds and they died, leaving the older people only - the people who have less time to live (and pay premiums according to the math guys)? Easy - the company would not be able to pay all of the claims. The bigger company which had to pay the smaller company who issued the insurance policies might default. Both companies might go bankrupt. So, the bigger company bets with even bigger company etc. What happens is that there might be 7 bets that the 30-40 year olds will live long. If they don't, 7 companies have to pay and 7 companies might file bankruptcy.

Were any of the assumptions wrong? It was a first time event, all those young premium payers dying, but they did die. Would that make all policies bad? No. It does point out that betting that a mortgage will go bad (OKAY CALL IT INSURING AGAINST IT GOING BAD) or any other such bet is fraught with potential disastrous problems. The biggest of these is the fact that there could be 5,6,7 or 100 bets on that 30 year old's life or those mortgages.

With MBS, and the underlying mortgages, the type of Derivative is a CREDIT DEFAULT SWAP. It would be more accurate to it Credit Default Insurance, or (longer name here) "My BET that your loans will not default for which you pay me a lot of money." IT IS A SWAP OF RISK FOR MONEY. Nothing more -nothing less

How did we get here, and where do we go? (understand that there are more than $40 trillion in these Swaps and other Derivatives). The Final installment of the series will focus on how to keep the $40 trillion from wrecking (for real this time) the world economy

Author's Copyright by Richard I. Isacoff, Esq., March 2009

rii@isacofflaw.com

http://www.isacofflaw.com/

The Real Toxic Assets - Derivatives (whatever they are)

This posting will begin a 3 part series, to be finished by week's end, where we try to make understandable the un-understandable. Obviously the topic continues to be the "Stimulus Package", TARP, TALF, and the latest entry into the lexicon of acronyms, the PPIFs. PPIF stands for "Public Private Investment Funds". These are going to be the repository of those evil and lurking "Toxic Assets".

(cartoon from The New York Times)

A short recap: - mortgages were sold that had the interest rate adjust ("ARMs"), on both prime and sub-prime borrowers, to the point that some homeowners could not pay the monthly payment. These, along with perfectly fine loans were then bundled together in $500,000,000 or larger pools, and sold to Wall Street firms which made them into saleable securities akin to a bond. They were then resold as investment quality bonds, in smaller pieces, to investors all over the Country and the world. After all, what could be safer than an investment, paying interest, that was backed by Home Mortgages. Everything was fine until the adjustments started to occur and delinquencies looked as if they would be greater than expected. The investments, Mortgage Backed Securities, "MBS", were no longer worth as much as everyone thought they were because of the fear of more defaults and foreclosures, so panic selling began, until no one would buy any of these MBSs. Because no one knew the exact value, IT WAS DECIDED, that the value would be ZERO, or something close to it and they became "Toxic Assets". (RECAP OVER)

The assets were no more toxic then than they were at the start. In reality, the true asset was the underlying collateral - home mortgages. How many would go to foreclosure and how much would be recovered was unknown, but there are a lot of percentages between 0% and 100% - none were used!! There were 2 hidden issues: 1. With the mortgages being bundled as MBSs and sold as bonds to investors (earlier posts please) no bank or lender or any one who sold them was at risk. The investors might lose some money, like they might on any corporate bond or a mutual fund, but the lenders were home free. 2. A little understood evil was waiting to steal the souls of all who succumbed to good interest rates - DERIVATIVES.

What is a "Derivative"? Simply put - a BET, a gamble that something will happen based on something else; like during the World Series, betting not on which team will win or lose but whether the score of both teams will be higher or lower than the number of strokes Tiger Woods takes in the first 3 holes of his current tournament. THIS STUFF REALLY HAPPENS!!! Here, it was a bet that mortgages would default in record numbers. It seemed like a safe bet to take, and had been for the past 50 years; mortgages had a more or less constant and predictable default/foreclosure rate.

Let's get an example that most of us understand more easily - LIFE INSURANCE. When you buy a life insurance policy, you are betting an insurance company that you will die before you have paid more in premiums than the policy will pay to your beneficiaries. The Insurance Company takes the BET, because they know that on average, very few policy holders dies before either paying in more than the death benefit, or simply let the policy lapse after many years of paying. The insurance company, having hundreds of thousands,or millions of other people buying and dying, have sophisticated mathematicians (actuaries they are called) who prepare statistics on the probability of someone dying.

For example, if you are healthy and 30 years old, and do not race cars, and want to buy a $25,000 policy, the company will say "fine" and charge you a modest monthly premium. They can do this because they have statistical proof that very few 30 year old healthy people die. If you are 70, the chances of death before paying a lot of premiums is far greater, so the payments are much higher.

REGARDLESS OF THE SITUATION, YOU ARE BETTING THE COMPANY YOU WILL DIE WHILE YOU ARE INSURED AND BEFORE YOU HAVE PAID A FORTUNE, AND THEY ARE BETTING THAT YOU WON'T. That is gambling/betting/buying chances... The company can do this because they sell hundreds of thousands of policies and the statistics prove them right enough of the time. Basically, you and hundreds of thousands of others pay premiums, and the Insurance Company pays relatively few claims. They get to keep the profit!

To be certain that the Company has guessed correctly, it will bet another and bigger insurance company to bet that the insurer might be wrong. The bigger company which has even more statistics takes the bet and collects easy money. It has bought a derivative - a bet not on the life of the insured, but a side bet on whether the first company will have to pay the claim. This second bet is DERIVED from the first bet -the insurance policy itself. It is equivalent to the bet on Tiger's golf game.

What would happen if a disease struck all of the 30-40 year olds and they died, leaving the older people only - the people who have less time to live (and pay premiums according to the math guys)? Easy - the company would not be able to pay all of the claims. The bigger company which had to pay the smaller company who issued the insurance policies might default. Both companies might go bankrupt. So, the bigger company bets with even bigger company etc. What happens is that there might be 7 bets that the 30-40 year olds will live long. If they don't, 7 companies have to pay and 7 companies might file bankruptcy.

Were any of the assumptions wrong? Yes and no. It was a first time event, all those young premium payers dying, but they did die. Would that make all policies bad no. It does point out that betting that a mortgage will go bad (OKAY CALL IT INSURING AGAINST IT GOING BAD) or any other such bet is fraught with potential disastrous problems. The biggest of these is the fact that there could be 5,6,7 or 100 bets on that 30 year old's life.

These DERIVATIVES, these side bets, are some of the main issues that "broke" A.I.G.

What happened in the financial markets that have left us with trillions in debt is next in this 3 part series.

Author's Copyright by Richard I. Isacoff, Esq., March 2009

rii@isacofflaw.com

http://www.isacofflaw.com/

Tinkerbell, Where Are You?

CREDIT CRISIS - MORTGAGE BAILOUT - TOXIC ASSETS - CREDIT CARDS


I had planned to move full force into the new tactics by the Credit Card Industry to help it even out its, and its parent companies', losses. Unfortunately, we are coming face to face with the reality of the current crisis, and why it just will not stop generating scary headlines; the kind that send financial markets, stocks, bonds, entire businesses, and through job losses the public in general into a tailspin.

This weekend CitiCorp, the parent of CitiBank, CitiResidential Mortgage, and Citi this and Citi that, (when combined they do business in 100 countries, and employ 375,000 worldwide), was deemed to be on the edge and in need of a massive infusion of government money or some other type of intervention. It seems that what was touted as a failure of the residential mortgage backed securities ("MBS") market, has been disclosed to be a breakdown of all types of Pooled Loans. You may read about derivatives such as CDOs (Collateralized Debt Obligations), and Credit Default Swaps. (Derivatives are just a name for products that allow investments in loans and other types of financial transactions, by buying not the loan, but the right to share in the profits from the interest earned. Of course the idea is that the loan or transaction is secured by collateral, not unlike the arrangement in a simple home mortgage.)

With the second or third largest banking organization in the country in trouble, everyone who already hasn't, loses faith in the underlying assumption that his/her investment, assets, have any value: THERE IS A FURTHER EROSION OF CONFIDENCE. Once the spiral downward began, and the Government did not prevent it from accelerating (by saving Lehman Bros. with their portfolio of MBS and other derivatives), we had the IndyMacBank takeover by FDIC, because of a run on the bank (see earlier posts), and here we are.

What we have found out about the CitiCorp fall is that through its multiple entities, the organization had, at risk, $2 trillion, much of it being "off the books". The risk was partially in MBS but only t relatively small percentage when looking at the entire picture. A view develops that might explain why the Mortgage Backed Securities issue created an immediate firestorm. Financial institutions like Citi, JPMorganChase, and Bank of America had invested enormous sums in high yield, high risk investments. Not only did they have MBS, but they were holding all nature of derivatives, especially credit default swaps.

This was essentially a bet that there would be defaults in loans, and therefore the bank had to hedge its bets. In essence, bet against itself, with other institutions buying the investments derived from the loans made by the bank. It was selling part of each loan in a portfolio, with the Seller protecting itself by sharing the risk, and the buyer trying to out-guess the Seller, paying a discounted price for what might turn out to be a perfectly solid loan. This was not done loan by loan, but by billions of dollars worth of pieces of loans, all at once.

As it turned out, when the spiral down began, even good loans turned bad because businesses, which had been solid, began losing orders, and as credit became almost non-existent with no one knowing who would be available tomorrow to pay back a loan taken today, the speed increased until it over-powered all reason. Panic set in, and while the panic has subsided, the anxiety has not. Just as the run on the bank (see earlier posts) was and remains due to a lack of confidence in the system rather than a failure of the system, the market plunge was due to everyone trying to sell "bad" stocks all at the same time. Was there a reason for concern? YES. Panic? NO.

WE NEED THE TINKERBELL PROJECT. Remember in Peter Pan, when Tinkerbell was weak and in danger of dying, and Peter asked everyone to believe in Tink, and to say so out loud so Tink would know that everyone believed, and she would live? Well, we need to believe in the system. Is it flawed? YES. Dead? NO. Will we recover- certainly, but the price will have been steep. Tens of thousands of jobs lost, companies forced into liquidation because no one wanted its stock, pension and other retirement plans devastated by securities losses (remember the MBS issue).

Interestingly, those who were the first to stop believing were the biggest losers (financially), including many of the largest investment houses and banks in the Country. The rest of us were dragged along for the ride.

When the system stops believing in itself, when the so-called market makers and money brokers lose confidence and bet against themselves and others of their kind, panic will inevitably start. This has been the worst realization of that fact since the Depression. Perhaps, and hopefully, the worst is over. Just keep repeating "I DO BELIEVE, I DO BELIEVE, I DO BELIEVE..."


Author's Copyright by Richard I. Isacoff, Esq., November 2008

http://www.isacofflaw.com/