We should be clear on what we are bailing out

I am not sure why this hasn’t made bigger headlines, as regards the now $850B bailout plan. But I think the readers deserve to know. There have NOT been $1.4 Trillion dollars in bad mortgages foreclosed on in the US. And there certainly hasn’t been $1.4 Trillion in mortgage losses. When a house gets foreclosed it does eventually resell, which mitigates the actual losses. That is not the loss we are talking about. What we are talking about is $1.4 Trillion in derivatives losses, on Fannie and Freddie “credit swaps”. For the readers that don’t understand what a derivative is or how it works, you are not alone. Apparently the people who trade them don’t understand them either. But a derivative is a kind of security that allows for exponential degrees of leverage. A $100,000 investment can lead to millions of dollars in losses. So literally a mere handful of individuals here in the US are entirely responsible for this enormous debacle. And guess who the biggest dealer of derivatives is? That would be the same Goldman Sachs where our Treasury Secretary Paulson came from, and where he made his $500M current net worth. Gee.. do you think he really cares about us, or about getting his cronies paid off?

The next question many people are asking is why this all wasn’t regulated. But I think that misses the point. You see in essence these large financial institutions used these derivatives to provide guarantees against mortgage defaults. In exchange for providing these “guarantees” they received HUGE fee incomes. However, they never had the capital reserves to make good on these guarantees from day one. And my friends, that is what we call FRAUD. We already have laws against fraud, and these handful of greedy traders ought to all be sent to prison for that travesty alone. But because they committed fraud with such abandon that it has reached this mind boggling level, it now threatens to collapse the stock markets worldwide. I say that because the entire derivatives market is somewhere around $600 Trillion. The “credit” derivatives market which is a portion of that is somewhere around $60 Trillion. If the $1.4Trillion of Fannie Mae and Freddie Mac debt swaps isn’t big enough already, there is potential for another $20 Trillion to be triggered depending on this outcome. One can only assume, none of these bright lads on Wall Street have the capital reserves available for those bad bets either. To put this in perspective the entire Gross Domestic Product of the US in 2007 was $13.81 Trillion. So a tsunami of $20Trillion in derivatives being called can’t possibly be absorbed by all the markets worldwide, or their collective governments. So we are all being “blackmailed” into covering their gambling losses.

So this $850B bailout is bogus and won’t fix anything. There are many other possibilities that could be considered. But we are being herded like sheep (with the media’s help) into believing we only have these two choices – a new Great Depression or to spend $850B which will primarily go to the beneficiaries of these bad bets (ie. other derivatives traders). We are now well over a trillion dollars in bailout monies with no end in sight, if we go down this path. We are making a horribly bad investment collectively to solve a problem of bad investing. Since when has gasoline ever put a fire out?

What kind of other solutions could there be? Well for one – the US could issue insurance on the “actual” bad mortgages being held by these financial institutions, like they do for FHA and VA loans. The banks holding these bad mortgages would have to pay fees into the government to get the insurance (we make a little money). That would make these mortgages liquid again. We could add the conditions that the rates on these mortgages all be reset to 6% 30 year fixed rate loans; all amounts currently in arrears could be added to the back end of the loans to bring all the borrowers current; and all prepayment penalties must be wiped out so people could sell the homes or refinance. Certainly many of these sub-prime loans would still re-default again and the government would pay out – BUT something like $50B instead of $850B.

For another thing, you could declare all derivatives trading illegal moving forward, and set up an international court of arbitration to deal with the settlements between these crazy traders. The derivatives currently out there could be left to unwind over time and/or expire as they naturally would. Any other colossal failures would be sent to the new court to resolve. Let the winners in court take over the companies that owe them the money. Meanwhile we have lots of “good banks” and financial institutions that have no exposure to derivatives and life will go on. They would be rewarded by the masses relocating their deposit and trading accounts, etc.

Finally, if derivatives trading is allowed to continue at all, then it is obvious that strict capital requirements would need to be legislated. But hey, I am just a mortgage banker for the last 22 years, so what do I know?