Zzigurrat opined:

Stay out of the financial McDonalds and head over to Whole Foods.

Yeah, well - I have. All moola pulled out of Wall-street based gambling entities - and put into fixed income (money market accounts, CDs)

Even the illustrious "Gordon Gekko" admitted that stock investment is like "throwing darts at a wall". Those who don't recognize that basic truth have no business in the debate.

I totally agree with the previous Anonymous' reasoning.

This tumoil in the financial industry has a potential to spill over to all the places. When dot com era bust, I feel most of the victims were small investors. This time around, the losers are big financial institutions--the banks, the hedging funds, the mortgage lenders, etc. When they lose or go down, the consequences are much larger and the ripple effect will be felt by more people.

So where is the hedging going in hedge funds? In just about every article I read about hedge funds, there is a lot of borrowing going on. No one seems to talk much about the purchase of one investment and offsetting the risk of the first investment with another investment that behaves differently. Secret Hedge Fund Partners may raise $1 billion from the Podunk County Public Employee Pension Fund as well as other pension funds, and then use this $1 billion as a base to borrow another $4 billion from First Leverage National Bank, which is leading a syndicate to parcel out participations in the loan to the Slick City University Pension Fund, the Daddy Warbucks Family Trust and other supposedly knowledgeable investors. So what is Secret Hedge Fund Partners investing its money in? I don't think anyone knows up front. It sounds like the old blind pools of the 1920's. And you, as a resident of Podunk County, will likely never know.

What if the whole business goes really bad? If you are a Podunk County resident, maybe your property taxes go up or your library service gets cut as the county looks for solutions to its investment losses. If you a student at Slick City University, maybe your tuition goes up even more, as the university tries to offset its investment losses. If you are a beneficiary of the Daddy Warbucks Family Trust, maybe you have to take Junior out of private school and put him into a public school. And if First Leverage National Bank is not able to sell all of its loan participations, maybe it has to cut its dividend and its own share price goes down. If you happen to own 100 shares of First Leverage in your IRA account, First Leverage's loss is all of a sudden your loss too.

Now that the proverbial horse is out of the barn, maybe the financial regulators will be able to come up with a way to reign in this cowboy capitalism, without doing a lot of damage to the economy, if WE the people are lucky. If we are not so lucky, maybe we are bound to repeat the experience of the 1930's. Unfortunately, this time around the lowly dime won't buy you very much.

All of these problems may have started with a few subprime loans going bad. But it is clear to me, that the problem is much greater than that.

If the Almighty did not look after his Chosen People during World War II, when six million went to their deaths, chances are, He will not look after your IRA either.

"Strictly speaking, a derivative is a financial doohickey whose value derives from some underlying asset. A mortgage loan is an asset. A pool of mortgage loans grouped together into a security that can be traded on markets is a derivative."

Strictly speaking, Andrew Leonard gets it right and then immediately wrong. All financial instruments are based on pieces of paper which slice up assets or cash flows. A share of stock is the ownership of a zillionith of a company. A bond is just a loan that is chopped up into bite sized pieces. Stocks and bonds aren't derivatives. Neither are pools of assets or shares of mutual funds.

Derivatives aren't little pieces of real things. They occupy a less tangible realm -- pieces of paper whose price depends on the price of something else. A simple derivative is a stock option whose price is based on something you could buy or sell, but other derivatives are more complex and are based things that can't be bought or sold.

In general, securitization is a good thing. In the bad old days, banks held mortgages, and your interest rate depended on what the local banks were charging. You got 3% on passbook savings, and borrowed at 6% and the local bankers pocketed the difference. Things are just more efficient now, and no one seriously thinks vanilla securitization is a bad thing.

However, it was just too tempting to see how far securitization could be pushed. Think of stage 1 as putting assets on a chopping block. You start with an onion or a piece of garlic and end up with nice little pieces -- and everyone knows what they are. I suppose you could use a food processor or blender. Then someone turns the blender on puree and tosses in whatever is in the fridge. And someone else decides to reverse the process and turn the goop into things that sort of look like food, but not like anything found in nature. And I suppose you could find someone to certify that they contain the same number of calories, vitamins, etc. Then, someone decides that the newly created goop is more valuable then the various pieces. Sort of like all those bizarre cuts of steak that are showing up these days (just what the hell is a cowboy cut? where's my tbone?).

The problem with securitization is that what was supposed to make things better (slicing/diceing with a vegamatic) went too far, and overpaid financial engineers made it impossible to figure out exactly what was in the pooled assets (lack of transparency). And so on and so on until you end up with antifreeze in the toothpaste.

Derivatives have other problems -- you have to collect from your counterparty -- but that's another story that will end badly.

Toss in a lot of leverage and that explains some hedge funds going belly up. That, by the way, is a good thing. You can't get rid of excess without a little blood in the streets. Pooling tends to reduce risk, leverage increases it.

Not a bad article, but we don't have a real crisis. Yet.

No real point in this letter, except to get rid of the stupid gambling analogies and think of it as food. Stay out of the financial McDonalds and head over to Whole Foods.