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The collapse of AIG exposed just the tip of a world-wide derivative bubble that Uncle Sam is desperately trying to keep from bursting. If it does, the financial devastation of the sub-prime mortgage crisis will be just "a drop in the bucket" in comparison.

While financial derivative instruments are extremely complex, their essence can be understood by going to the track and making a bet on a horse. The horse goes off at a certain "odds" and you can structure your bets, and projected profits (or losses) on what you think will be the outcome of the race and how much risk you are willing to assume in accordance with your analysis of the horse's past performance and your resulting assumptions about risk. Then, perhaps, you hedge your bets - and minimize your exposure to risk - by making a bunch of "exotic" bets. The "derivatives game" is on!

One, unregulated division of AIG, for example, insured "bets" - in the billions - on whether or not borrowers (whose mortgages were securitized in pools and sold on Wall Street) would make their mortgage payments. These "bets" were made by folks like Goldman-Sachs. In fact, Goldman-Sachs was one of the parties that got "paid off on their bets" by Uncle Sam with billions of taxpayers' dollars when AIG collapsed (i.e. couldn't make good on its derivative insurance contracts with Goldman-Sachs and others).

As you might recall, this is not exactly the way that the AIG collapse was presented to the American people. After all, it wouldn't exactly be good PR to have it known that companies like Goldman-Sachs made billions of dollars in fees and profits by, literally, (a) betting on the default of hundreds of thousands of sub-prime mortgages, and then (b) getting paid off by Uncle Sam, (with taxpayer dollars) because their "bookie" (AIG) went bust. Rather, the government and banks want to focus the blame on the homeowner; even though it was known in advance (or should have been) that the sub-prime mortgage borrower would eventually default. However, by the time these defaults took place, billions of dollars had already been siphoned off in fees and profits generated through the origination, sale of mortgages on the secondary market, and through a host of speculative derivative arrangements (like AIG's insuring the return on a sub-prime mortgage portfolio).

If this makes you angry, save some of your fury.

Total worldwide derivative arrangements (of which residential mortgage derivatives are a very, very small part) are estimated by some to be on the order of $550 trillion (ten times the entire global economy of approximately $55 trillion) - and by others to be approaching a mind-boggling $1.4 quadrillion.

Oh, by the way, the entire U.S. Gross Domestic Product is less than $15 trillion and the recently sky-rocketing U.S. national debt is almost $11.5 trillion as millions of Americans are struggling to survive in a U.S. economy that is failing across the boards.

Yet there are some that believe, quite strongly, that this situation somehow sets the stage for lower taxes and economic recovery.

You be the judge.

- Ed Smith, Publisher
The EHS Letter Manual