But when it comes to the CDS fairy, there are a lot of members of the financial community who are in complete denial. The way it works is, you go to sleep with a lot of risk managment problems and capital requirments under your pillow, wrapped in a piece of tissue paper or maybe sealed in an envelope, and when you wake up they have been replaced by nice shiny profits from CDS. It happens like clockwork, and has been going on for years.

Listen up. There is no CDS fairy. CDS is a zero sum game, whatever one player wins another must lose. The only way you can continue to claim that everybody is making money is by continuing to increase nontional amounts and premiums, an ongoing Ponzi scheme. They don't create price discovery for bonds, they create manipulation of bond spreads.

I don't know why you don't listen to Uncle Warren and Uncle George, they both say CDS are weapons of destruction but you sit there sucking your thumb and believing the CDS fairy will solve all your risk management problems and your capital requirements and your need for trading profits to mask the credit losses and you have peed and pooped your pants again and made a mess.

There is no CDS fairy.

A frequent result is so-called "buy ins," mostly at the end of the day. Those who have made naked short sales must locate stock to borrow or buy the shares to deliver. The result, prices run up rapidly for a half hour or so, then fall back to where they were before. It's like a mini short squeeze, and short-sellers regard it as a cost of doing business.

I have been buying John Hancock Bank and Thrift Opportunity (BTO), a mutual fund that specializes in banks, mostly regional, and thrifts, with the idea of letting someone else do the stock picking but playing for a bottom in bank stocks, if there is one. So Thursday last week I went to buy a few more shares and my brokerage software informed me my BTO is "hard to borrow."

I was a little surprised - the fund now trades at an 18.8% discount to NAV, so my thinking has been that I have 12 or 13% built in when the discount gets back to a more normal level, as well as the expected recovery in the prices of the bank stocks in the fund's portfolio. I couldn't fully grasp why anyone would want to borrow a fund that trades at a large discount to NAV, in order to sell the whole for less than the sum of the parts. I guess it's simple, they have been making money doing it, or otherwise they would give it up.

I asked my brokerage rep to comment, he didn't have much to add, yup, theyr'e doing it. Looking at BTO's holdings, they had some names I have heard of and some names I'm not familiar with - but there were an awful lot of them and I would assume they put some thought into the selection.

This is less upsetting than for example when short-sellers attack an individual stock that may be subject to rating agency downgrades based on nothing more than the share price, with triggers activating collateral calls and destroying credit and tipping over the apple cart on some derivatives somewhere. It's not possible for short-sellers to do any permanent damage to a mutual fund. All they can do is drive the price down lower, increase the discount to NAV.

To me, this is a symptom of a negative bubble - a short-seller by definition is selling this fund for about 12% less than it is worth, based solely on the belief that the downward march of doom must continue indefinitely. Eventually it will end as all bubbles do, suddenly, and with pain for the greatest fools.

Here is what Brown had to say:

We believe that it is critical that eligible collateral be in securitized or certificated form. Neither "whole loans" nor synthetic exposure on a referenced basis should be accepted. More specifically, synthetic exposure is a position taken in credit default swap form where the party does not have an insurable interest in the underlying asset, but rather only references an asset through their derivative, hence suffering from an inability to deliver under the Direct Purchase Program of TARP...

The volume of synthetic assets created, transacted and insured among market participants could easily overwhelm the capacity of this program. In addition, guaranteeing positions in these contracts has no direct impact on the real economy. When these contracts settle in the ordinary course or as a result of losses in the reference portfolios, no wealth is created or destroyed - it is merely a "zero sum" game. MBIA has been a participant in this part of the market, guaranteeing over $100 billion of such contracts. Nevertheless, we strongly urge that the Treasury avoid extending the Guarantee Program to synthetically referenced assets. If the performance of underlying mortgages improves, the synthetic assets and derivatives based on them will take care of themselves.

First, as a shareholder I was not pleased. Readers are familiar with my concerns about "naked" CDS, that is, CDS that are not supported by an insurable interest. I believe these deals may create moral hazard. Eric Dinallo, NY State Superintendent of Insurance, in an effort to bring some degree of regulation to the CDS market, determined that CDS are insurance when supported by an insurable interest. "Naked" CDS in his analysis fall into two classes, grey area cases where there might be some social benefit, and unregulated gambling.

MBIA will not be providing future protection in CDS form, and from the tone of the above I doubt they will provide any form of credit insurance in the absence of an insurable interest, going forward. As an investor, I am sorry that they got involved in the zero sum game, but I have been hopeful that in the absence of collateral requirements they can wait this one out.

But the 100 billion from one company, at stake in a zero-sum game, with no direct impact in the real economy, got me thinking: what is this stuff, how much of it is there, and what if it does have an impact in the real world economy? What was the involvement of other companies in the financial sector? Then I went on to other interests.

Today in the WSJ we learn that AIG had about 10 billion of this stuff. The Maiden Lane III facility, which is supposed to buy the assets underlying AIG's troubled Super Senior CDO portfolio, has a problem: the insured party does not own them - the exposure was in synthetic form. The WSJ article mentions "Abacus" and Goldman Sachs: a search of the terms reveals the following from a Moody's downgrade announcement: "Abacus 2005-CB1 is a synthetic collateralized debt obligation (CDO) that closed on Dec. 7, 2005 created to enter into credit default swaps with Goldman Sachs Capital Markets." Making bets with Goldman Sachs hasn't been profitable to anyone, as far as I can see, it's like betting against the house, the odds are in their favor. Why it would be a suitable investment for anyone is beyond me.

Personally, I prefer to take my exposure to certain asset classes in natural form: "no synthetic, please."

Few hold such beliefs for individual stocks, having noticed over the years that large and profitable companies can disappear in a flood of red ink, litigation, and disappointment.

But for the market as a whole, most of us believe in our hearts that it always come back: first it goes down, then it goes up, but it always goes higher in the long run. If that does not play out as projected over the next 20 years, there are going to be a lot of disappointed retirees, myself among them.

Mr. Market has an opinion, I think. He studies the words and actions of those who are supposed to protect us from a meltdown, a global economic catastrophe, and takes a guess at whether the nostrums, remedies and panaceas actual or proposed will have the intended effect of getting everything back on track again. If the actions work, the market will go back up, same as it ever did. If they don't, it will just keep getting worse, forever.

Right now, Mr. Market is not sure...

I am mildly hopeful, based primarily on the Federal Reserves suggesting that they have more arrows in their quiver, above and beyond simple rate cuts.

Overview - Pericom specializes in serial connectivity. Their website includes an Investor Fact Sheet http://www.pericom.com/pdf/fact/PSEM_financial_facts_Q109.pdf. R&D amounts to about 10% of sales and produces 6-8 new products in a typical quarter. They do business with the likes of Hewlett Packard (HPQ) and Dell (DELL). Five year revenue growth has been 18% (GARP too!) and margins have improved in recent years.

It trades just slightly above the per share value of its cash plus short term and long term investments. Cash and investments is in excess of operating capital needs and could be used for a nice special dividend, or to repurchase shares, never a bad idea when a company's share price falls below tangible book. The company has a repurchase authorization outstanding. Acquisitions are possible: management looks at deals as they become aware of them.

Strategy - From the 2Q 08 transcript: "For the last few years, we've focused our efforts on enabling the transition from parallel to serial connectivity in computer, communication, and consumer electronics systems. This has helped us achieve a unique position compared to many other semiconductor companies. We've achieved success so far on providing high-speed serial protocol solutions for digital video, auto-mobility devices, and high-performance PCs and servers, end markets that we believe will continue to grow at a healthy rate."

"Given the tangible productivity benefits from faster high-quality connectivity, we believe our products provide cost-effective differentiating solutions to key OEMs. We believe this has been a key factor for our continued growth in the current market."

Growth and Margins - up to the end of the most recent quarter, management had been able to increase revenues faster than SG&A, meanwhile increasing gross margin. Net income as a percentage of revenue increased from 5.5% for fiscal 2006 to 10.22% for fiscal 2008. Revenues increased 16.5% and 32.7% year over year during the same time span.

Weak Guidance - After reporting a very respectable 1st quarter 2009, guidance is weak, based on a sudden slowdown in bookings and lack of visibility. This, together with the overall poor performance of the equity markets, tanked the stock. 2nd quarter guidance works out to revenues of 38 million and EPS of .09, vs. 44 million and .15 for the quarter just ended. Looking back over the punishing 2001-2003 period, it appears management kept expenses in line and R&D intact, so I expect they can manage through the coming downturn: they have the resources.

Target - over the past ten years, PSEM has always traded at above 1.5 P/B at some point during the year, and is now at a ten year low on that metric. Using P/S, a midpoint target would be 20 per share, using P/B, a midpoint would be 12. Assuming some kind of economic recovery, my two year target would be 12. Under favorable economic conditions, that target would be around 20 per share.

I have opened up a starter position and plan to monitor quarterly, looking for management to control expenses, maintain R&D, and implement their strategy successfully. If and when visibility and outlook improve, or if prices drop without cause, I will attempt to enlarge the position at a favorable price.

The problem is, when a company is under short-selling attack, their hands are tied as far as defending themselves. There are definite rules, aimed at preventing companies from manipulating their share prices, which limit the amount and price of buybacks a company can do. To be protected against allegations of manipulation, they can't trade more than a certain percentage of the day's volume, I think its 25%, and they can't buy above the last trade.

CitiGroup at 3.77 is now trading at a fraction of tangible book value per share, which is about 9. GAAP Book value is around 18. As pundits pointed out yesterday, the company's market cap at 20 billion was less than their TARP infusion of 25 billion. We know they have the funds, why not buy back as many shares as possible? Some would complain on behalf of taxpayers, that the use of TARP funds was inappropriate. But I would answer, Tresaury holds warrants - if the value of shares is increased, the value of the warrants is increased.

My suggestion: when a company's shares trade below book value, it enhances shareholder value to buy back the shares. So, once the stock gets below book, management should be given carte blanche to buy as much stock as cash resources permit. Current legislation should be changed to provide a Safe Harbor exception of this type.

MBIA (MBI), whose shares closed Friday at 4.24, which is .36 of book, would be a case in point. The company has approximately 293 million left on its buyback authorization: at Friday's close they could buy back 69 million shares, approximately 25% of the total 273 million that have been issued. That would increase management's best estimate of the total economic value of each share from 37.55 to approximately 50.00, well worth doing.

If management's hands were not tied by law, they could make a quick end of the problem of aggressive short-selling, by buying up the entire short interest. In MBIA's case, there are quite a few large holders such as Warburg Pincus and Third Avenue, leaving a limited amount of shares available for short-sellers to cover with. A wonderful short squeeze, like the one on VW, could be created.

Hartford Insurance Group (HIG) would be another case where the legal permission to conduct aggressive buybacks would be appropriate. Even Allstate (ALL) is trading at half its book value.

Again, the rule would be, once shares trade under book value, the company can do buybacks freely and unannounced, as many shares as the market offers for sale on a given day.

This type of short-selling is basically a down in the gutter brawl: the problem is, management is playing by Marquis of Queensbury rules while their adversaries are kicking them below the belt and gouging their eyes out. Why not change the rules so company management can defend the interests of shareholders? We could give company management access to the same financial weapons of mass desturction used by the short-sellers.

Many expect that by Monday CitiGroup will have been disposed of by another of these week-end marathons, with the shareholders wiped out. It would be better to let the company defend itself than to ratify the damage done by short-sellers and rumormongers in a fear-crazed market.

As a matter of fact, I think it would be legally correct for a company to assert the self-evident fact that they are creating share value as a defense against any and all charges of manipulation in a case of this type. A company like CItiGroup, when under attack, should simply buy as many shares as possible. If taken to court, the defense is simple: it is self-evident that management was acting in the interests of shareholders - the shares were trading at less than the value of the assets. Res ipsa loquitur.

Ambac has immediate liquidity problems as a result of the downgrade - they will be required to post collateral or terminate deals in their asset management business. In reporting earnings, the company disclosed they are several billion short of what will be needed. To bridge the gap, they will need permission from the Wisconsin Insurance Commissioner, Sean Delwig, to make intercompany transactions. The issue has been under discussion but had not been resolved as of the earnings conference call this morning.

Ambac shares were running up before earnings, on rumors and speculation that Treasury would include the company in the TARP program. As the economic outlook darkened, I had been progressively more uneasy about Ambac's CDOs and reduced my Marketocracy position substantially.

In my personal portfolio, I had taken enough profits to lock in a breakeven on the whole misadventure. I have been playing the stock by use of options, Jan10 2.50 calls, under the theory that I could control more shares with less capital at risk in case the stock goes to zero. The bid/ask on the calls is usually fairly wide, and as I was trying to sell them yesterday it was hard to get filled, even at the bid. As a way around the problem, I sold enough shares short to offset most of the calls - made the position almost "delta neutral" in the parlance of the trade.

After the downgrade, Ambac shares are trading at 1.69, down 50%, in the after hours market, with fairly heavy volume. That leaves me with the question, do I close one half of the position and play the stock to go up or down, or do I just take my ball and go home? It has been a wonderful learning experience, swinging from a large loss to a large gain to a stalemate: maybe I should just look at it as a tuition refund and go on to something more constructive.

With the market down as far as it is, and with volatility still high, my preference is to play beaten down stocks, looking for the proverbial four bagger. There are a lot of them out there - no need to continue with Ambac when there are so many qualtiy stocks trading at prices that leave ample room for profit in the event of a recovery.

I have been using nonGAAP adjusted book value as my valuation metric - it is GAAP book value plus the present value of future installments. That now stands at 7.18 per share, and if you think mark to market losses will revert to zero over time, you could add them back and come up with an "adjusted analytical book value" of about 19. With the shares trading at 1.69, there is still quite a bit of attraction as a speculative value play, either by means of a bailout or by realizing the intrinsic values with the company in run-off.

Treasury could get involved by buying assets from Ambac's asset management business, by providing reinsurance which would increase rating agency capital, or by taking an equity position. If Treasury were to take an equity position, the question would be whether they would treat Ambac as kindly as Goldman Sachs, for instance, or whether Ambac would be treated like AIG, with 80% dilution to shareholders.

Ambac CEO David Wallis is pushing for the reinsurance solution - with good reason, it avoids diluting shareholders. He argues that Ambac meets the two basic criteria for assistance - systemic importance and solvency. My suggestion would be, call the main players in for a conference, make them accept a 5 billion infusion of capital by preferred stock, with warrants at the 20 day trailing average share price, and in the amount of 15% of the preferred capital. That would mean MBIA (MBI) and Ambac, as the two largest monolines, would be bailed out with sufficient captial to make the ratings unimpeachable.

I would gladly accept the dilution in favor of the immediate boost to share value and the improved rating stability, presumably at the triple A level. I don't have a clue whether any intervention by Treasury is possible or likely. As of this moment, I will look for the share price to get down under 1.00, at which point I will close the short position and take my chances with the calls.

P.S. after this was written, Ambac published a response to Moody's downgrade, which included this statement: "Based on Ambac's most recent analysis, the liquidity gap between the market value of the investment securities held in the financial services businesses and the value of the financial services liabilities that may need to be collateralized or terminated at the Baa1 rating is approximately $3.2 billion. Almost all of the transactions entered into by our financial services businesses are guaranteed by AAC. Ambac has received approval from the Wisconsin Office of the Commissioner of Insurance (OCI) to utilize the resources of AAC to resolve this liquidity gap." I take this to mean that there will not be a fire sale or an AIG style intervention.

Looking at the conference call transcript here on Seeking-Alpha, the analysts homed in on the potential need for more capital. Hartford has already received a 2.5 billion infusion from Allianz, which diluted existing shareholders, and if more capital needs to be raised under today's conditions serious harm would be done to shareholder value. Accurately predicting an outcome requires the ability to predict the course of the S&P 500 as well as the changing assumptions of the credit rating agencies, specifically Moody's (MCO), which has Hartford under a negative outlook.

I believe the S&P 500 will rally in due course. No realistic person will attempt to predict what Moody's will do next.

As usual when updating my files, I recomputed HIG's book value. With earnings so badly influenced by the performance of the stock and bond markets, I tend to look to book value for financial companies. Hartford posts a quarterly supplement on its website, and discloses a GAAP BV/Share of 41.80, and a nonGAAP BV (excluding AOCI) of 55.13. AOCI is accumulated other comprehensive income and holds unrealized losses (mostly on investments) that have not been passed through the Income Statement. The last time I looked at this issue, I felt that the company was able and willing to hold the affected bonds to maturity and accordingly the proper metric was nonGAAP.

However, Hartford will now be reducing the risk inherent in their investment portfolio, which will involve realizing some losses on Alt-A and Sub-prime RMBS. Under the circumstances, I will now use GAAP BV, and adjust that for dilution from the Allianz infusion. Part of the Allianz deal involved warrants exercisable at 25.32. Because this is less than GAAP Book Value, I expect that the warrants will be exercised in due course and included their effect in computing dilution. Book value per share, for my purposes, is now 30.78.

Believing the share price will eventually recover to 1.5 X Book, I see a target of 45 per share, within 2 to 3 years. If the unrealized investment losses can be salvaged, that figure would be 60. On the other hand, if a worst case combination of adverse market developments, short-selling, and forced capital raises can be precipitated, a very poor outcome is possible. I have been operating under the assumption that intelligent regulatory intervention and the normal actions of legitimate investors could prevent these outcomes: however, that assumption has been expensive, to date.

I see some positives here. Hartford's P&C business, looking past the catastrophe claims, has a very respectable 90.1 combined ratio. Because many market participants have had bruising investment losses, the industry will probably start pricing to an underwriting profit. Reduced mileage due to gas prices and the economic slow-down should help Personal Auto results.

It is still early in the 4th quarter, and if Treasury can get the TARP program going on the Asset purchases, and stabilize MBS values, much of the pressure would come off Hartford's investment portfolio.

With these thoughts in mind, I am holding my long position in HIG. When averaging down in financials, my procedure is to spend equal sums of money at successive fractions of my metric - in this case, my estimate of book value including future dilution. Working off 30.78, shares are already less than ½. My next buy point would be 1/3, or 10.26. After that would come ¼, or 7.69.

Now would be a good time to talk about the problems I have experienced as a value investor drawn to financials. Fundamentally, these stocks have been attractive based on book value and the expectation that the housing market, and with it capital and credit market conditions, will eventually recover and return to normal. As the situation has developed, book values have become very soft - there are ongoing write-downs of assets, at some point capital is required due to regulatory or rating agency concerns, and then short-selling sets in. Frequently viable companies are cut off from access to the capital markets. Private Equity, or other smart money, has come in repetitiously, but the smart money gets burned too.

Drivers have included the CDS spreads, which I believe are subject to manipulation, and mark to market accounting, which is idiocy. The rating agencies have become intimidated by their inability to predict the sudden demise of previously highly rated companies, and have been down-grading in self-defense. Collateral requirements, based on credit ratings, have created liquidity problems.

A number of observers have suggested that there was a panic on the way down, and there will be a panic on the way back up. I believe this will happen soon. Mark to market will eventually exhaust the available distortions, or be abandoned. When that occurs, those who saw mark to market as idiocy will seem to have been prescient, clairvoyant, perspicacious, etc. The CDS market will be brought out into the daylight, and intelligent decisions will be made about insurable interest requirements. Going forward, no sane manager will expose his company to the vicissitudes of rating downgrades, and eventually the damage caused by collateral requirements and rating agency downgrades will burn through the last of the vulnerable companies. Smart money will come in again, and be rewarded.

In the meantime, I will hold, and add if HIG goes down to my next buy point.

This whole thing is degenerating into a morality play. AIG has been given the scarlet letter - the company is a poster child for everything that's wrong with our financial system. Paulson imposed the penance - a usurious bridge loan and confiscation of shareholder interest. Even Bernanke seemed to hold his nose when he discussed the bailout of AIG.

I must digress here - to demonstrate that I am in no way soft on evildoers. Please consider my stance on the moral hazard created by credit default swaps, or my attacks on the dishonesty of all participants in the sub-prime mortgage fiasco, starting with mortgage applicants, moving along to brokers, appraisers, banks, those who sponsored securitizations, rating agencies, bond underwriters, etc.

Before I retired, I worked for a sleazeball contractor, whose wife was a real estate broker. One of his ace maneuvers was to take her customer's deposits out of her escrow account and use the money in his construction business. Being the book-keeper, I became aware of this when reconciling the bank accounts (no easy task) and elected to report them to the appropriate regulatory authorities. Ever straightforward and honest, I gave them a copy of my letter, just so they could know where I stood. Their lawyer was incredulous - he asked me if I had "really done that." Yes, I had really done that. Soon enough, I was laid off for lack of work. Oh well.

Getting back to AIG - it is very rare that large and powerful companies are run by boy scouts. Usually they are run by capable individuals with outsize egos and a pragmatic attitude on moral and ethical issues. For that matter, most governments and government agencies are run by similar persons, if not worse. A man has a tendency to believe what puts bread on the table, and to attribute his success to his merits, and his failures to bad luck.

Now the exception to this observation would be Berhshire Hathaway. Warren Buffett is too old to be a boy scout but he is just a squeaky clean guy who is always prepared. He is a nice guy who is in the process of finishing first.

I am long AIG in my Marketocracy portfolio, with an average cost of 4.45. I also own it in my personal portfolio, with a somewhat lower average cost. Given AIG's status as an outcast, a moral pariah in the wasteland of American business ethics, what am I to do? Perhaps I should sell my AIG and buy some Berkshire Hathaway.

I am going to wait for the earnings report. Now that we have a new CEO installed by Mr. Clean, and a new CFO who is going to be watching expenses, perhaps there will be some clarity forthcoming. I did a long and detailed analysis of AIG's disclosed CDS exposures and maxed out at a 4 billion dollar loss. I missed the securities lending exposure, but half of that is a liquidity issue, not a realized loss. In any event, it was already marked to market. It is going to be fascinating, to see how AIG got to where they need 85 billion plus 37.8 billion of bridge loans. I suspect mark to market lunacy.

Perhaps Edward Liddy can dress in sackcloth and rub his head with ashes, make a pilgrimage to Washington, demonstrate humility and an awareness of AIG's awful sins, and make some headway on that 80% confiscation.

I looked at options activity and saw October puts at 30 and 35 trading at what I considered to be expensive prices. Often that kind of activity is a sign that "someone knows something," and reason for concern. With Hartford on the list of stocks that can't be shorted I don't have short-sellers to blame.

When reviewing the stock before I bought, I noted that it would normally trade at a P/B of greater than 1.5 at some point during the year and buying in the area of book value I expected to do well. Possible issues included a large amount of MBS, creating a riski of being forced to liquidate at market prices rather than holding to maturity, a DAC unlock for the 3rd quarter, and the exposure common to any financial of a rating agency downgrade. DAC stands for deferred acquisition costs and is a timing issue as I understand it - the company has to recognize the agent's commissions on Life and Annuity as an expense, but the exact timing is variable.

Double checking, I searched the 10-K to see if HIG has any exposure to the collateral type liquidity issues that created AIG's problems and did not find any.

My experience has been that these financial stocks, once they start trading well below book value, can just keep going down - often to mere fractions of that metric. HIG does not appear to have any Achilles heel of the sort that sank AIG so I am at a loss to see why that should happen here.

It is the last day of the quarter, so maybe somebody is dumping a position to take it off the books before they report.

Taking all of this together my big decision is to do nothing. I will consider adding to the position if and when it trades at well under half the book value, because in the past that has permitted me to average in at favorable prices. I will not reduce the position until I have more information - such as whether a bailout will be passed and a look at 3rd quarter earnings.

P.S 10/1 Located an article that cited exposures to WaMu, AIG and Lehman totalling 655 million. that would be 3.2% of Book Value or $2.08 per share. That number would compare with a capital cushion of 1.5 billion Hatford estimated they had on the strictest rating agency requirments as of 6/30/08. With the stock already trading under book the declines of $10-20 per share are over-reactions. Earnings will be out in late this month

Here we are, guests at a Stock-picker's party. At a country estate, on the carefully landscaped grounds of a newly built mansion, we are enjoying a pleasant gathering, chatting with old friends, sipping a drink, munching on various delicacies, strolling through the spacious formal gardens. I forget who our host is, it doesn't really matter, there's plenty of good food and a truly wonderful spirit of companionship and camaraderie among all concerned. Day Traders, Active Traders, Swing Traders, Investors, Speculators, Brokers, Analysts, Gurus and Guru wannabees - everybody is having a good time.

Suddenly a cloud comes over the sun, the day grows noticeably darker, and we hear a whispered rumor: "unwelcome guests, uninvited, they are crashing the party." The first to appear is Risk, perhaps you have seen him on TV lately, bleary-eyed and with a sallow complexion, he keeps sneaking around, insinuating himself into the conversation, slyly sabotaging all the arrangements. He saunters over to the punchbowl and surreptitiously spikes it from a small flask he carries in his pocket. Soon his cousin Volatility arrives, built and dressed like a professional wrestler, he drains the bowl in one long swallow and then starts picking fights and tipping over the tables, smashing glassware, hurling plates and saucers at everyone.

Then comes Call, not the pleasant fellow who always hangs around with Put, but Dr. Margin Call. When Margin calls, people listen - they have no choice. With a rueful grimace he informs his victims of the precarious state of their financial health, and prescribes his remedies - purging and bleeding. The last unwelcome guest is Loss, mournful and lugubrious, like an undertaker come to lay to rest our fondest hopes of quick profit, not to mention our legitimate aspirations to financial security.

Can't we do anything about this? Where is our host, surely he can have this riffraff evicted - he can call the authorities and restore order. We will send them back to where they came from and continue with our party, none the worse for the temporary interruption. Alas, our host is the renowned architect of financial disaster, Professor Leverage. A gifted man, incredibly inventive, but he sometimes overreaches himself. Some even question his sanity. Our unwelcome guests are his offspring, and he is powerless to make them leave. As we look on in horror, his mansion, in reality nothing more than an elaborate house of cards, collapses in a cloud of smoke, which billows upward and eclipses the sun...a flock of financial vultures circles overhead...

But wait! Isn't that a helicopter I hear? Perhaps Ben will come to the rescue.

Note from the author: this is where I dropped the narrative in March 2008. Now I will resume the tale.

The sun shone for a minute or two, a helicopter hovered aloft, baskets of greenbacks showered down on the guests, and the party picked up where it left off.

But then terrible, horrible, ghastly misfortunes started to strike various guests. Bear Stearns turned pale, pirouetted, and fell. The coroner appeared, as if out of nowhere, Dr. Paulson pronounced him dead of natural causes, and promptly sold the corpse to J.P. Morgan. Then Freddie and Fannie turned pale and started making weird gurgling noises. Paulson's diagnosis was grim - terminal capital inadequacy. He called in Lockhart, who reversed his previous finding of good health. Fannie and Freddie were both bled and purged of 80% of their shareholder interest, then resuscitated with the promise of a transfusion.

Somewhere in there the Lehman Brothers were attacked by mysterious forces and fell to the ground. Paulson's diagnosis, instant triage, "not too big to fail, let them bleed to death, moral hazard must be prevented, at all costs."

Goldman Sachs and Morgan Stanley started to look weak and woozy, but they hustled over to Dr. Paulson who examined them briefly and declared they needed nothing more than a change of climate. He wrote them out a prescription - move to commercial bank-land, the asset valuations are better there. Warren Buffett very generously donated some of the precious green blood to strengthen Goldman.

Soon a gasp of horror went up from the guests. "They're here, the executioners, the agency executioners!" A squad of stooped, monk-like figures appeared, hooded and cowled, toting AK-47s, the dread minions of S&P and Moody's sprayed an indiscriminate fusillade of downgrades at anyone and everyone, before picking out their special victims: Ambac, MBIA, and American International. Lining them up, they opened a devastating fire of multi-notch downgrades. MBIA and Ambac flinched but stayed on their feet. AIG started bleeding profusely, gushing and hemorrhaging green blood, he fell, gravely wounded. Dr. Paulson appeared: the diagnosis, terminal lack of capital, the prognosis, grim. The cure: a liberal purging and bleeding, 80% of shareholder interest, followed by a prompt resuscitation with a transfusion of government backed promises. A crowd of onlookers screamed in protest: "moral hazard, moral hazard, you'll teach all shareholders to expect a bailout." The shareholder muttered among themselves, complaining their board gave them the run-around.

Moody's executioners paused to reload with new assumptions and projections, more deadly than before. MBIA stood there stoically, "I've got a bullet proof vest." I looked, and sure enough, there it was, direct from AAAcme Manufacturing Company. "I am not dependent on capital markets," intoned MBIA, "go ahead and shoot me." Ambac called on his congressman - "please don't let them shoot me, I can't stand the loss of any more blood. The cavalry is on their way, please make them wait, five minutes, ten minutes, I beg of you. By the way, if you made insurance part of the solution I could do some wonderful things."

Then the Mighty WaMu fell, a pernicious run of deposit withdrawals had weakened him. OTS pronounced the diagnosis, death of natural causes, and then FDIC ripped his heart out and handed it to JPM as a trophy. The crowd watched in utter amazement, shocked and awed by the spectacle.

Finally Professor Leverage appeared, accompanied by his friend, George. Calling for silence, George proposed a solution: "Rebuild Professor Leverage's mansion," he said, "restore it as it stood before, and the party can go on." Paulson and Bernanke outlined the plan: using a 700 billion lever, and applying immense forces at certain strategic points, they claimed they could raise the mansion in a matter of days. Some doubted the need for that much leverage, suggesting lesser sums, as little as a niggardly 150 billion. "That won't do it," wheedled Paulson," we need a big bundle of bucks to raise this sucker back up." The onlookers debated furiously: some thought a policy of insurance on the mansion would be a better solution. Others thought depriving offending CEOs of their golden parachutes would be a an improvement, guys like Willumstad and Freeman, prime offenders. Or more purging and bleeding of shareholders, 80% is too little. The debate raged on as darkness fell.

At the outskirts of the crowd, a superannuated bean-counter watched in wonder. "Maybe if they can prop that thing back up again, even for five minutes, it would be a good time to leave the party."

One answer Hank and Ben didn't volunteer was that the quarter ends on 9/30 and all of these mark to market values on MBS need to be pegged to the prices as of Tuesday. If as we have been told none of these things have been trading, and it is not possible to get reasonable quotes, what are they going to be marked to?

I suppose you could set the mark to market values by checking out the spreads on CDS. Maybe that wouldn't work real well because the things are thinly traded and widely used to hedge long bond positions. Nobody wants to sell any of the precious protection while the end of the financial system as we know it hangs in the balance.

It might have been simpler to have strangled the mark to market concept before it got out into GAAP and played its part in creating the crisis. That part of the system wasn't broke: there was no need to fix it. If Congress can't agree on a bailout I think the people at the Financial Accounting Standards Board should pull an all-nighter Monday night and change the rules back to what they were. Otherwise those who regulate banks and insurance companies are going to have to change their capital standards to work around the problem.

Even the talk and potential for action has been driving the ABX upward - a nice bailout plan, all signed, sealed and delivered would at least push it up long enough to get past Tuesday.

Another question that isn't getting answered is why this plan? Why not go back to the basics, fix the regulatory system and allow the market to correct itself over time?

There is one part of the regulatory system that doesn't need fixing because it doesn't exist. That would be the part where Credit Default Swaps are regulated, the selling of "naked swaps" is outlawed or severely reduced, where there is a central clearing house and transparecy about this 62 trillion dollar high stakes casino in the middle of the financial system.

Neither Paulson nor Bernanke dares to precipitate the great unwind that will end the CDS debacle. They are hoping to slowly ease the CDS market back to reality by exerting force on the underlying bonds, allowing all the players to unwind gradually without taking each other down in a massive counterparty crisis.

Have a nice day.

This is another serious embarrassment to the SEC, as a state regulator has been forced to extend his own jurisdiction in order to compensate as much as possible for the serious omissions of Federal oversight. The announcement encourages the SEC to step up to the plate and regulate credit default swaps that are not insurance - ie., "naked swaps."

The purchase of a credit default swap, when the buyer does not own the referenced debt, is in point of fact euivalent to a naked short sale of the bond. The announcement explains: "... just as with short selling of stock, most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company's debt. Swaps bought by speculators are known as "naked swaps" because the swap purchasers do not own the underlying bond. Speculation in a company's bonds can under some
circumstances hurt that company's ability to borrow."

To quote Dinallo: "The severity of this crisis was substantially increased by what the government chose not to regulate, principally credit default swaps.This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now."

The point is, the SEC needs to halt the sale of naked swaps immediately, as they are causing far more of the problem than the activities of legitimate short-sellers. Thes is the same issue I have been referring to as the moral hazard caused by credit default swaps.

This will be good news for Ambac (ABK) and MBIA (MBI), as they will now be able to provide insurance on corporate bonds without competition from unliclensed, unregulated and potentially irresponsible market participants.

Watch for an announcement from the SEC. When that appears, the crisis is over.

PS After this was posted SEC Chairman Cox asked Congress for authority to regulate CDS. It turns out that Congress blew the call in 2000 with the Commodity Futures Modernization Act, which barred the CFTC from regulating credit-default swaps. Already smart lawyers are asserting Cox has no authority even to investigate fraud or manipulation in connection with CDS.

Cox was very careful in his testimony at the Senate hearing today to point out that the buying of "naked swaps," those that are not supported by an insurable interest, is in point of fact a naked short sale of the underlying bond. It has huge leverage and very little downside risk. Cox further notes that the amount of CDS purchased frequently is greater than the total amount of bonds outstanding.

So now what is needed to to write your congressman to pass a law to enable the SEC to regulate these contracts. I now think that naked swaps are gambling contracts, and as such illegal per se.

Many of our ancestors lived as slaves, serfs or tenants on the estates of a privileged few, subject to the arrogant whims of a ruling elite, landless and powerless. Over a period of centuries, and at the expense of the self-sacrifice of many brave men, we have forged a nation that is freer, more equal, and more just than any other. To own one's own home in such a nation is a valuable privilege, beyond the means of most if it were not for the institution of mortgage financing. A home is the one acquisition for which borrowed money is normally a necessity: a mortgage can lay the foundation for a steady increase in personal net worth, enriching homeowners and society as a whole.

So let's not call residential mortgages, as an integral part of the American Dream, toxic waste.

In a previous existence, I was an insurance agent and wrote and serviced homeowners insurance on a good many houses. I inspected them all: went out and took a picture, and either measured them myself or secured a copy of the Assessor's field card, which included the dimensions. Using the dimensions and information provided by the insurance companies, I estimated the replacement cost of all of them and provided insurance in appropriate amounts. I lost a few customers because I would not insure the house itself for more than its replacement cost: remember, the land can't burn. I also lost some customers because I wouldn't under-insure in order to reduce cost. That was OK with me.

Across the hall from my office there was a mortgage broker, who seemed very prosperous. One of my clients, I'll call him Tommy because that was his name, used their services. I asked him why he didn't just go down to the bank and get a loan for himself. Tommy's response was straightforward: "He tells my lies for me." I supposed at the time that this was reasonable given Tommy was self-employed and couldn't document his income. But I used to ask myself whether telling people's lies for them didn't pay better than what I was doing.

It has become distressingly evident that there was a great deal of dishonesty involved by many parties to real estate transactions leading up to the bursting of the bubble. Some home-buyers overstated their incomes or claimed they would owner-occupy houses that were intended for flipping or rental. Some up-raisers submitted inflated appraisals, whether on their own or under encouragement from mortgage issuers. Some mortgage issuers knowingly accepted fraudulent or inflated transactions, secure in the knowledge they could pass the risk on down the line. Those who packaged the resulting transactions at times failed to do due diligence in verifying the quality. The rating agencies at times ignored their own duty of due diligence. Some underwriters at my bond insurers no doubt used a studied carelessness to avoid verifying the quality of the business they wrote. Those who sold the resulting structured finance product at times recommended the investments as safe when they knew otherwise. And so on and so forth, up and down the line.

The toxic waste here is greed and dishonesty.

Plans are being developed to permit the Treasury to buy these transactions. I believe it is necessary, support it, and look forward to the resulting improvement in the economy and the financial sector.

But I hope Treasury does not lose sight of the root cause of this evil. The individual transactions should be examined, bean by bean, and pushed back down the feeding chain to the responsible party. If there has been fraud, misrepresentation, or breach of warranty, let the perpetrators bear the consequences of their own actions. I don't mind contributing as a taxpayer to the support of the privilege of homeownership for as many as possible: what I do mind is paying for losses caused by greed and dishonesty.

To introduce my argument: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance creates an active desire for a loss to occur. As an example consider what would happen if someone were able to buy fire insurance on a house he didn't own, or to purchase life insurance on an enemy or a complete stranger. Moral hazard is created by the lack of an insurable interest in the life or property insured. Someone who buys fire insurance on a building he does not own wants the building to burn down: that's why he buys the policy. The motivation is arson for profit. Because of this, life insurance, as well as fire insurance, cannot be legally purchased if there is no insurable interest.

The relevance to the current market difficulties is this: credit default swaps are a kind of insurance, created to permit protection by those who are exposed to loss because of an interest in a debt or bond.. For example, someone who owns a bond issued by MBIA (MBI) can protect himself from loss by buying a credit default swap on that company. But there is no requirement of an insurable interest. The problem this creates is that speculators buy CDS protection on a company's debt and then put out rumors or distortions while shorting the stock. The results lately have been devastating. I regard it as the financial equivalent of arson for profit.

I first became aware of this phenomenon as a shareholder of MBI. William Ackman, of Pershing Square, sold the stock short and also bought CDS protection on the company. He owned none of their debt: the only reason to buy the CDS was to make a profit when its value increased, or best of all, to collect on it if he could engineer an insolvency. To that end, he and others spread grossly exaggerated estimates of possible losses arising from MBI's business of providing insurance on structured finance products.

Ackman's persistence and tenacity were extraordinary. When doubts about MBI's survival became sufficiently grave to draw regulatory attention, he had the gall to introduce himself into the debate, writing to NY Insurance Department Superintendent Eric Dinallo and proposing a solution that would have the effect of creating a loss on MBI's bonds. In point of fact, he was motivated by a vendetta arising from an incident in a previous life: he had tried the same trick before, while a principal at hedge fund Gotham Partners. Gotham Partners was liquidated, in part because of losses incurred while shorting MBI. How sweet, to get revenge and make a profit too.

In my previous blog on this topic, in December last year, I issued the following warning: " A determined group of negativists can short a companies stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors... Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard."

Recent events - the demise of Lehman (LEH), Bear Stearns (BSC), Fannie Mae (FNM) and Freddie Mac (FRE) - provide a chilling chronicle of moral hazard run rampant. In each and every case, huge profits were made by causing business failures that may have been preventable. The recent episode involving American International Group (AIG) which has not been resolved as I type this, is only the latest chapter.

General Electric (GE) credit default swaps have been trading at increasing spreads. GE is an industrial, perhaps, but has a very large financial services business. Perhaps the studious financial arsonists have identified a chink in the armor, a flaw which can be exploited to bring down another icon of American business. I saw a graph of their CDS spreads on TV yesterday, it was stunningly familiar.

At this point I am sad enough to wish that I was wrong.

To talk of moral hazard as emanating from the shareholders of a legitimate business, as if they were stupidly oblivious to the danger of attack by financial murderers, is stunningly inappropriate. In a law abiding society, most of us walk around unarmed. Most of us sleep at night in frame dwellings, secure in the belief that we will not be incinerated by an arson attack. However, in the financial arena, that is no longer the case. Any business that is not armored and fire resistive is an instance of moral hazard, a victim looking to be the target of attack, and culpable in its own demise.

As Warren Buffet noted, derivatives are a weapon of financial mass destruction. These weapons are trained at the heart of American business.

Our regulators have been stunningly inept. The up-tick rule has been abolished. Niggling distinctions between "abusive" naked short-selling and acceptable naked short-selling become the basis for a tentative approach to possible regulation. A state official, Eric Dinallo of the NY Insurance Department, was the only regulator to come to the defense of MBI, when he finally wrote an article in the Financial Times, noting the illegality of Ackman's defamatory attacks.

Meanwhile, the huge credit default swap industry, a totally unregulated business of insurance, continues as an arena of toxic machinations. Here, in total obscurity, bets are placed: which of the remaining financial companies should be the next victim? Would you be comfortable if strangers could legally place bets on your longevity? Or on whether your house would burn down?

Paulson has been cleaning up the best he can, conducting the last rites and finalizing the effect of the short-sellers attacks. He administers the coup de grace, placing the shareholders of FRE and FNM in a position where the short-sellers will never have to cover, and legitimate shareholder's losses become permanent. This actually creates further moral hazard, as short-sellers can rely on Paulson to complete their work and make the damage permanent and fatal.

I have been writing to my congressmen, as well as the appropriate regulatory bodies, and suggest you do the same.