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Name: Mike Dixon
Location: Edmonds, WA
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A lesson in derivatives and why the bailout is irrelevant

I was recently chatting with a brilliant ex-banker friend who remarked how insignificant the risk of default on troubled mortgages is compared to the potential impact of the tsunami of complex financial instruments known as derivative securities.  Here are some eye opening facts about this hidden market, a market that is poorly understood, even by its practitioners.  Further, it is rather difficult to regulate a complex industry that not only dwarfs our national economy, but that has grown at a faster rate than even the most spectacularly successful companies we have ever seen.
 
United States GDP (purchasing power parity): $13.78 trillion (2007 est.)
Notional Amount of Outstanding Credit Derivatives, ISDA Mid-Year Survey 2008, International Swap Dealers Association $54.6 trillion
Notional Amount of Outstanding Interest Rate Derivatives, Mid-Year 2008, ibid $464.7 trillion
Notional Amount of Outstanding Equity Derivatives, ibid $11.9 trillion
Total Notional Amounts, ibid $531.2 trillion
Gross Mark to Market Value of all Notional Amounts                                                   (* This is the gross credit exposure) 2.4% of notional amounts = $12.7 trillion, estimated value
Net Credit Exposure, net of collateral 0.3% if notional amounts = $2.7 trillion, estimated value
 
Here's the challenge.  There are complex and poorly understood valuation models used to estimate these risks.  If the Nobel laureates that ran Long Term Capital Management and the various failed Wall Street CEOs who inadequately assessed the risks of their mortgage derivative portfolios could not properly price or estimate these derivative risks, how do we expect government regulators to do any better?  Simply put, if the pros can not, how can the schmoes do any better?
 
I am not a practitioner, but allow me to explain what a derivative is and the significance to our economy.  The term literally defines a financial instrument deriving its value from the intrinsic value of some other underlying securities or set of conditions affecting these underlying securities.  For example, derivatives may be created through a contractual obligation to issue debt in the future or an interest rate contract to synthetically convert your interest rate from fixed to variable.  And yes, the lowly mortgage backed security and collateralized mortgage obligation, themselves securities arising from the securitization of underlying pools of mortgages, are also financial derivatives.  However, what is poorly understood by the general market is the volume and rapid growth of the derivative market.
 
From 1987 to 2007, total interest rate and currency derivatives had a notional value that grew from $866 billion to $383 trillion, at a compounded annual growth rate over 20 years of 36%.  I defy you to find a market that has grown that fast and for that prolonged a period of time.  To put in contrast, the market size of the semiconductor industry is $270 billion.  The global electronics industry is
$1.7 trillion.  Microsoft, arguably the single most successful company in recent times, grew from sales of $140 million in 1985 to $60 billion in 2007, for a 23 year compounded annual growth rate of 30%.  Yes, the notional amount of outstanding derivatives is 8,900 times the size of Microsoft and growing at a faster rate than Microsoft ever has!
 
But are these esoteric securities with minimal impact for Wall Street?  Let's examine the not-so distant history of the demise of a firm called Long-Term Capital Management.  Started by the distinguished theoreticians and Nobel laureates who created the stock option pricing model, an innovation that ushered the era of financial engineering, Long-Term Capital Management was a Connecticut hedge fund employing sophisticated pricing models to manage its highly leveraged investments and complex bets on the market place.  Turmoil in the financial markets in 1997 placed unusual and unaccounted for stress on these financial models, leading to massive losses.  Further, the positions were so highly leveraged that Long-Term Capital Management received a Federal bail out.  According to Wikipaedia, "At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps."  Poor market bets led to losses in their equity position, triggering a decoupling of certain other key investment strategies and ultimately the prospect of significant losses.  Further, their significant off-balance sheet derivative positions threatened to impact the broader markets as it was feared that other creditors would similarly be pressured and fail to meet their obligations.  Ultimately, the Federal Reserve Bank of New York orchestrated a $4 billion bailout which successfully averted a panic in the financial markets and enabled the private sector providers of the bailout funds a small profit over time as the fund assets were liquidated.
 
Joe Biden is wrong in stating that "past is prologue."  The past is in no way an indicator of the future.  The world is rapidly unfolding.  No two times are exactly alike - there are myriad factors all impacting each other in myriad ways at any one given time.  So, pardon me Senator Biden, but the past is a false hope and illusion.  As Nassim Taleb has explained so well in his books on statistics and the trouble with extrapolating based on the past, 500 successful tries does not indicate a successful model.  It may in fact mask that a massive failure will occur on the 501st trial.  I don't know about you, but I would surely like to understand how these $531.2 trillion in notional debt really only amount to a net debt of $2.67 trillion.  Under what conditions does that model fail and if it does fail, what will the impact be?  And what about the mark to market gross debt that approximates the entire US GDP?  I agree with my friend - the derivative market is the more pressing problem.  Populist sentiment aside, the mortgage market is the tip of the iceberg.  Wall Street is not necessarily crooked, but definitely too clever by half.
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First Presidential Debate

Wow!  What a barn stormer!  As an unabashed McCain fan, I must say I haven't had this much fun since Spider Man beat the Abomination!  McCain pummeled Obama mercilessly for 90 minutes with a lock-jawed determination that was inspirational.  I came away convinced that McCain is running not only because he knows he is fully prepared for this role: he is also fully aware of how dangerously ill prepared Barack Obama truly is.  On issue after issue, McCain hammered away.

I'll recap a few of my favorite moments:
 
1.  McCain flogged him over his foolish comment regarding meeting without precondition rogue dictators and legitimizing them with a Presidential meeting.  This comment has dogged him from the day he foolishly uttered it on July 23, 2007 in the SC Primary Debate.  Listed below is the transcript of that infamous moment from the CNN transcript archives. 
 
Democratic Primary, South Carolina, July 23, 2007, CNN Transcript    

QUESTION: In 1982, Anwar Sadat traveled to Israel, a trip that resulted in a peace agreement that has lasted ever since.

In the spirit of that type of bold leadership, would you be willing to meet separately, without precondition, during the first year of your administration, in Washington or anywhere else, with the leaders of Iran, Syria, Venezuela, Cuba and North Korea, in order to bridge the gap that divides our countries?

Senator Obama?

OBAMA: I would. And the reason is this, that the notion that somehow not talking to countries is punishment to them -- which has been the guiding diplomatic principle of this administration -- is ridiculous.

CLINTON: Well, I will not promise to meet with the leaders of these countries during my first year. I will promise a very vigorous diplomatic effort because I think it is not that you promise a meeting at that high a level before you know what the intentions are.

And I will use a lot of high-level presidential envoys to test the waters, to feel the way. But certainly, we're not going to just have our president meet with Fidel Castro and Hugo Chavez and, you know, the president of North Korea, Iran and Syria until we know better what the way forward would be.

2.  McCain, the statesman, explains to Obama, the freshman Senator, the fallacies of prematurely announcing military strikes against a soveriegn country.

 
First Presidential Debate, MI, September 26, 2008, CNN Transcript
 
OBAMA: And that is a strategic mistake, because every intelligence agency will acknowledge that al Qaeda is the greatest threat against the United States and that Secretary of Defense Gates acknowledged the central front -- that the place where we have to deal with these folks is going to be in Afghanistan and in Pakistan.
 
MCCAIN: Now, on this issue of aiding Pakistan, if you're going to aim a gun at somebody, George Shultz, our great secretary of state, told me once, you'd better be prepared to pull the trigger.

I'm not prepared at this time to cut off aid to Pakistan. So I'm not prepared to threaten it, as Senator Obama apparently wants to do, as he has said that he would announce military strikes into Pakistan.

We've got to get the support of the people of -- of Pakistan. He said that he would launch military strikes into Pakistan.

Now, you don't do that. You don't say that out loud. If you have to do things, you have to do things, and you work with the Pakistani government.
 
3. McCain movingly relates a personal account of a mother asking him to fight on for her recently fallen soldier son. 
 
OBAMA: Jim, let me just make a point. I've got a bracelet, too ...
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I debated a liberal on economics and NObama ... and convincingly won!

I recently debated a relative of one of my wife's friends.  I found this exchange to be an excellent forum to clarify common misconceptions about our economy and the general tone of the Democrat party.  Specifically, the Democrat party has steered a populist course for some time, to the financial ruin of our great country.  Anyone remember Dick Gephardt and his famous isolationist policies?  The reality is that we have a truly global economy, where dislocations and inefficiencies will be outrooted.  Read on and enjoy!
 
------------------------------------------------------------------------
 
I was pleased to see your faulty logic on “windfall profits”.  The argument of demonizing corporations is indeed prevalent in the media and the left wing.  Merely citing a number of incorrect opinions does not equate to a convincing argument.  Rather, I will attempt to illustrate actual facts instead of reciting the opinions of others or of union lobbyists rebutting policy.  Do you understand the impact of corporate tax rates on business?  Evidently  not.  The US now has the second highest corporate tax rate amongst industrialized countries. 

(http://www.taxfoundation.org/news/show/1466.html )

You attempt to have it both ways on this point by patronizing middle America with protectionist, absurd policies and threats to “cut out evil tax loop holes so big bad corporations won’t send your job overseas”.  Let me explain what will happen if you increase taxes on corporations, or as you describe it – cut out evil tax loop holes.  Corporations will employ tax accountants and divert revenues overseas.  Diverting revenues overseas means the products must be made overseas, which means the jobs will indeed go overseas.  So, please do explain to me the mystery of taxing the heck out of corporations and how that will create jobs here in the US.  By the way, since most of us have money in our 401K’s managed by mutual funds that invest in these evil corporations, reducing the earnings on our investments reduces our retirement benefits.  In fact, we need desperately to CUT corporate taxes, not increase them! 

(http://www.taxfoundation.org/files/corporate_income_taxes_cost_families-20080818.pdf  )(http://www.taxfoundation.org/publications/show/23473.html )
 
On education, please explain to me what is wrong with providing vouchers so that parents can choose to either send their child to a private school or to the local public school.  I am looking forward to your response on this.  The AFT position here is indefensible and reprehensible.  Further, those disproportionately affected (poor blacks) should stop voting 90% for the Democrats.  Good parochial private college prep schools exist.  Vouchers are good. 

(http://www.census.gov/Press-Release/www/releases/archives/economic_surveys/006685.html )

$9000 per student per year seems like a lot of money to me.  Most private school tuitions are far below that.  How can the private schools do what the public schools awash in money fail to do? 
 
Barack and Hillary campaigned on platforms of providing healthcare to every person.  If that’s not nationalizing, I’m not sure what is.  Canada does not have an excellent system.  Have you ever spoken to a Canadian about that?  Do you know that their marginal tax rate is 80% for a worker earning $30K?

(http://economics.about.com/b/2008/02/10/marginal-tax-rates-of-over-100.htm )
 
In spite of all the blather from the left on the “record profits” of oil companies, what is not considered or reported is the actual profit percentage.  In reality, if you bother to check a 10K, you will see that:
   Exxon reported 10% Net Income in 2007. 
   Microsoft reported 28% Net Income on revenues of $51B in 2007. 
  Similarly, Pfizer reported 17% Net Income in 2007. 

(http://www.pfizer.com/investors/financial_reports/financial_report_2007.jsp  )(http://www.microsoft.com/msft/reports/ar07/staticversion/10k_fh_fin.html  )
(http://sec.edgar-online.com/2008/02/28/0001193125-08-041781/Section29.asp )

Will you propose a windfall profit on them too?  I am for all forms of energy, which includes the forms we have available today.  (http://www.powerlineblog.com/archives2/2008/07/021099.php)  So, drill baby DRILL!!!  I suspect environmentalists really want gas to hit $10 a gallon so we will all have to live in a yert and ride a bike to work.  I’m not ready for that lifestyle.  I really like my SUV!!!
 
(http://www.nber.org/cycles.html)  In spite of what you read in the paper or hear on CNN, the recession on record ended in 2002.  We are NOT in recession.  Have we had sluggish growth of late, yes.  However, a lot has happened in the financial markets, which I think you would do well to consider.  Do you remember Glass-Steagall?  Don’t you think that removing the barrier between investment and commercial banking had some impact on the consolidation into ever larger financial behemoths with massive balance sheets?  If assets increase your balance sheet, then leveraging through sophisticated derivative instruments that were poorly understood by the regulators would have been to your advantage.  Loans fueled that engine, as they were securitized into CMO’s and CDO’s – the assets that these behemoths needed.
 
McCain is Pro-Life.  Obama is not.  Isn’t Life a Choice?  Why is Life demonized by the Left? 
 
Last, Obama has NO substantive national experience, LITTLE at best foreign policy experience and NO executive experience.  Even Hillary Clinton and John Biden made this argument during their primaries.  The Left is in love with a charismatic man who gave one speech in 2004.  That was Obama's signature political achievement.  Obama declared his run for presidency within 2 years of being sworn in as a US Senator.  I don’t think you can include your time in office since then you have been busy running.  OBama therefore is a US Senator with 2 years of experience, often criticized by your peers for not actively engaging in his role as a sitting Senator but having the hubris to run for President upon arriving in Washington.  To paraphrase John McCain, for Obama to assert that he is qualified to be president because he has been running for president is desperate circular logic. 

(http://elections.foxnews.com/2008/09/02/obama-i-have-more-executive-experience-than-palin/ )
 
Let me add something on this notion of middle class tax cuts and increasing taxes on the wealthy.  Much has been made of Obama's plan to rescind SSI contribution maximums.  Allow me to focus on a different topic.  Attached please find a download from the IRS.  You have to pay taxes to receive a tax cut.  If you pay no tax but receive money from the government, that’s called welfare.  If that money comes from someone else, that’s called redistribution.  It has been steadily increasing, but the top 50 percent of income earners now pay 97% of all Federal tax.  The top 25% pay 86%.  The top 10% pay 70%.  The top 5% pay 60%.  The top 1% pay 40%.  How much more should the top PAY?  When is enough going to be enough?  Hell, let’s pay all the taxes.  Maybe when we die and stop paying any taxes, someone will realize that taxing the life out of the producers is not a good way to maintain a society.  Did you know that the income rate for the top 50 percent is $30,881?  So when you hear the notion that somehow the bottom 50% never get a tax cut, think hard about that.   How much tax do you think they are paying?  Don’t you think the progression in this progressive tax is far too steep?  I think it is grossly unfair!
 
As for your More of the Same argument, McCain has differed substantively from Bush in a number of areas.  To attempt to tie McCain to Bush and simply run against Bush because of Bush’s low popularity is simply a political tactic.  You have a paper thin resume’ and you’re running on a platform built on demonizing George Bush.  So, yes, let’s Change for the sake of Change, because we are the Change that we’ve been waiting for...enough IS enough.  Let’s vote to make the most powerful man in the free world someone with more than 1-1/2 years of actual relevant experience.  I’m voting for John McCain, the only credible choice in this election.
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Cogito, ergo American

I recently read Stupid Black Men: How to Play the Race Card … and Lose, by Larry Elder. Larry has hit it on the head, again. I am a successful man by any measure: high earner, two degrees from MIT, a general manager of a $100 million business, manage a team of 400 people, married and a father of four. My wife is of Polynesian, English and Irish heritage, and I have a distant European heritage in my own family line. I am particularly dark-skinned and grew up in the American West Indies. 

What I find chilling in America is the overt efforts by many in the ‘black’ community to build an entire culture and identity out of a skin hue. I find this amazing because visually it is difficult to determine whether many ‘blacks’ are, in fact, ‘black’. Simply on appearance, is Barack Obama Middle Eastern, Hispanic or ‘black’? Further, why is Halle Barry ‘black’? Why is Henry Louis “Skip” Gates, the chairman of African American Studies at Harvard, ‘black’? Why, in spite of his explanation of his multi-cultural heritage, is Tiger Woods ‘black’? 

In fact, what is ‘blackness’ as defined in 21st century America? I truly don’t know. Bear with me on this point.  I understand that I am a descendant of sub-Saharan Africans. What I don’t understand is the minimum requirement to ascribe ‘blackness’ in modern America. In America’s racist past, it was the infamous 1/32 rule. However, today, it appears to be little more than strict adherence to a separatist, isolationist code. Again, bear with me on this point. 

Conservative descendants of sub-Saharan Africans are routinely dismissed and caricatured by the African American community. Even Colin Powell’s Jamaican heritage could not save him this fate. For the uninitiated, within the African American community, ethnic blacks from the Caribbean are admired and viewed as more closely linked to Africa than African Americans without that experience. The particularly Negroid features and dark skin of Condoleeza Rice and Justice Clarence Thomas neither apparently meet this minimum requirement for ‘blackness’. Yet, the straightened hair and particularly Caucasoid features of Halle Berry, or non-Negroid features of Al Sharpton, Jesse Jackson or Tom Joyner, and even Barack Obama’s 50/50 cultural heritage do not preclude their full attainment of ‘blackness’. Evidently, ‘blackness’ is a state of mind or a willingness to go on record with a very narrowly defined world view that is popularly accepted by many. And, if you deviate from this view, you are deemed devious, deficient or deceived. Worse yet, you are assumed to have deep psychological issues resulting from your self-loathing due to the pain of partial acceptance by a “hostile majority society.”  And, if you reject this psychological evaluation, you are simply too deeply deceived to see clearly your true state.

Nor is ‘blackness’ genetic. I watched intently Skip Gates' series on PBS detailing his ancestry and DNA confirmed testing to determine that he is, in fact, less than 30% ‘black’. According to Skip, DNA researchers have assembled a genetic database of native Africans to use as a baseline with which others may test to determine correlation and, thusly, their ‘blackness’. In Skip's case, his DNA was determined to be less than 30% sub-Saharan African and more than 70% European. Therefore, if ‘blackness’ is not genetically defined (since it is not apparently even correlated with a genetic relationship to sub-Saharan Africa as Skip Gates is much more ‘white’ than ‘black’, but, oddly, is not considered ‘white’) or barely discernible visually, just what is it exactly? 

I have pondered this question for much of my adult life and have come to the sad conclusion that for many in this country, racial identity politics is a convenient package to wrap an affirmation and victimization mentality around. Simply put, it is popular to be the under-dog. In fact, it is even hip. Borne of a longing for a romanticized image of a past culture severed by the history of African slave trading, this intensified longing gives rise to viewing modern neighborhood slang, cadence and gait as evidence of a “culture”. A fondness for a particular type of music or clothing fad is viewed as further evidence of “culture”. Ironically, if anything, these symbols of culture are symbols of American pop-culture as they were foreign to me when I came to the mainland for college. 

Exaggerated reference to injustices of the past trivializes not only those injustices; it trivializes all injustice. Blind adherence to a victimization mindset, regardless of one’s accomplishments and life experience, diminishes those adherents to mediocrity at best or a cycle of despair at worst. Clearly there are instances of overt or covert unfairness based on race. I would argue that these are of much less severe nature than ever before in American history as there are today sufficient legal protections amounting even to legal preference. 

However, attitudinal adjustment is not the responsibility of one group alone. Like the overly sensitive rape victim venturing out on a first date, today’s generation of African Americans could stand to not perceive racial animus in every slight. I would therefore argue that the single best thing that the person of sub-Saharan African descent can do in America is to disavow himself of any concept of ‘blackness’ and to affirm a concept of American individuality. Clearly ‘blackness’ is a construct of a racist past where the very term was meant to denote a sub-human condition, as distinct from ‘whiteness’. Why in the world would any rational being cling irrationally to this construct and then fight to define an entire world view around this outdated construct? 

In the Bible the synoptic Gospels relay the story of the Cyrenian Simon who carried the cross for Christ while Christ was on his way to his crucifixion. I’ve often marveled at that simple reference to Simon that so obviously described his likely appearance. He was most likely a medium to dark-skinned African, as Cyrene is present day Libya.  However, in the Bible, he was simply described as a man of Cyrene, as that is either where he was from or he had a strong resemblance to the vast majority of Cyrenian people with whom the authors of the Gospels had interacted.  He was not described by characteristics of his physical appearance, but by aspects of his origin.

I love myself, which is why I reject ‘blackness’. I am a human being, an American, a descendant primarily of sub-Saharan Africans, a Christian and a father. I am a native of the US Virgin Islands and a lover of Caribbean foods and music. I love the American experiment and the bounteous gifts it has provided for me and my family. I happily served her military and hope to leave a legacy of contribution to this greatest country on God’s Earth. I am no more ‘black’ than any one else is ‘white’. Rejecting race classification is the necessary step to move the human race forward. Let us no longer view ourselves as hyphenated Americans. Rather, let us accept her goodness borne of a precious price of a racist past, but also borne of a wondrous epiphany to craft a country and a culture around ideals of individuality and the freedom and responsibility to pursue the aspirations of that individuality. Let us simply accept ourselves as amongst America’s oldest citizens. Let us simply accept ourselves as American.

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