Scandals, they are good for something.

Just as was the case with the bankruptcy of Enron, Worldcom and the like, the latest troubles underlying the capital markets will help to reveal some questionable behaviour that has otherwise gone unnoticed. Following the big scandals earlier this decade, newspaper headlines were jam-packed with executives on their way to jail and establishment of new laws and regulations like Sarbanes Oxley. With the spotlight now on acronyms like CDO, CDS and CMO, the next round of similar headlines is not far away.

I just read this article and it really drove-home how the big banks, in their take-no-prisoners approach to turning a buck, may have unwillingly taken those dollars straight out of the pockets of the people who could least afford to be separated from them. Jefferson County, Alabama, is the latest municipality at risk of bankruptcy and the cause are the swaps it purchased to avoid this very situation.

JPMorgan, Bank of America, Lehman Brothers and, yes, Bear Stearns, all sold interest rate swaps to Jefferson County to help them hedge their risk on loans purchased to finance the county's latest public projects. With interest rates going in just the opposite direction, it's left the County with the obligation to pay rates in the double-digits only weeks after paying as little as 3%. The county, now in dire straights, has hired its own independent analysts to review their swaps purchases and has been stunned to learn that the aforementioned banks collected as much as $100 million in excess fees by charging far and above the prevailing rates for the securities.

When our car is running well, we don't visit the mechanic. It's only when strange noises alert our attention to a possible problem, that we hire someone to figure-out what needs to be fixed. When you drive a domestic car, you can generally visit any mechanic and find the services you need at reasonable rates. When you drive an exotic, however, you need to visit specialists who will charge you far more for their expertise. The types of exotic securities being purchased these days require just such specialists and, unfortunately, these experts are taking advantage of their clients in much the same way an unscrupulous mechanic might. Fortunately, unlike mechanics, these financial institutions must answer to their regulators who will penalize them for these acts, but hopefully the buyers will learn from these experiences too. Being able to afford a Ferrari goes well beyond having the funds to pay its sticker price; don't be buy exotics, be it cars or financial instruments, unless you thoroughly understand how they work and have the funds to pay those unexpected bills.

CDSs & Counterparty Risk; What Every Investor Should Know

Credit Default Swaps (CDSs) are making headlines these days, and not for good reasons. CDSs are essentially insurance contracts on debts - investors buy them to protect their income streams and principal investments in debentures should the issuing party default on their obligations. Most notable of these almost-defaults, of course, has been Bear Stearns and CDSs have been in the headlines ever since.

Why do you care? Well, would you believet that CDSs are unregulated and that there's no public record of the sellers solvency should they actually have to deliver on the contracts they sell. As an investor, this should scare you to death. Think about it this way: imagine you paid into your insurance policy, for your car, your home or even  your life, and when the worst actually happened, the insurance company just disappeared; this is the situation that may very well still happen. Yes, still; we're not out of the woods by any extent.

George Soros has been one of the most outspoken investors on the subject of how "unacceptable" it is to have a market such as this develop in an unregulated fashion. Now representing as much as $62 trillion in contracts, the collapse of such a market could mean worldwide financial fallout. This is no joke folks.

How's this for a revelation. JPMorgan is not only the investor of these types of contracts, but is also one of its biggest issuing firms (i.e. counterparties). Unlike traditional insurance companies, there is no agency that monitors the sellers of swap contracts. What makes things even more interesting, you don't even have to own the asset that you want to protect when you buy the swaps. Yes, that's like buying a life insurance policy on someone else - could you imagine if that were possible and what sort of practices that would condone?