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9:00 AM EST Thursday, June 5, 2008: Will Lehman Brothers go under? No. Will Lehman Brothers go down further? Most probably. It won't go under because the Federal Government is providing some form of implied guarantee and the market believes that. It will go down further because Lehman owns too many toxic assets. No one (including Lehman management) knows what all its toxic mortgage-backed securities (and other toxic assets are worth) are worth, since there's no market. No one will buy them.

My Lehman short is nicely in the money but I'm not extending it.

I'm continuing to stay away from financials. There's far too much uncertainty, and too much toxicity in their assets. I've been remiss, however. I should have shorted more financials. Many are Super Cockroach Stocks. Think Super Mario Brothers. Keep reading.

George Soros is a financial genius: When a billionaire investor writes a book called "The New Paradigm for Financial Markets -- the Credit Crisis of 2008 and What it means" you figure he's going to give you some useful investment tips. You, too, can become a billionaire.

Soros' new book.

I won't disappoint you. Here's how Soros picks his investments, courtesy his son. The quote is from the book:

My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it's this early warning sign.

If you're around him a long time, you realize that to a large extent he is driven by temperament. But he is always trying to rationalize what are basically his emotions. And he is living in a constant state of not exactly denial, but rationalization of his emotional state. And it's very funny.

A bad back makes a good investor. I bet my back rivals Soros'. I'm going to watch it in future. Maybe if I correlate my back pains it to the height of skirts, I'd have a better chance with the market?

The length of women's skirts tells you the way the market is going to go, according to the so-called Hemline Theory. In the 1920s and 1960s hemlines were at a high and so was the stock market. And in the 1930s and 1940s the stock market was so low that women were almost tripping on their skirts. The hemline theory was also on the ball in 1987. Miniskirts were all the rage, and the stock market was at a matching high. But then the market quickly crashed in October, right when designers such as Bill Blass decided that miniskirts looked ridiculous. Hemlines dropped and so did the market.

Right now, every woman I know is wearing pants. In fact, it seems as though God has outlawed women's legs. And the Hemline Theory says nothing about pants. So much for that theory. I'm back to my aching back and George.

The best part of his book is his explanation of what went wrong:

The crisis was slow in coming, but it could have been anticipated several years in advance. It had its origins in the bursting of the Internet bubble in late 2000. The Fed responded by cutting the federal funds rate from 6.5 percent to 3.5 percent within the space of just a few months. Then came the terrorist attack of September 11, 2001. To counteract the disruption of the economy, the Fed continued to lower rates-all the way down to 1 percent by July 2003, the lowest rate in half a century, where it stayed for a full year. For thirty-one consecutive months the base inflation-adjusted short-term interest rate was negative.

Cheap money engendered a housing bubble, an explosion of leveraged buyouts, and other excesses. When money is free, the rational lender will keep on lending until there is no one else to lend to. Mortgage lenders relaxed their standards and invented new ways to stimulate business and generate fees. Investment banks on Wall Street developed a variety of new techniques to hive credit risk off to other investors, like pension funds and mutual funds, which were hungry for yield. They also created structured investment vehicles (SIVs) to keep their own positions off their balance sheets.

From 200 until mid-2005, the market value of existing homes grew by more than 50 percent, and there was a frenzy of new construction. Merrill Lynch estimated that about half of all American GDP growth in the first half of 2005 was housing related, either directly, through home building and housing-related purchases like new furniture, or indirectly, by spending the cash generated from the refinancing of mortgages. Martin Feldstein, a former chairman of the Council of Economic Advisers, estimated that from 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. A 2005 study led by Alan Greenspan estimated that in the 2000s, home equity withdrawals were financing 3 percent of all personal consumption. By the first quarter of 2006, home equity extraction made up nearly 10 percent of disposable personal income.

Double-digit price increases in house prices engendered speculation. When the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one wants to occupy. By 2005, 40 percent of all homes purchased were not meant to serve as permanent residences but as investments or second homes. Since growth in real median income was anemic in the 2000s, lenders strained ingenuity to make houses appear affordable. The most popular devices were adjustable rate mortgages (ARMs) with "teaser," below-market initial rates for an initial two-year period. It was assumed that after two years, when the higher rate kicked in, the mortgage would be refinanced, taking advantage of the higher prices and generating a new set of fees for the lenders. Credit standards collapsed, and mortgages were made widely available to people with low credit ratings (called subprime mortgages), many of whom were well-to-do. "Alt-A" (or liar loans), with low or no documentation, were common, including, at the extreme, "ninja" loans (no job, no income, no assets), frequently with the active connivance of the mortgage brokers and mortgage lenders.

Banks sold off their riskiest mortgages by repackaging them into securities called collateralized debt obligations (CDOs). CDOs channeled the cash flows from thousands of mortgages into a series of tiered, or tranched, bonds with risks and yields tuned to different investor tastes. The top-tier tranches, which comprised perhaps 80 percent of the bonds, would have first call on all underlying cash flows, so they could be sold with a AAA rating. The lower tiers absorbed first-dollar risks but carried higher yields. In practice, the bankers and the rating agencies grossly underestimated the risks inherent in absurdities like ninja loans.

Securitization was meant to reduce risks through risk tiering and geographic diversification. As it turned out, they increased the risks by transferring ownership of mortgages from bankers who knew their customers to investors who did not. Instead of a bank or savings and loan approving a credit and retaining it on its books, loans were sourced by brokers; temporarily "warehoused" by thinly capitalized "mortgage bankers"; then sold en bloc to investment banks, who manufactured the CDOs, which were rated by ratings agencies and sold off to institutional investors. All income from the original sourcing through the final placement was fee based -- the higher the volumes, the bigger the bonuses. The prospect of earning fees without incurring risks encouraged lax and deceptive business practices. The subprime area, which dealt with inexperienced and uninformed customers, was rife with fraudulent activities. The word "teaser rates" gave the game away.

Starting around 2005, securitization became a mania. It was easy and fast to create "synthetic" securities that mimicked the risks of real securities but did not carry the expense of buying and assembling actual loans. Risky paper could therefore be multiplied well beyond the actual supply in the market. Enterprising investment bankers sliced up CDOs and repackaged them into CDOs of CDOs, or CDO-squareds. There were even CDO-cubeds. The highest slices of lower-rated CDOs obtained AAA ratings. In this way more AAA liabilities were created than there were AAA assets. Towards the end, synthetic products accounted for more than half the trading volume.

The securitization mania was not confined to mortgages and spread to other forms of credit. By far the largest synthetic market is constituted by credit default swaps (CDSs). This arcane synthetic financial instrument was invented in Europe in the early 1990s. Early CDSs were customized agreements between two banks. Bank A, the swap seller (protection purchaser), agreed to pay an annual fee for a set period of years to Bank B, the swap buyer (protection seller), with respect to a specific portfolio of loans. Bank B would commit to making good Bank A's losses on portfolio defaults during the life of the swap. Prior to CDSs, a bank wishing to diversify its portfolio would need to buy or sell pieces of loans, which was complicated because it required the permission of the borrower; consequently, this form of diversification became very popular. Terms were standardized, and the notional value of the contracts grew to about a trillion dollars by 2000.

Hedge funds entered the market in force in the early 2000s. Specialized credit hedge funds effectively acted as unlicensed insurance companies, collecting premiums on the CDOs and other securities that they insured. The value of the insurance was often questionable because contracts could be assigned without notifying the counterparties. The market grew exponentially until it came to overshadow all other markets in nominal terms. The estimated nominal value of CDS contracts outstanding is $42.6 trillion. To put matters in perspective, this is equal to almost the entire household wealth of the United States. The capitalization of the U.S. stock market is $18.5 trillion, and the U.S. treasuries market is only $4.5 trillion.

The securitization mania let to an enormous increase in the use of leverage. To hold ordinary bonds requires a margin of 1.5 percent. This allowed hedge funds to show good profits by exploiting risk differentials on a leveraged basis, driving down risk premiums.

It was bound to end badly.

As to where we go now, here's Soros' prediction:

A sixty-year period of credit expansion based on the United States exploiting its position at the center of the global financial system and its control over the international reserve currency has come to an end. The current financial crisis will have more severe and longer-lasting consequences than similar crisis in the past. Every crisis involves a temporary credit contraction. The central banks will be able to provide temporary liquidity, as they did in the past, so that the acute phase of the crisis will be contained as usual; the international banking system will not break down as it did in the 1930s.

But on previous occasions each crisis was followed by a new period of economic growth. This time it will take much longer for growth to resume. The ability of the Federal Reserve to lower interest rates will be constrained by the unwillingness of the rest of the world to hold dollars and long-term dollar obligations. Some recently introduced financial instruments will have proven unsound and will go out of use. Some major financial institutions may yet prove insolvent, and credit will be harder to get. The extent of credit available for a given collateral will definitely shrink, and its cost will rise. The desire to borrow and take risk is also likely to abate. And one of the major sources of credit expansion, the United States' current account deficit, has definitely peaked. All this is bound to affect the U.S. economy negatively.

One can expect some longer-lasting changes in the character of banking and investment banking. These have been growth industries since 1972, launching ever more sophisticated new products and enjoying ever looser regulation. I expect this trend to be reversed. Regulators will try to regain control over the activities of the industry they are supposed to supervise. How far they will go will depend on the severity of the damage.

Back up your files when you travel: U.S. Customs is taking some travelers' laptops away and keeping them for weeks. It's not a good idea to enter the U.S. without having backed up all your working files. Use a portable hard disk and the Internet.

The French Tennis Open continues.
Watch it in high definition (HD). The quality is mind-blowing. The best HD seems to be from DirecTV and shown on my Samsung DLP big screen TV. HD is the only way to watch sports. The Tennis Channel is 455 on Time Warner Manhattan and 217 on DirecTV. ESPN is 209 on DirecTV and 29 and 729 (HD) on Time Warner. Your channels will be different.

As you watch the tennis, You'll notice: 1. How deep they hit the ball. 2. How much they move the ball around, from side to side. 3. How often they run around their backhands. 4. How consistent the better players are. They simply make fewer mistakes.

College Examination
At Penn State University , there were four sophomores taking chemistry and all of them had an 'A' so far. These four friends were so confident that, the weekend before finals, they decided to visit some friends and have a big party. They had a great time and partied through the night, slept all day Sunday and didn't make it back to Happy Valley until early Monday morning.

They explained to their professor why they missed it. They said that they visited friends but on the way back they had a flat tire. And as a result, missed the final. The professor agreed they could make up the final the next day. The guys were excited and relieved. They studied that night for the exam.

The next day the Professor placed them in separate rooms and gave them a test booklet. They quickly answered the first problem worth 5 points. Cool, they thought! Each one in separate rooms, thinking this was going to be easy.... then they turned the page. On the second page was written....

For 95 points: Which tire?

Understanding Engineers
To the optimist, the glass is half full. To the pessimist, the glass is half empty. To the engineer, the glass is twice as big as it needs to be.

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.
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