With another April 15th behind us, let’s take a look at where some of that money we paid to the government in 2008 went. You should find this an eye-opener. It’s not about the usual “pork-roll” of wasteful government spending. Something far more wasterful and shocking has been going on.

First, however, we were wondering if you’re feeling better about things? Apparently, a lot of people are these days. In the world of finance, one gauge of sentiment is the “Confidence Index.” It’s been rising. So has the stock market.

In our little part of the maze that is New York City, we’ve been watching Spring’s handiwork: longer days, warmer sun, flowers blooming. Check out this little guy’s purplish glow. Nice little flair by Mother Nature, isn’t it?

Last month we said we’d pose the question, “Are you prepared for what’s coming?” One way to begin answering that question is to first look at exactly what’s going on, which brings us back to your 2008 taxes. Question: How much did you pay in Federal taxes this year? If you don’t remember, look it up. You’ll want to know when you read our story.

It starts with AIG. While the media focused our attention on $160 million in bonuses to certain executives, at around the same time approximately $100 billion went to investment bankers on Wall Street. It was taxpayer money. This should have been BIG news.

How could this happen with almost no uproar? Two reasons:

First, in a breathtakingly short period of time, billions seem like chump change in the new world of trillion dollar stimulus and bailout packages.

Second, most of us are simply too busy to pay attention. In addition to the usual busy-ness of work and family matters, it seems a lot of us have become slaves to gadgets (which we’ve written about numerous times) and now “social networking services.” (e.g., Facebook, MySpace, and the latest fad, Twitter. See our comment at the end of this letter).

This is no time to be “tweeting” our lives away. While the jury is still out on whether we’re going into recovery or depression, one thing is certain: budget deficits (the shortfall between taxes taken in and government spending) and the increase in thenational debt (how much the nation owes to its various creditors) have exploded and will continue to grow at rates never before seen.

Since we’re all adults here, we know there’s no free lunch. So what’s the current price tag? Bloomberg.com estimates that as of March 31st the amount of money the U.S. government and the Federal Reserve spent, lent or committed to topped $12.8 trillion (yes, with a “T”). That amount is almost as much aseverything produced in the U.S. for all of 2008 (GDP).

Since “GDP” can be somewhat abstract, let’s look at it another way. With 100 million families in America (according to the Census Bureau) and a median family income around $45,000,$12.8 trillion represents about 2.8 years of median annual earnings for every family in the U.S. That’s the rough equivalent of around 2.8 years of the sweat and toil of 100 million working American families.

We hope you can see why, rather than twittering and tweeting, we need to keep our eyes on our elected representatives and government officials who are allocating and spending this money. To drive home the point, we’re going to spend the rest of this letter on one specific, outrageous example of why vigilance will be critical in the months and years to come.

At the same time that the AIG bonuses were getting “the people” all riled up (remember the demonstrations, even personal threats to AIG executives?), the real scandal flew right by most of us.

It happened when a “slug” of about $200 billion was distributed to AIG – this after an initial $80 billion – in order to “save” the insurance company.

It turns out that AIG paid out somewhere in the neighborhood of $93 billion – $105 billion (reported figures vary) to investment bankers at firms like Goldman Sachs, Morgan Stanley, Citibank and JP Morgan who had bought CDS from AIG.

The sparse coverage given by the media focused on the fact that AIG “owed” this money to buyers of CDS, or “credit default swaps,” issued by AIG. Had AIG been allowed to go bankrupt they would not have been able to make payments owed to the owners of these CDS. Somehow these payments were mixed in with the claim that the world’s financial system would collapse if AIG were allowed to go under.

The media should have, however, asked:

CDS can legitimately function as a kind of insurance policy. Not these CDS. We’ll use a typical home insurance policy to make our point.

You buy an insurance policy on your home in case a fire or some other disaster damages or destroys it. The insurance company calculates the premium you pay based upon historical data that can be combined with prudent projections on the probability of the occurrence of the particular risk against which you are insuring your home. In its legitimate form, a CDS (credit default swap) is a kind of insurance policy you take out if you lend money to another party and you want to make sure you’re paid in the event that party can’t pay you back. You, the creditor, want to insure against a possible “default” on your loan. AIG sold these sorts of insurance contracts. So far, so good…until investment bankers turned these legitimate instruments of risk management into ways to make quick, enormous profits.

To use our home insurance example, imagine your neighbor buying insurance on your home. (In real life he can’t do that because he wouldn’t have any “insurable interest” in buying a policy on your home.)

To give some color to our example, let’s say you haven’t really kept the place up and your neighbor figures the old shack is a fire-trap. So he goes to his insurance company and takes out a policy on your home, speculating that it will burn down.

Meanwhile, other neighbors get the same idea. They all buy a policy on your house. In fact, the idea catches on in the whole neighborhood and now your neighbors find some other fire-traps waiting to burn down and buy policies on those houses too.

Fortunately, your neighbors can’t do this. But investment bankers did buy CDS on loans where they weren’t the creditor (i.e., where they hadn’t lent the money in the first place). They were betting on the loans defaulting. And they paid hefty premiums to AIG for these sorts of CDS.

Simply stated, AIG engaged in speculative activities with investment bankers. The payments made to the investment bankers were different than the typical claims paid out by insurance companies. The CDS that AIG had sold were far from the sort of quality insurance policies for which AIG had developed an international reputation.

AIG sold boatloads of CDS to investment bankers. Because of the massive credit defaults triggered by the financial crisis last year, the investment bankers who placed the right “bets” wanted to collect on the defaulted loans on which they bought “insurance.”

We could go into a lot of detail about how investment banks and AIG, as regulated financial services enterprises, got away with this sort of naked speculation, but in the interest of time, we’ll stop here and cut right to the big question:

Let’s go back to those 100 million American families to understand just how outrageous these payments were. But instead of the “mean” we’ll use “average” earnings for an American family – around $70,000. While the number can vary, in 2008 that family may have paid around $15,000 in Federal taxes. (That’s just Federal taxes, not counting FICA tax ($5,300+), Medicare tax ($800+)…and let’s not forget State income tax.)

A back of the envelope calculation tells us that the amount of money passed on to the investment bankers is the equivalent of the Federal taxes of some six million seven hundred thousand (6,700,000) families – just to make sure these bankers collected their speculative profits.

But let’s not stop here. Let’s remember that $100 billion is but afraction of that $12.8 trillion that’s been spent, lent or committed by the government. What additional “fractions” do you imagine have been or might be spent on “distributions” similar to this recent AIG transaction? With this amount of money at stake, you can almost feel the schemers trying to get their hands on some of it.

Now please understand that this is not political commentary. The incident we’ve just pointed out began under a Republican administration and was consummated under a Democrat administration. Spread the blame around if you want.

We’re also not commenting on whether the government should or shouldn’t be spending these enormous sums (more, for example, than was spent on all of World War II, even adjusted for inflation). Plenty of economists have registered the opinion that money must be spent by government as a “stimulus” to prevent a worsening recession, or possibly a depression.

All the more reason why the money being spent needs to be used to stimulate economic activity, not fill the pockets of speculators.

These gargantuan amounts being thrown around will dramatically change our lives in ways we don’t even know yet. And they will change the lives of our children.

We can only guess what the economic impact will be. But more important will be the impact of the misuse of money. Can we excuse or, worse, ignore money being transferred to speculators at taxpayer expense? What do we tell our children who will be paying off the debts we’re piling up? And how can we expect people who are losing their jobs or who have lost much of their retirement money to not become discouraged…or worse?

To put it simply, besides the financial implications, this a serious moral issue.

Whew! We’ve got to stop here or we’ll soon switch from our pursuit of the True and concern with the Good into an extended rant. And that won’t serve anyone’s purpose. Besides, most of us have real work to do – work that generates the taxes that the government is using in its stimulus and bail-out plans.

We’ll end by going back to one of our initial observations about the “busy-ness” of our lives – and the latest gimmick to take up the precious minutes we could be using to pursue the True, the Good and the Beautiful: Twitter.

If you’re tweeting right now, all we can say is just don’t spend too much time on this stuff. Really.

Are Twitter and other forms of “social media” a way to communicate with others? We recently came across a particularly good comment about these media by the writer John Carlton: “The “social” part of social media is murdered in its sleep when so little actual interaction takes place.”

If you need more convincing (or if you just want a good belly laugh to end this rather serious letter), click on this link to a very funny Youtube video about this latest invention in the world of “social networking.”

http://www.youtube.com/watch?v=PN2HAroA12w

NEXT MONTH

Some new data that may shake up your notions of whether stocks are really the obvious choice we all thought they were for long-term investing.

Meanwhile, enjoy the beauty of Spring!

P.S. – While there was no time for the usual comments, tips and updates this month, if you’re interested you can find more ideas about this crisis and “what’s happening” at:

http://rickesposito.blogspot.com/

I hope you find the personal commentary interesting and helpful.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com