Not an easy question to answer, but critical to do so none the less. Almost all of the losses taken by the banks in actual housing are "mark to market" write downs on mortgages that borrowers are still paying, including the mortgages for which AIG wrote "insurance". In a study released last week, UVA professor William Lucy states that actual realized losses in foreclosed housing by the banks is only $125 billion Study: Foreclosures in States and Metropolitan Areas: Patterns, Forecasts, and Pricing Toxic Assets. Almost 35% of these losses are from California mortgages and almost 90% are from California, Vegas, Phoenix and Florida. The remainder of the financial system's losses, estimated now in the "trillions" (everyone just tosses numbers around with no underlying support) are from ; 1)write downs on loans where people are still making payments (I guarantee you, your mortgage, if you have one, is trading in the market somewhere at less than par) and; 2) losses by financial institutions from credit default swaps or credit "insurance" like those that AIG wrote.

But both these types losses are of a different nature than actual realized mortgage losses.  If Lucy is correct, actual realized foreclosed mortgage losses are a fraction of the mortgage losses taken by the banks. As for derivatives, AIG's losses are literally Goldman's et.al. gains. The financial system as a whole has no gains or losses from derivatives. Derivates are a zero-sum transaction.This does not make it irrelevant because defaulted derivatives by, for example, AIG can cause chaos as their counterparties entered these transactions relying on them hedging other positions. But the nature of the problem is still less severe than realized foreclosed mortgages, which are true losses to the financial system. (One can argue everything is zero sum relative to some benchmark--I do not want to get into that discussion--it is technically true but not germaine at all to my point).

It still remains that all derivatives trades are "instantaneous cash zero sum" transactions which is far different than other zero sum issues and way different than realized housing foreclosures. My loss is your win in a derivative. Derivatives are much more analogous to betting on red at the roulette wheel in Harry Reid's Vegas. It is like a Vegas bet; red comes up, I win and you lose. This AIG mess is a tempest in a teapot turned into a travesty. The insurance companies should have been spun out of AIG, the holding company should have been declared bankrupt, and its counterparties should have taken the $40 billion hit in September. Once again, mark to market accounting made this option appear, but only appear, undesirable at that time.

The reason AIG has caused a problem is the Street was careless. It did not require any collateral from AIG on its derivatives trades. As a result, Goldman and other AIG counterparties, had cash losses on one side of a trade offset by unrealized non-cash gains with AIG. This would not be permitted by public derivative exchanges---i.e., the futures and listed options markets. These bail out problems do not exist in the futures markets despite "trillions" of derivatives being traded. But the combined losses/gains of AIG and its counterparties are still zero---as it always is in derivative trades. AIG's losses equal all its counterparties gains. Zero.

The mundane and localized realized mortgage losses as outlined by me in September and October in 3 essays ("California Dreamin"? , Where is Cool Hand Luke When You Need Him?, and And the Darkest Hour is Just Before Dawn is still true today as was confirmed in great detail by the the Lucy Study. I think losses will be higher (but are not yet) from foreclosures-- I think realized can approach $600  billion---by the end (Mark Zandi had a similar conclusion from Moody's). But these losses have already been taken and are small relative to the mark to market losses on the 93% of mortgages still paying. Yet it has caused our economy to enter a deep recession and given the most radical politician in American history an unprecedented opportunity to ruin the country.

The very strange thing about this is that Insurance companies do not mark their other insurance premiums to market like they do their "mortgage insurance premiums". If they did, they would have massive problems. In fact, if AIG and Goldman et.all were theoretically allowed to not mark these credit derivatives to market, neither side would have mark to market gains or losses. They would accrue losses and gains over time as defaults occurred or did not occur. This is what does happen in other insurance. Why is this different? A long story, but it is political at its core. I am not necessarily saying that "accrual acounting" is what should be done. I am also not saying it shouldn't be done. What I am saying is this mark to market accounting treatment is contributing mightily to the current problem.

Berkshire Hathaway, i.e., Warren Buffet, has entered into trades where he has supposedly lost--on a "mark to market" basis close to $10 billion dollars (therefore the "Street" has "made" $10 billion theoretically) on "equity insurance" trades made to the "Street" Is Buffett the Biggest Bubble of All? He does not have to post cash and won't have to for 20 years because he has even stronger "no post cash" provisions than AIG had before its downgrade. But these marks are so theoretical as to be absurd. Yet, it is almost certainly the case that the "Street" is "hedging" these---i.e.realizing cash losses of $10 billion---and offsetting them with unrealized non-cash gains from the Buffet trade! Just like AIG! But Buffet has the cash--but will he in 20 years when he needs to pay if he loses? Yet counterparties are likely marking these as gains.

IRONY PREVAILS

Confused yet? I am, and you should be too. What I am getting at is that while mark to market matters, it is not all that matters. This financial crisis was caused by a localized severe real estate bubble, primarily in the west, and through shear panic and an inability on the part of the Government to recognize the underlying nature of the problem, it created a monster. 

Yet as I write, this self induced panic may have begun to stop. This means it is even plausible that there could be some recovery of mark to market losses. The 50% plus return in the finacial sector in the last week has been caused by the announcement that the banks are making money in the first quarter. The hedge funds have also stopped losing money and Bernanke has piled on with his $1 trillion hedge fund. The irony is that just as it is possible the "mark to market" panic  may be now subsiding, Obama is now using AIG "greed' as a cover for his very unpopular budget and further restrictions for the proposed new regulatory framework.

Leadership in this crisis has been horrible and the people instinctively know it. The language being used simply conveys more confusion. Every time a government official or public commentator for that matter, uses the phrase “toxic assets”, prices of mortgages decline another half percent. I would love someone to define in operational terms what a “toxic” asset is. I believe this is a merely bad crisis—effectively a localized real estate bubble—turned horrific by panic and fear led by Hank Paulson/Tim Gethner and now continued by the Obama team.

Still we refused and seemingly still refuse to acknowledge what has and is happening. We have been in the financial equivalent of a crowd rushing from a theater as someone yells “fire”. But no one in Government has the courage, knowledge and confidence to state that perhaps "the crisis has no clothes". We would rather divert our attention to AIG bonuses as Obama creates his Statist nightmare.

I know Greenspan is everybody’s new favorite whipping boy, but somehow he managed to get through 7 crises, each of which looked as bad at the outset as this California housing meltup/meltdown, without us imploding into a self reinforcing cycle of financial despair. Leadership matters and we have had none--at least none who actually want to stop the panic. As Rahm Emmanual unabashedly said, a crisis is an opportunity to implement a Statist Agenda.