I just read Charles Morris's The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash. It's a quick read, and he cogently explains some very abstruse financial instruments, like credit default swaps. Banks used these swaps--which generated interest payments--to increase their cash flow. One mistake they made was retaining the local branch or entity to service the loans and guaranteeing it loan payments even in case of default. For more on credit default swaps, click here.
I will be selling my KCAP stock and any hedge-fund related stocks, because it appears that hedge funds have been buying tranches of debt or giving loans to enterprises that are too speculative. Morris's overarching theme is that in a search for greater profits, Wall Street started marketing products that had higher yields and relied too much on economic models that assumed rational investors would withdraw their funds from these financial instruments in an orderly manner.
Basically, Wall Street's models created debt instruments that offered risky but higher yields within a package of more safe debt. Various investors could buy the safer debt at a lower yield; however, the more marketable debt was the riskier debt because it had a higher yield (lower yield bonds compete with the government's ultra-safe Treasuries and muni-bonds, meaning the market isn't that broad for private sellers of very safe bonds). Standing alone, neither the low-paying safe bonds would get many buyers, nor the higher risk bonds. So Wall Street made an unholy alliance of junk bonds with AAA-rated debt to create a very marketable product, increasing yields for everyone in an instrument that was supposed to be safer by spreading the risk.
The flaw was that these instruments assumed that the better-rated payers, who had been placed with riskier debtors, would be able to absorb a certain default rate. The models never thought the better-rated (AAA-rated) payers/debtors would default as well as the lower, more riskier tranches. When both the higher rated and lower rated tranches started defaulting, it became known as a "black swan" event (loosely translated, it means sh*t happens). Mr. Morris is shaping up to become this generation's John Kenneth Galbraith, arguing that the free market is no longer working, and we need more governmental intervention. (Thankfully, Mr. Morris's style is Hemingway-esque, the polar opposite of Mr. Galbraith's wordy, academic writing style.)
Mr. Morris's message hit home much harder, when, the same night, I watched a documentary about coal mine workers in Kentucky, called Harlan County, USA (1976). Barbara Kopple filmed this movie during one of the worst times in the American economy and profiled some of the worst working conditions in America. It is astounding to think that in the 1970's in the U.S., companies were talking about improving working conditions in terms of upgrading laborers from a situation with inadequate indoor plumbing to trailers as evidence of their commitment to their workers. At that time, benefits were about two dollar raises and 6 days of sick leave, and "pensions" were 150 dollars per month for some older workers. It's hard to believe that since then, other workers in positions requiring much less risk and daily manual labor, such as office government workers, have moved from demanding an equitable wage to receiving lifetime medical benefits and annual pensions worth more than what an average American makes in an entire year. During one interesting scene, a protesting coal miner near Duke Power Company's Wall Street offices strikes up a conversation with an amiable New York cop who says he could probably retire in his mid-30s with a pension worth 10,000 dollars a year. As you can see, inflation has serious consequences.
As a libertarian, this film shook me to my core, until I realized how lucky we are today. Few workers today in America risk so much for so little, and to the extent they do, they are typically poor immigrants trying to make a new life for themselves in a new country and aware of the sacrifices. In addition, despite the brouhaha about manufacturing jobs moving overseas, it is apparent that the old tactics of a strike and blocking roads to prevent scabs from going into a factory would not work today. In the modern world, you've got about 3 billion "scabs" all over the world who want prosperity and are willing to work in unstable and terrible working conditions to get a small piece of it. Globalization, by the way, is not new--Kopple's relatively more recent work, American Dream, about a group of Hormel workers in Minnesota, shows that to some extent, globalization has always been with us. The degree of that globalization, however, has changed rapidly, creating scenarios that may eventually create a tale of two cities: one prosperous, with many options, and another with few options and no union capable of staving off capitalism's "creative destruction" of certain jobs.
The promise America makes to its citizens is that while there will be differences in income and outcomes, the path to the middle class--of owning a home, putting your children through college, and being able to retire before 65 years of age--will always be there for anyone willing to work hard and make sacrifices. Recent globalization has enacted a period of creative destruction akin to dropping a nuclear bomb on certain industries, especially in the manufacturing sector. Yet, seeing Kopple's film shows how far we've come. Today, fewer Americans need to work in dangerous jobs, and we can outsource menial labor to other countries or their citizens--that is a sign of prosperity, one that is harder to see without seeing the history behind the labor movement and the working conditions that caused it.