Charles Morris: The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash

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.

FYI: Brokers that Allow Direct International Trades

Disclaimer: of course, this post is not a recommendation to buy or sell any stocks/funds/ETFs. Do your own due diligence. This post is also not a recommendation of any broker. I am not licensed to give and do not give investment advice.

It is surprisingly difficult to trade directly in foreign shares, as opposed to just ADRs. Here are some brokers that allow direct access to international markets (taken from April 3, 2008 edition of WSJ):

bursamex.com/mx (Mexico)
boom.com (most Asian countries)
directbroking.co.nz (New Zealand and Australia)
etrade.com (Canada, France, Germany, Hong Kong, Japan, United Kingdom)
hermesonline.com (Middle East)
everbank.com
interactivebrokers.com
investorseruope.com
stockbrokers-botswana.com
visocap.com (former USSR satellites)

The international companies I am interested in, such as Siemens and AXA, already have ADRs. In addition, Singapore, an underrated 20th century success story, already has an ETF, which I own: "EWS." However, the Philippines may present an interesting opportunity, given the number of expats sending remittances. It is estimated immigrants in the U.S. sent 66 billion dollars abroad in 2007.

Disclaimer: of course, this post is not a recommendation to buy or sell any stocks/funds/ETFs. Do your own due diligence. This post is also not a recommendation of any broker. I am not licensed to give and do not give investment advice.

Polygraphs: Reliable or Just Imperfect?

The April 3, 2008 Wall Street Journal published a letter by an economist re: the unreliability of polygraph testing that I thought worth of sharing:

Your article makes it crystal clear why a person should never consent to polygraph tests, which suffer from two types of errors: showing an innocent person to be guilty and showing a guilty person to be innocent. The article illustrates that a person is likely to fail the test because of perceived or actual guilt on subjects that aren't even being tested. The test i much more likely to show an innocent person to be guilty than a guilty person innocent. This is especially true if the person being tested is reasonably honest and worries about minor peccadillos, such as taking home a paper clip or coming to work a few minutes late. Because of this, polygraph tests encourage law enforcers who "know you are guilty" to keep digging until some question of innocence can be found on some (perhaps unrelated) activity.

Duane Eberhardt
Professor of Economics, Retired
Missouri Southern State University
Joplin, MO

See related article at Mother Jones:

http://www.motherjones.com/news/feature/2002/11/ma_148_01.html

Chip Johnson of SF Chronicle, Holding Government Accountable

Chip Johnson in his April 1, 2008 column in the SF Chronicle's B1 page, reports that almost 1/3 of Oakland's city workers are making over 100,000 dollars in salary per year. That figure, of course, does not include benefits and pensions. Overall, non-federal government (meaning, county, city and state) salaries probably make up between 10 to 15% of gross domestic expenditures, which doesn't sound like a lot until you realize that it's harder to reduce salaries once they achieve such a high level. More troubling is the fact that it's harder to reduce government benefits because such benefits are vested; in addition, such costs are difficult to estimate due to the guesswork in determining a former employee's health and life expectancy for pensions and medical benefit purposes.  In short, the public is indebted to the government for amounts unknown, even if the economy enters a period of recession or constrained growth.

Strangely, government employees making over 100,000 dollars a year are still eligible for overtime pay. In the private sector, most employees making 100K+ annually in base pay would be exempt and still expected to put in the hours that come with making such a salary.

The recent California Supreme Court decision allowing the public to see such salaries is INTERNATIONAL FEDERATION OF PROFESSIONAL AND TECHNICAL ENGINEERS, LOCAL 21, AFL-CIO et al., v. SUPERIOR COURT OF ALAMEDA COUNTY, REAL PARTIES IN INTEREST: CONTRA COSTA NEWSPAPERS (2007), which can be found at this link:

http://cprareq.blogspot.com/2007/08/contra-costa-newspapers-inc-v-city-of.html

The origin of "K Yew"

Some readers might notice the "K_Yew" nickname I have on my blog, but in no way is this a cute phonetic bit. The International Heald Tribune did a wonderful interview with Lee Kuan Yew that I just discovered. Here is one of my favorite bits from the interview:

The system works regardless of your race, language or religion because otherwise we'd have divisions. We are pragmatists. We don't stick to any ideology. Does it work? Let's try it and if it does work, fine, let's continue it. If it doesn't work, toss it out, try another one. We are not enamored with any ideology.

Let the historians and the Ph.D. students work out their doctrines. I'm not interested in theories per se.

It should not surprise anyone that this man is one of my heroes. The full interview is below, but if the link expires, you can go to the International Heald Tribune, Asia-Pacific, and do a search for the full interview, which spans eight pages and is dated August 29, 2007.

http://www.iht.com/articles/2007/08/29/asia/lee-excerpts.php?page=1

Starbucks Shareholder Meeting (Howard Schultz: "This will not stand." )

Puget Sound
U of Washington Law School
Seattle's Museum of Flight
First Starbucks at Pike's Place Market
Pike's Place
I went to the lovely city of Seattle to attend my first Starbucks (SBUX) shareholder meeting. This particular meeting was highly anticipated because of Howard Schultz. After leaving the CEO helm, only to see a downward spiral in SBUX's share price, Mr. Schultz returned and was greeted as an anointed savior. My friend said he looked like a cross between Pat Riley from his L.A. days and a Sopranos character, and he meant it as a compliment. Mr. Schultz does come across as a street-smart, wiry Mafia guy who was born to lead. (His slicked-back hair and nice suits draw comparisons to Pat Riley, another man from humble origins.)

First, let's talk about Seattle: the city is clean, fun, and mid-sized. I wanted to spend some time seeing the city, so I planned a three-day trip. The first two days, I felt like I was in a ghost town, because after being in San Jose, which has twice the population, Seattle felt tiny at just 500,000 people. On the other hand, the upside of fewer people is a better ability to control the local environment. As a result of conservation education and being so close to several lakes and near Puget Sound, Seattle's air feels noticeably clean and healthy. Indeed, one look at the view around Puget Sound, and you can't help but relax. Larger cities often forget that they are virtually concrete and asphalt fortresses, and spending a few days in Seattle proves that modern urban living and the environment can harmoniously co-exist.

Besides the cleanliness and beautiful lakes, Seattle distinguishes itself by having no state income tax. While that does seem to reduce government spending, it also results in making some cities, like Bellevue, into designated shopping mall areas and not much else ("Old Bellevue" is one unexciting, short block). Thus far, the retail businesses have left plenty of land for other uses, and with a sales tax of around 9% generating significant revenue, it seems reasonable to assume Seattle will continue to welcome retail establishments.

I would suggest skipping Bellevue, as well as the Space Needle (Seattle's version of Toronto's CN Tower, allowing visitors a bird's-eye of the city). After Chicago's Sears Tower, the Space Needle seemed unexciting and smallish to me. Instead, spend your time walking up and down "The Ave" near the University of Washington (don't miss the majestic George Washington statue near Red Square) and Broadway Street, Washington's version of Berkeley's Telegraph Street. I had a fantastic time walking up and down the Ave and Broadway.

The other "touristy" areas are Pike's Place, Pioneer Square, and the International District, all within walking distance from each other. The "original" Starbucks is at the Pike's Place, and was fun to see, old logo and all. Pioneer Square has an interesting memorial dedicated to firefighters who died in the line of duty and a few bars and shops, but not much else. A few blocks away are a small Chinatown and Little Saigon (after the trouble San Jose has had with this name, I chuckled at how common the "Saigon" name seems elsewhere). Neither district impressed me much, as they consisted of only a few blocks. Other than good restaurants--including one that sold a delicious durian milkshake--the "Asian" districts didn't seem to offer anything unique.

Seattle owes quite a bit to its Asian population--one of the first Boeing designers was Chinese, and Asian immigrants have revitalized the city. Seattle calls itself diverse, and nearby the university, it certainly is; yet, when compared with such an integrated Asian population in the main downtown and university areas, the International District seemed to include a less upwardly mobile immigrant population.

The Flight Museum, nearby the airport, was also fascinating, if you enjoy seeing actual, life-size planes used in World War I and II. There was even a miniature model plane section, which displayed about 100+ mini-planes. The price of admission included seeing the inside of an older Air Force One and Concorde. The Concorde wasn't much different from a regular plane on the inside, but the aerodynamic design was obviously novel at the time. Air Force One was plush, as expected, with some couches and large seating spaces.

Some downsides to Seattle: a) the water coming out of my hotel faucet was opaque; as a result, I would recommend not drinking Seattle's tap water; and b) Seattle is very eco-conscious, and seems to discourage driving by making parking somewhat expensive and limited. Parking is not an issue for tourists like me, who can use Seattle's decent bus system, and the parking situation is nowhere near the level of difficulty in San Francisco; at the same time, it was unusual to see a city discouraging personal transportation.

Now, to the main event: the Starbucks meeting took place at the Seattle Center in the Queen Anne neighborhood (near the Space Needle). Schultz came out to cheers from the audience, and immediately launched into a motivational speech about how although these were tough economic times, Starbucks needed to focus on making better coffee to attract customers back. His speech was geared to both shareholders and employees ("partners"), and many SBUX partners came to the meeting. After telling everyone that the poor performance "will not stand," Schultz had several ideas on how to improve sales, including using a new espresso machine that allowed the fresh aroma of beans to permeate the stores ("Mastrena"). This machine also had a lower height, allowing more interaction with customers. The SBUX baristas cheered the lower height of the machine, but it was unclear whether the cheers were because their shoulder muscles would be less weary, or whether they were looking forward to the prospect of easier eye contact with customers.

Mr. Schultz also announced Starbucks' acquisition of a local company that invented a machine that brewed an individual cup of coffee in seconds, creating a single, ultra-fresh cup of coffee ("Clover"). In addition to those two innovations--the "Mastrena" and the "Clover," Schultz introduced a loyalty card that allowed regular customers to receive their "customizations," such as syrup shots, for free, as well as a partnership with an eco-company (whose direct impact on the bottom line was ambiguous). There were a total of six new ideas, including a web-site for customer feedback and the introduction of a new blend of coffee, but the Mastrena was the main upgrade.

k.d. lang performed a few songs, and her voice was beautiful, even better than her "Constant Craving" days. Her rendition of Leonard Cohen's "Hallelujah" was inspiring. (Starbucks doesn't announce who their annual musician will be, which creates additional buzz around their meeting.)

The other entertainment highlight was Mr. Schultz playing a "Colbert Report" clip on the host's travails when SBUX shut down for a few hours to re-train employees (Schultz said, in all earnestness, that the limited shutdown was not a publicity stunt). Upon leaving, each shareholder was given a bag with some SBUX goodies, including a CD (I learned that Aretha Franklin copied her "Respect" song from Otis Redding), a mug, and some coffee beans. All in all, the meeting was a great experience.

CalPERS and CalSTRS

Teachers and government employees always ask for more money, claiming that they cannot attract good employees because entry salaries are too low. Putting aside the argument that government employees exchange, in some areas, somewhat lower salaries than their private industry counterparts for a pension and other benefits, the amount of money government employees have taken from private citizens is vast.

Benn Steil, Director of international economics at the Council on Foreign Relations, provided recent numbers on how much private citizens have given California's state government (Wall Street Journal, March 2008):

The Public Employees' Retirement System has 259 billion dollars in assets.

The State Teachers' Retirement System has 169 billion dollars in assets.

Even so, these entities are underfunded in future obligations/payments, meaning that they will most likely put initiatives on future ballots asking for more funds/taxes from private citizens.