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The Moral Hazard Club

Bennet Sedacca Apr 21, 2008 12:18 pm


		Taxpayers pick up tab for bank blunders.

The Federal Reserve, clearly in panic mode, began changing the rules under which financial markets has operated for many decades. In the table below, you'll see just how desperate it's have become.

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I know some people applaud the Fed for being creative. I believe it's played the ultimate moral hazard cards for investment banks. The banks take low quality loans, turn them into esoteric securities, sell them to investors, pay themselves huge bonuses, lever their balance sheets with esoteric securities and are then allowed to simply ship them off to Fed in exchange for Treasuries. The Fed has now become nothing more than a hedge fund in disguise. The notable exception is that unlike a fund like ours, the Fed doesn’t have a ‘P & L’. The Fed can take these securities onto its balance sheet -- just like the Resolution Trust Corporation did in the early 1990’s -- except eventually the assets will probably be written down and taxpayers will foot the bill.

What strikes me as particularly odd is that there seems to be some favoritism displayed here by the Fed. Millions of people have lost their homes or will likely soon lose their homes, the economy is sinking into recession, companies are going bankrupt and what do we do? We allow brokerage firms and banks to shamelessly exchange their ‘supposedly AAA rated Mortgage Backed Securities’ for Treasury securities of the Federal Reserve.

I use the word ‘supposedly’ because if they were really AAA and had a market, why wouldn’t these firms just sell them in the open market? Because there is no market.

I've been referring to our economy as an ‘asset based economy,’ one based on high levels of money and credit growth, for the better part of ten years. Now credit growth and leverage have finally caught up with the creators of this mess, namely the Fed and the broker-dealers themselves. Since the government has begun to rescue them from their own self inflicted wounds, I guess you can call the dealer community ‘the Moral Hazard Club’.

What I want to know is why I didn’t get an invitation into the club. We manage money on behalf of clients and ourselves, yet when we make mistakes, I can’t just call up Chairman Bernanke and ask how I exchange my mistakes for Treasuries at 2.5% per year. It would be nice -- and would feel shameless -- but I have to admit that if I had a free put option underneath every trade, I would take a lot more risk. Wouldn’t you?

The Problem with the Moral Hazard Card

Suppose an investor correctly made a directional credit bet against Bear Stearns via purchasing a 5-year Credit Default Swap. As Bear approaches bankruptcy, the Fed and Treasury Department offered a sweetheart deal to JP Morgan and tossed in a $29 billion backstop against Bear’s worst assets.

Because the Fed intervened, the buyer of CDS that should have profited would have gotten killed. The price of 5-Year Bear Stearns CDS went from 200 basis points to 800 basis points to 100 basis points. Had Bear gone under as a free market would suggest it should have, the CDS buyer would have profited from his accurate bet.

5-year Bear Stearns CDS

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If the bailout of Bear becomes a trend -- as I suspect it will -- then measuring risk and reward and establishing positions will become a bit more difficult than in the past. Our firm prides itself on having gotten the macro-economic picture mostly right over the years, but when the Fed and Treasury intervene it makes us play a little closer to the vest.

It's hard enough to get the big picture right, but even harder to get it right and lose as intervention continues - we just never know what intervention, new facility or surprise rate cut will greet us when we walk in each morning. It's a bit frustrating, but to be frank, we have to observe actions of the markets and invest accordingly, even if we miss out on a little bit of upside that was a result of outside forces.

For example, as I write this, I just read that the Bank of England will offer similar terms to British Banks. I guess the ‘Moral Hazard Club’ just got a little bigger! I'm still waiting for my invitation, but I suppose I shouldn’t hold my breath.

The Balance Sheet of the Federal Reserve System

Each week the Fed publishes its balance sheet on Friday afternoon as of the prior day’s close (see below as of April 17th, 2008). Taking one glimpse at the balance sheet is enough to make a grown man cry.

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The Fed is slowly becoming the dumping ground for dealers and banks - members of the ‘Moral Hazard Club.’ It's is running out of capital, and quickly.

The problem assets (at least the ones we know about) are way too large for the Fed to completely absorb. It's waiting and hoping the economy and credit markets stabilize before it runs out of ammunition.

Because we haven’t yet received our invitation to this exclusive club of value destroyers, we will continue our cautious view until such time we are convinced that the worst of the credit crisis is behind us. I believe this will take more time than most people think, despite some ferocious bear market rallies along the way.

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Comments (8)

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Mike Dill

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04-21-2008, 5:46 pm
I get my accounts Marked-to-Market every night. What makes these banks so special? I also want to give the Federal reserve some of my level 3 assets, so that I can get out from under them. How do I get to be a member of the club? Read More

James Fraasch

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04-22-2008, 8:41 am
The Fed has said they will continue these programs indefinitely. So they are essentially rolling 28-day repos that will not expire until the Fed believes the assets can be sold on the open market again. Read More

John Powers

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05-05-2008, 4:25 pm
It seems to me the core problem is one of refusing to devalue the instrument in which all this massive, unpayable debt is structured; i.e. fiat currency. Since this problem is global in nature, it would seem that no fiat currency is � Read More

David Gondek

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05-05-2008, 6:38 pm
The idea is that the Fed will keep rolling over these 'loans' until nobody is watching. Then the banks will just default on the 'loans' and the Fed will be stuck writing them off...which, if I understand it correctly, Read More

Gene Byrne

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04-24-2009, 12:34 pm
Let's not forget regulation.As a former regulator I am very confident that many of the past problems could have been substantially slowed or stopped. If we can put decent regs and regulators in place we can make huge strides along with all the Read More


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