Moral hazard is the prospect that a party insulated from risk may behave differently, for example, that an insured party's behavior will be more risky than it would without the insurance. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.
-Wikipedia

I come from a middle class family with parents that worked hard and though that people were responsible for their actions. Responsible for their actions. Think about it. When you wake up each day, do you think you are responsible for your actions? I cannot answer for all that are reading this piece, but I know that I am responsible for mine. I may not like the outcome, but as a market participant, I still deal with both my correct and incorrect decisions.

It is how we all go up the learning curve of life—by making mistakes. How would I act each day if every mistake were "made whole" by some outside source with unlimited capital? Yep, you guessed it. I would take risk—lots of risk. What if we all operated in this manner? We would have an unlimited amount of risk outstanding and a ‘put option’ beneath our every move. This is the moral hazard card at play. Truly a dangerous card. One that should not be in play. At least not in this humble man’s opinion.


Where is Professor Darwin When You Need Him?

Darwinism - A theory of biological evolution developed by Charles Darwin and others, stating that all species of organisms arise and develop through the natural selection of small, inherited variations that increase the individual's ability to compete, survive, and reproduce.

In 1977, I went to college thinking that I had to survive the next four years. To be sure, there were bumps in the road that made it take five years and I fought the laws of what many of us call ‘Social Darwinism’—survival of the fittest at the collegiate level. The collegiate level leads to the professional level. The simple point of Darwinism is that the strong survive and that the weak, as unfortunate as it may sound, must fail. There is simply not enough room in our society for all to win.

Otherwise, the words ‘winner’ and loser’ would not exist, just the word ‘neutral.’ I say all of this from purely a business point of view. Sometimes those that should survive don’t for short periods of time and those that should survive do not. Longer-term, without a moral hazard card, the cream eventually rises to the top, and sadly, the others do not. To be sure, I hope that those that do not rise to the top learn from their mistakes, and this opportunity is what makes this country so great. We must all learn from our mistakes, as painful as that process can be. We should learn from taking on too much risk in portfolio management, too much credit card debt, taking on too much mortgage debt or from trying to leap large buildings in a single bound. In sum, we should all be responsible for our actions no matter what our job description. 

When I find myself in times of trouble, mother Mary comes to me,
speaking words of wisdom, let it be.
And in my hour of darkness she is standing right in front of me,
speaking words of wisdom, let it be.
-Let It Be (The Beatles)

So what do we do now? Do we avoid Darwinism? Do we accept the ‘Moral Hazard card’? Do we reward those who took out second and third mortgages? Do we reward investment banks that created all sorts of esoteric investment vehicles that by and large improved their own earnings without regard to their client’s needs? Do we change the rules of mortgage resets?

Sometimes, you have to own up to what you have done to yourself. I take risk on my own behalf and our client’s behalf daily in the most prudent manner possible. Unfortunately, sometimes you make an ill-chosen decision and you lose. Yes, lose. If I had a moral hazard card in my deck of risk cards each day, I wouldn’t really care how much risk I took. In fact, I would take more and more and more and more (ad infinitum) risk as I knew I would always get bailed out for taking risk and never lose. This is where politicians (yes I know it is an election year) and the Fed have become too "loose" in their policy. Taking "defined risk" is acceptable. Taking risk without regard to loss is a keg of dynamite waiting to be ignited, which seems to get bigger every day.


The Promised Land

So what do we do now? We have ignored credit risk for what seems like a long time, but in reality has only been a few short years. Credit risk is slowly being re-priced but thankfully that process seems to be accelerating. We will patiently wait to take credit risk, but know this: When it is time and when we are paid to take credit risk, we will take credit risk.

There is a fine line between a portfolio manager that understands credit risk only to never take it, and the portfolio manager that sees the risk and gets paid to prudently take risk. I do not profess to know when it will occur, only that I shall take risk on my client’s behalf when it is appropriate.

When will this opportunity present itself? Truly I do not know. The one thing that bothers me is that the longer the ‘moral hazard card’ is played and the longer that ‘Social Darwinism’ is delayed, the worse the outcome. This will simply delay the time we take risk. But, on a final note, when it comes, I shall pounce. Hopefully, as the lyrics below indicate, I won’t have to wait for a financial rainbow. 

Somewhere over the rainbow
Way up high
There's a land that I heard of
Once in a lullaby
-Over The Rainbow (Arlen-Harburg)

In sum, I look forward to taking advantage of market imbalances as they occur. Until such time, my firm will look to protect client capital as well as what we like to call ‘emotional capital.’ It is far better, in my opinion, to miss minor moves in the context of a difficult environment than to get caught in a situation where you experience a large loss, making recovery of such loss a major impediment to winning in the longer term.