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Moral Hazard: The Great Debate

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Moral Hazard is the notion that someone insulated from risk may behave differently than they would if they were fully exposed to risk.

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Editor's Note: This mailbag is in response to Minyan Malcolm's op-ed column yesterday which was a reaction to Prof. Sedacca's column from Monday.


Toddo,

I just read
Minyan Malcolm's piece and was reminded I meant to write you a short note last week after hearing of the bail-out plan. You are (rightfully) proud of trying to bring financial education and literacy to little Minyans with your new Minyanville for Kids initiative. But I have to wonder, what is the point of making good financial decisions?

Like Malcolm, I have to express dismay at the last few years of government work in the realm of free markets. After graduating from college five years ago, I went to work and began making money. Around 2005 or so, I had enough to buy a house, but, from my view, that looked like a very poor decision. So, like Malcolm, I watched my friends make 10's of thousands of dollars, while I rented. For the last 3 years I have promised myself to just be patient and give it time. Now, I too, wonder...

But, to the original point of my e-mail, should you be focused on giving kids a good education, or one that will work and make them money? Maybe your program ought to show them how to cozy up to those in the elite, as that seems the best way of being assured risk-free wealth.

As the year winds down, I find myself thinking... It's just prolonging the inevitable, your time will still come... but I realize I've been saying that for a while now, and, as it has been 3 years, I fully admit to being wrong for at least the first two of them.

Minyan Steve


Minyan Steve,

You're e-mail and Minyan Malcolm's column strikes the heart of the great debate currently in vogue on Wall Street and beyond: Whether the policies being implemented by the government-from superfund M-LEC conduits to sub-prime rate freezes to central bank fiscal and monetary policies-create moral hazard.

Moral Hazard is the notion that someone insulated from risk may behave differently than they would if they were fully exposed to risk. That, if an individual or institution does not bear the full consequences of its actions, they would have a tendency to act less carefully than they otherwise would, leaving another party to bear the responsibility of the consequences of those actions.

To your point, I was raised to believe that if you do the right thing long enough, someone will eventually notice. However, I too felt penalized for making seemingly prudent choices at different junctures of my life.

When I started my career at Morgan Stanley, I made $28,000 per year while kids my age worked at the penny-stock shop Stratton Oakmont, driving Ferraris and drinking Cristal. All the while, I lived at my grandparents, took the bus, saved my change and brought sandwiches to work.

I did this for a few years, questioning why I was taking the straight and narrow path when others cut corners as a matter of course. I watched, sometimes with envy, as they dated models, ordered bottles and lived in the fast lane. Yes, I was tempted by the forbidden fruit but never bit into the quick fix. My grandfather made sure of that.

In time, as fate would have it, most of those kids were indicted for stock fraud and tax evasion as I climbed the corporate ladder. The rate of my lifestyle change wasn't swift, mind you, it was slow and steady as I gained valuable experience and learned from my lessons and losses.

I never wished harm upon them but I did feel a semblance of validation when that world crumbled. What goes around, comes around, as a wise man once said, and while I don't know when the current "grand experiment" will unravel, I'm unsure if history will smile kindly upon Alan Greenspan, Franklin Raines and perhaps Hank Paulson.

Navigating the financial markets, in it's purest form, is capturing the disconnect between perception and reality. That dynamic becomes increasingly difficult when both sides of the equation are fluid. The growing perception, as evidenced by your email and others, is that someone will continually step up to absorb risk gone awry. The unfortunate reality is that cumulative imbalances will eventually shake the very foundation of our capitalist system.

Early last week, when the bulls were on the ropes, we observed eight rays of light that could potentially shine bright for the bovine into year-end.

After the proposed bailout plan sparked a rally and performance anxiety began to manifest, the FOMC announced that they were "only" cutting the Federal Funds and Discount Rate by 25 basis points each. The futures markets that track such things forecast those precise actions but for some reason, market players felt entitled to more.

And it is that sense of entitlement-our conditioned complacency, if you will-that is the inherent risk of moral hazard.

The bulls, scanning the headlines, will quickly offer that news is always the worst at the bottom. It's hard to stake that claim with the S&P 5% off it's high, however, and even more difficult when you scratch a bit deeper. To quote Mr. Practical, who wrote yesterday on Minyanville:

"Libor rates are at their highest ever to government rates. This means banks can't or won't lend to each other. Instead of taking central bank liquidity through the repo-market and lending it out to other banks (thus expanding liquidity through the multiplier effect), they have been sucking up all of it to their balance sheets in desperate need of capital. Banks need huge amounts of capital as they write down the value of their assets like loans. This is why you are seeing Citigroup (C) and UBS (UBS) borrow money at 11%, MBIA (MBI) diluting its stock, and Washington Mutual (WM) cutting its dividend and laying off a bunch of people: they are all desperate for cash."


While many are asking whether we'll enter a recession, I will offer that for many, we already have. It's simply been masked by the lower dollar (down 37% since 2002) and hidden by economic figures skewed by the have's (opposed to the realities of the growing number of have-not's). The fact that there are so many steadfast bulls makes us wonder where we are on the denial-migration-panic continuum.

Indeed, it may seem that you've been penalized for your prudence but I would argue the opposite. There are a lot of people out there who wish they practiced what you and Malcolm and others seemingly lament preaching and, for many of them, it's too late to change.

Given where we are and what we're seeing, I would offer that it's never to late to start.

No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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