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The Moral Hazard Club


Taxpayers pick up tab for bank blunders.

Free and open market:
A market in which prices are determined by the free interchange of supply and demand.
- Bloomberg financial definition

Moral Hazard:
A dilemma that arises when government officials take steps to bail out countries or businesses that are in serious financial trouble. Although the action may help prevent widespread financial turmoil, thereby protecting innocent parties, it creates an expectation that governments will always come to the aid of failing countries and companies, potentially increasing risky behavior because there is no penalty.
- Webster's Dictionary

Saying Goodbye to the Free and Open Market System

I learned in Economics 101 the intersection of supply and demand was defined as "the price at which the highest buying and lowest selling price exist on a specific security at a particular time and place." I also learned about "social Darwinism," whereby the most fit and prudent survive and the weak suffer and or fail.

Under these rules, banks and brokers that made poor loans would lose money and possibly fail. Those that loaned prudently prospered at the expense of their less talented competitors. Unfortunately, many of these rules have changed or been eliminated by government institutions like the Federal Reserve Bank and the Treasury Department.

Why is this a problem? There are some favored parties -- such as brokerage firms and commercial banks -- that have managed their finances so imprudently they need to access special funding from the Fed. In other words, loans were made to borrowers that had no right getting a mortgage in the first place. These mortgages were often without full -- if any -- documentation and with barely any equity down. As housing prices have fallen, many homeowners now find themselves in a negative equity position.

Whether this low quality lending practice was the fault of the borrower or the lender (or most likely a combination thereof), there was considerable lack of prudence by the lenders. Many mortgage companies (251 at last count, according to have been forced out of business.

Certainly these companies went out of business due to their poor lending practices. But what about the people that borrowed the money? At the peak of the real estate craze, the website was hot. The new hot website is, which has over 1.7 million listings.

It's truly amazing how full circle we have come in such a short period of time. Millions of Americans are losing their homes and now their jobs as the unemployment rate begins to rise. Delinquency rates on all sorts of mortgages -- not just sub-prime -- are on the rise in a big way.

Seriously Delinquent and Mortgage Loan Foreclosure Rates

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Subprime and Prime Seriously Delinquent Mortgage Rates

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Manufacturing jobs are being lost at a frightening pace in the U.S. as jobs are exported overseas. This brings me to the real problem that exists in the financial markets today.

The 'Moral Hazard Club' - How Do I Get In?

When the subprime crisis began to accelerate in the summer of 2007, it became clear what the market created by turning low quality loans into esoteric securities was unwinding. It's simple to see now that the genesis of the crisis was the bad mortgages themselves. And until the mortgages begin to perform, we're simply placing a trillion dollar band-aid on the financial system.

Broker-dealers and banks ended up with the esoteric securities on their own balance sheets and were forced to write down the value of the assets.

Please note the term "write down," which is rather different than "write off." When you write down an asset, the hope is you may be able to write the asset back up at some point in the future. When you write something off, it is permanently gone from your balance sheet.

As write-downs continue, the banks and brokers are forced to go hat-in-hand around the globe seeking capital just to remain solvent. So far, with the exclusion of Bear Stearns (BSC), banks and brokers have been able to raise capital, although they've been forced to pay onerous rates that are sure to reduce profitability for years to come.

In the table below, you can see that banks and brokers have been forced to write down over $231 billion since last summer.

Click to enlarge image

Further, banks and brokers are told to value their levered balance sheet in three distinct types:

  • Level I: Mark to Market - readily observable market prices.
  • Level II: Assets that aren't actively traded, but have quoted market prices for similar instruments - otherwise known as 'mark to model.'
  • Level III: Assets that have model derived valuations in which one or more significant inputs or significant value drivers are unobservable-otherwise known as 'mark to myth' or 'mark to management's best guess,' 'mark to a hope & a prayer,' etc...

When you add up all the Level II assets by just the eight largest holders in the U.S: JP Morgan (JPM), Citibank (C), Bank of America (BAC), Merrill Lynch (MER), Goldman Sachs (GS), Bear, Morgan Stanley (MS) and Lehman Brothers (LEH), it comes to a staggering $5 trillion - nearly half the size of the economy. Level III assets are nearly $600 billion.

Is the Fed big enough to bail out all these assets? My best guess is probably not, and more firms will fail. If the loans and economy both don't start performing, these failures will happen more quickly, which is why my firm continues to avoid credit risk. It's not hard to envision an acceleration of this process if the market starts to believe the special loan facilities and other funding processes artificially created to deal with this mess cease to work.

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No positions in stocks mentioned.

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