The Moral Hazard Club
By Bennet Sedacca Apr 21, 2008 1:00 pm
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 www.ml-implode.com) 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 www.condoflip.com was hot. The new hot website is www.foreclosure.com, 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
Click to enlarge image
Subprime and Prime Seriously Delinquent Mortgage Rates
Click to enlarge image
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:
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 www.ml-implode.com) 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 www.condoflip.com was hot. The new hot website is www.foreclosure.com, 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
Click to enlarge image
Subprime and Prime Seriously Delinquent Mortgage Rates
Click to enlarge image
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.
No positions in stocks mentioned.
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Reply
2008-04-21 14:43:29
write-off table
The table of bank write-downs needs to be updated for the Royal Bank of Scotland new write-offs.
2008-04-21 17:03:35
You're in our you're out
This is not good news. I've been suspecting this for a while now. Thanks for confirming, Bennet. There are no fixed goalposts, only moving ones. Good luck to all you money managers. Hopefully Mr market exposes the manipulators this time around and we do not have to endure this for another cycle. So what if we all suffer while getting rid of this nonsense. In the meantime, I might as well move my money to Shanghai where at least I have a currency tailwind, and unfettered capitalism reigns supreme. Sayonara America, you bunch of bums. (just kidding)
2008-04-21 22:46:46
You're in our you're out
The cycle, IMHO, is just in it's infancy. Most believe it is over. I think they will rue the day that they said so. If I m wrong, I suppose we can miss a move up. If I am correct, fearfully so, then perhaps we will be happy to take risk when opportunity knocks. B.
2008-04-21 23:21:25
You're in our you're out
This is exactly why the system WILL fail: because there are no mechanisms to slow the overshoot of consumption or of exploitation of that consumption. When things point to reduced profits in this country, investors look elsewhere for profit potentials to keep paying the big rents they could pay until now. The giant sucking sound is the remaining useful capital heading out that could have been used to develop a replacement economy.
Once the hole shows up in the dam, everyone starts running out of the valley instead of repairing the dam. Sometimes, hiring people to actually do some work is better than laying them off to save money. It just depends if you had them doing useful work in the first place. The problem may not be that there aren't enough jobs to go around, but that the jobs aren't contributing to the future. Investing in some other country because they are still climbing the Burning the Future hill is only temporary and a poor excuse for wisdom. It's "o.k.", though, 'cause you'll get your instant gratification fix.
Poll question: How many stimulus checks are going to go for wide screen TV's made somewhere else? Did anyone consider that perhaps NOT converting our TV system to digital might reduce the amount of money we send out of the country which was supposed to stimulate OUR economy, not China's?
Once the hole shows up in the dam, everyone starts running out of the valley instead of repairing the dam. Sometimes, hiring people to actually do some work is better than laying them off to save money. It just depends if you had them doing useful work in the first place. The problem may not be that there aren't enough jobs to go around, but that the jobs aren't contributing to the future. Investing in some other country because they are still climbing the Burning the Future hill is only temporary and a poor excuse for wisdom. It's "o.k.", though, 'cause you'll get your instant gratification fix.
Poll question: How many stimulus checks are going to go for wide screen TV's made somewhere else? Did anyone consider that perhaps NOT converting our TV system to digital might reduce the amount of money we send out of the country which was supposed to stimulate OUR economy, not China's?
2008-04-22 14:08:19
corruption exposed
WOULD IT BE ASKING TOO MUCH FOR SOME YOUNG WHIPPERSNAPPER INVESTIGATIVE JOURNALIST WHO ISN'T AFRAID TO DIE TO DIG UP THE GORY DOPE ON EXACTLY WHO IN THE GOV IS MANIPULATING THE MKT, THE EXACT WHAT, WHEN, WHERE, HOW AND WHY???
2008-04-22 20:23:05
The geniuses of Wall Street (and other places) have truly excelled themselves this time around. They do outrageous things, they get obscenely rewarded and when the rotting edefice they've created comes crashing down, they get bailed out by the Government, for the common good, of course. Why would they change?
This latest batch put Gordon Gecko from the film, "Wall Street", to shame.
This latest batch put Gordon Gecko from the film, "Wall Street", to shame.
2008-04-22 23:29:44
Oh c'mon Bennett
Bennett, you know how to gain the keys to the clubhouse, it's simple: Forget everything you know about portfolio management (What's an efficient frontier anyway? I've got a correlation strategy that should get me 350% ROE if I juice the trade with 600x leverage!!), forget that you're using other people's money, and roll with it, baby!!
2008-11-19 14:00:26
help
Bennet,,, what are some of the closed end funds that you are talking about , ie 20% below nav and high yield
thanks
Lee
thanks
Lee
2008-11-19 15:13:02
corruption exposed
Its called the Plunge Protection Team otherwise known as the 'Working Group on Financial Markets'.
The Plunge Protection Team's (PPT) modus operandi was revealed by a former member of the Federal Reserve Board, Robert Heller. Heller said that disasters could be mitigated by âbuying market averages in the futures market, thus stabilizing the market as a whole.â
Since the Fed openly manipulates the money supply every day in transactions that everyone can see, in order for the Fed to hide the activity of the PPT, they would have to take out liquidity by selling treasury notes. Otherwise, the numbers at the end of the day or week would not add up, and someone would notice.
This may explain why the Federal Reserve mysteriously decided to stop publishing its M-3 report. Since the Fed is the âmain resourceâ for buying averages in the futures market âthe money is injected into markets via the New York Fed's Repo desk, which easily showed up in the M-3â¦. Without the useful resource of M-3â, Robert McHugh, Ph.D.says, âwe need to find other tools to monitor when the PPT is likely to intervene, and kill shortsâ.
http://www.gamingthemarket.com/2008/07/front-running-systemic-market-crash-ppt.html
2009-11-24 22:58:17
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