Moral Hazard
August 28th, 2008 by 
reality
“The Federal Reserve is in business to create moral hazard.” Harvey Rosenblum from the Dallas Fed. This whole video makes me want to rush for the heads and throw up. This is why we are so screwed. The Fed keeps trying to deliver an economy which is not real, by creating an illusion of safety and persuading lenders that they will be saved from the consequences of excessive risk. Distorting credit risk is a bad idea, because it does not eliminate the real losses, as we are finding out. It just causes risk to be mispriced, so that when the losses do come, they are lethal, because credits were written too cheaply and there is no cushion from the fat spreads that should have been charged.
The Fed’s proposition is that it is both a lender of last resort, and the controller of interest rates, and it will use these powers to make the world a safe place for lenders. A lender of last resort can certainly provide liquidity, but that does nothing to offset credit losses, which destroy capital.
The Fed’s strategy to deal with capital losses has been to increase bank earnings by cutting short rates, so that the banks can rebuild capital by borrowing short and lending long (in the past this has meant buying long Treasuries, which carry no credit risk and therefore use less capital than other assets). But this only works so long as the lenders can continue to expand their balance sheets, in other words as long as they can be made profitable despite their credit losses. And, of course, it helps the banks at the expense of everyone else, discouraging saving and investment and encouraging over-consumption. But now so much capital is being destroyed that lenders can only borrow at high rates, closing off this traditional remedy for the lending excesses caused by the Fed’s moral hazard. You can’t make a positive carry with Treasuries at 4% or so when you have to pay 5% on a CD (APY, rate 4.89%, WaMu, today, 1-year CD, per bankrate.com). We are facing a depression because the financial system has been encouraged to be over-leveraged, a “Bridge Too Far,” with too much liquidity and not enough capital.
How can these people be so incredibly stupid?
Edit: WaMu trawling for dollars. (credit CR)
Posted in Fixed Income, Rogues and Rascals, Strategy & Scenarios, The Economy, The Fed | 
September 4th, 2008 at 6:20 am
Yesterday found an interesting link in Decision Point (public) Chart Spotlight section: 08/25/08 - Pictures of a Stock Market Mania (Updated)
http://www.cross-currents.net/charts.htm
(I suspect this link is not permanent).
Anyway, there are three interrelated articles about “asset creation” at brokers-dealers, related to stock trade velocity and naked short selling.
According to authors, liquidity (in equity markets) is directly related the level of ~phantom-assetization and overall distraction of valuations of traded assets. Authors argue quickly traded stocks are tended to be overpriced. I agree.
Similar interrelations between liquidity and valuation distractions, liquidity and perceived moneyness of credit instruments probably exist. Understanding of these relations are crucial to any person, involved in trading/finance.
Would be interesting to know your opinion about linked article, Reality.
September 4th, 2008 at 7:43 am
I find little in the article to disagree with. I do suspect that his concerns about short-selling are a little overblown, in that even normal three-day settlement will tend to exaggerate the size of short positions in the heavily traded ETFs. Obviously we agree about the role of the SEC and the speculative nature of the stock market.
September 22nd, 2008 at 4:04 pm
Bah! The Fed didn’t create this risk, nor is a bailout increasing it.
Look at James Cayne, former head of Bear Stearns. His holdings there were worth more than a billion dollars, and are now worth $60 million. Can you imagine his successor saying, ‘Hey, I may lose 95% of my net worth, my job, and my company, but at least the Fed will protect my risk?’
The real ‘moral hazard’ is for the government. If taxpayers may assume debts of financial giants in the future, we at least deserve to have them well-regulated.