The Real Moral Hazard Already Passed

Moral Hazard as defined in Wikipedia:

“The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

 

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.”

The flame out of Bear Stearns, while it wasn’t a bailout of shareholders, was a bailout of Bear Stearns creditors and counter-parties.

Counter-party Risk

The current crisis is the direct result of the moral hazard created with the bailout of Long Term Capital Management (LTCM), in 1998 (more details below the fold). As with Bear Stearns, the shareholders of LTCM were NOT bailed out, but the counter-parties and creditors were bailed out. Thus, the Fed sent a message that if you lend recklessly to a hedge fund or investment bank, don’t worry, the FED will guarantee private contracts, as long as the lending is reckless enough to put the entire economy at risk.

The saying, “too big to fail”, directly and inexorably leads to the kind of reckless lending that crushed Bear Stearns and still threatens the US economic and monetary supremacy.

Who would lend billions of dollars to Bear Stearns unless they know, via the actions in 1998, that Bear Stearns debt would be backed by the faith and credit of the Federal Reserve? Rather then squelch the reckless lending that allowed for the current crunch, the Bear Stearns creditor bailout reinforces the LTCM lesson that as long as you lend to large enough institutions you need not worry about default and counter-party risk.

The problem today is that there isn’t enough money to bail out the entire system as LTCM’s creditors were bailed out in 1998.   In 1998, LTCM was the only over leveraged firm threatening the economy, now virtually all investment banks are over leveraged (and banks as well given Glass-Steagall’s 1999 repeal).

Had the FED and Wall Street allowed LTCM to fail, causing counter-parties a lot of financial pain, perhaps Bear Stearns would not have been allowed to borrow 3000% of their equity. Homeowners buying houses with zero equity is understandable as they are laypersons, Wall Street over leveraged precisely because of the backing of the FED as implied by their behavior in 1998. Just as Wall Street misjudged the severity of home mortgage defaults they are still misjudging the severity of their own over-leveraging.

Grab you hats, this roller coaster is still on the way down.

Moral Hazard

Bailout or By, By Bear Stearns… or Both and Worse

When talking about helping underwater home owners or over leveraged hedge funds, any bailout talk is met with fear of creating a moral hazard.

Wikipedia sums up Moral Hazard as follows:

“The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.”

 

The debate centers on the detriment to the overall economy of allowing the bankruptcy of a firm deemed “too big to fail.” Roughly put, if Firm A goes bankrupt it will ripple through the economy wreaking havoc far greater than any perceived moral hazard.

My assertion is that the greater economic havoc we are now facing is the result of the moral hazard of preventing greater economic havoc in 1998. Any attempts to save Bear Stearns will not create moral hazard, but in fact, these efforts will fail precisely because of the moral hazard of insulating counterparties from risk that resulted from the Long Term Capital Management (LTCM) hedge fund bailout organized, like today, by the NY Fed.

First the Current Situation

On March 14, both JP Morgan and the NY Fed chose to bailout Bear Stearns. The question of whether the Fed or Wall Street would consider moral hazard when a big investment bank is involved seems to have been answered by this move with a big no problemo.

On a grand scale, Bear Stearns had echoed the individual home owner in believing that home prices would always go up, and they are now paying the price. Even with the bailout, stakeholders have seen the market value of Bear Sterns plummet from $159.36 on April 25, 2007 to close at $30 on March 14, 2008. A stunning 81.2% drop.

Many can argue that an 80% loss is enough to dissuade future players from exposing themselves to such risk, thus discounting any moral hazard implications. Others will argue that allowing Bear Stearns to avoid an even more costly flame out reinforces their reckless behavior of the prior two to three years.

Those who discount the moral hazard assert the greater economy is important and a Bear Stearns fire sale is avoidable, counter productive and possibly catastrophic. Other assert that the failure of a few institutions are just what the doctor ordered to prevent the same mistakes in the future, and the greater economic impact is overstated.

I think both sides of this debate are missing the mark. Neither of them asserts that the failure and the greater economic harm are precisely what will happen. What if the moral hazard tipping point already passed?

The History

In 1998, Long Term Capital Management (LTCM), a small hedge fund by today’s standards, almost went belly up. They had begun 1998 with $4.7 billion of equity but had borrowed almost $120 billion. Similar to buying a $120,000 house with $4,700 down.

Surprising both LTCM and their counterparties, the bets they had made on safe government bonds thrust LTCM to the brink of bankruptcy. They had lost $4.6 billion the first few months of 1998 erasing most of their equity. The counterparties to LTCMs transactions included Goldman Sachs, JP Morgan, Chase, Merrill Lynch, foreign governments, pension funds and many more entities. Similar to today’s credit fears, many on Wall Street feared a domino effect if LTCM was forced to liquidate all their positions in a fire sale.

A consortium of investment firms and banks, organized by the NY Fed and ironically not including Bears Stearns, pooled together about $4 billion to inject into LTCM and bail out the firm. History also shows that the firms involved even turned a small profit from their participation in the bailout once the panic had passed a prices stabilized.

What you do not find in Wikipedia but can quickly locate via Google was the intense debate about the moral hazard created by the LTCM bailout; simply Google “Moral Hazard LTCM”.

The debate was intense and complex. Was there no moral hazard because it was a private consortium that bailed out LTCM and therefore simply free market machinations? Since the consortium actually profited from their involvement was it not even a bailout?

These all miss one important point: counterparty risk. Had LTCM been allowed to fail, it was thought that the corporations and governments on the other side of LTCM’s transactions would have suffered immeasurable losses possible causing further bankruptcies. Like today, there was a fear of a “domino effect” were LTCM to declare formal, legal bankruptcy.

Thus, the LTCM bailout was not just a bailout of LTCM but a backstop for the entities that had done deals with LTCM. This is the great moral hazard we are dealing with today.

The moral hazard isn’t just that individual firms will recklessly take risk, confident in an eventual bailout. The events of 1998 anesthesitized all firms from the even greater risk of counterparty failure. Subsequent to 1998, all firms have assumed that if the firm on the other side of a transaction is big enough, they represent zero risk.