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Sunday, 30 March 2008

Moral Hazard, Merrill Lynch, Goldman Sachs, Spiders and Margin requirements

Moral Hazard, Merrill Lynch, Goldman Sachs, Spiders and Margin requirements

Now if that title doesn't cause Google bots to have a happy hour I don't know what will?

There is a lot of talk about moral hazard being assumed in the Markets, what with the intervention of the Fed with Bear Stearns, the Bank of England with Northern Rock and the Bundesbank with a whole host of German banks.

Some ask what is there to worry about, intervention is good, stopping further havoc in the markets and adds "stability". Let's have a look at a couple of definitions of moral hazard, back to basics:

From Global Business Today: Moral hazard. "Arises when people behave recklessly because they know they will be saved if things go wrong."

From Deardorff's Glossary of International Economics: Moral hazard. "The tendency of individuals, firms, and governments, once insured against some contingency, to behave so as to make that contingency more likely. A pervasive problem in the insurance industry, it also arises internationally when international financial institutions assist countries in financial trouble."

I had a good search through my books and on the internet and I could not find one definition of accepting moral hazard as a method to protect the financial system. In every case it either specified or implied a change in behaviour that would make the event that had caused moral hazard to be invoked more likely to occur.

The main keywords used were dishonesty, questionable integrity, a lack of incentive, more risk, danger, incompetence and temptation.

Just the kind of attributes you do not want associated with the Markets in their current state. Still, it has happened, intervention in "free" market mechanisms has occurred and we now have to accept it as a reality. To protect ourselves we need to know how does the acceptance of moral hazard cause an increase in the risk of the very event that was being avoided?

Here are the words of a Central Banker and a Treasury official. Both have been involved in creating a moral hazard in 2 different International markets.
First up is Mervyn King of the Bank of England. Having already bailed out and the acquiesced to the nationalisation of Northern Rock (in my view against his own better judgement) this is what he had to say to Parliament on Wednesday:

"So we are discussing with the banks how a longer-term resolution of the problem might be reached,
This would be based on two principles -- that the risk of losses on banks' lending remains with bank's shareholders and that the longer-term solution "should focus on the overhang of assets and not subsidise issues of new assets.

With reference to increased lending facilities by the B of E, he said "Such lending can be only a temporary measure but it can be a useful bridge to a longer-term solution."

Mr King has been reading his definitions too. I suspect he is very worried about moral hazard leading to its conclusion and is attempting to tell the markets that reliance on a lack of perceived risk is misplaced. However, until the UK governing politicians back him up it will be seen as jawboning.

Next is Hank Paulson, US Treasury Sec who is credited with being instrumental in the Fed sponsored buyout of Bear Stearns. He takes a very different view of how moral hazard should be viewed. After praising the Fed for its "creativity" he went on:

"It would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed's liquidity facility,"
"The trade-off for this subsidized funding (for banks) is regulation tailored to protect the taxpayers from moral hazard this insurance creates."
"and the sooner we work through it, with a minimum of disorder, the sooner we will see home values stabilize, more buyers return to the housing market, and housing will again contribute to economic growth."

In Q&A after his speech he then said "financial institutions are critical to the economy and innovation precedes regulation."

No flat out refusals in this text, the use of the word "premature" in relation to permanent access to Fed liquidity implies the idea is on the table, encouraging increased risk taking. Think of it like this, you get a fallback position allowing you to take one great bet. If it fails then the Fed pick up the pieces and you walk away. If it works you join the Big Players League. If a whole sector tries it, no problem, the temporary arrangements will become permanent as to do otherwise would invoke the very problem trying to be avoided now.

Notice one other subtle difference between Mr King and Mr Paulson? It's the implied threat as to who gets hurt if the situation isn't allowed to run the course they have set out. Mr King points squarely to shareholders, there will be no offer to buy shares of busted banks. Not so from Mr Paulson, he threatens the public, by insinuating that if he and the Fed do not get their way, housing and the economy will suffer.

As for "innovation precedes regulation" Hank needs to look at some timings, repealed laws and the amount of lawyers it takes to change an SPV to an SIV. Threatening banks with regulation has the same effect as threatening a warmongering dictator with a major leaflet campaign.

Moving on to an interesting chart which could be titled "Dude - Where is my bear market?"

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Here we have Merrill Lynch, Goldman Sachs and SP500 Spiders on a 1 year comparison chart (Bloomberg). You can see my dismay. My bear market hasn't really started yet. It could be easily said that the credit crisis fallout is restricted to the financial sector. SPY is down around 7% (approx) from last year. It's not exactly leaping off a cliff. Think of this chart as displaying positive divergence for the S&P. Will it last is another question, divergences have an unfortunate ability to correct, as well as pointing out a disequilibrium. I shall be watching MER very closely though, it is struggling to join in with the current rally.

Of course if the S&P is reflecting a measured worth of intervention, then it is probably correctly priced. The problem is if moral hazard reaches its conclusion and the attempts to avoid the problems are unsuccessful, then the S&P will have some "catch up" to do on the downside.

Finally, instead of the market snippets this week, I want to just tip you off about margin requirements. Some of you may already know that margin levels are being raised by a number of brokers. Here is why:

"As a result of the Margin requirement changes imposed by the Exchanges, we will be revising the margin requirements on the following Futures contracts":

10 Year US T-Notes Composite (Globex-CME/CBOT)

5 Year US T-Notes Composite(Globex-CME/CBOT)

30 Year US T-Notes Composite(Globex-CME/CBOT)

Euro FX/Swiss Franc(Globex-CME/CBOT)

Euro FX/Japanese Yen Cross Rate Future (Globex-CME/CBOT)

European Rapeseed (Euronext)

Corn (Euronext)

AEX Index (Euronext)

CAC 40 Index (Euronext)

In other words add to your capital or get closed out. The question is who is going to get squeezed, longs or shorts?

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