Tuesday, February 12, 2008

Hair of the Dog

Moral hazard is a term many investors are not familiar with but recently I am seeing an economic world rife with it. In the insurance industry it is a particularly relevant concept as an insured will undertake riskier activity than normal if some part of the risk has been transferred. People who have life insurance are more apt to skydive and those with medical coverage will ski a bit more aggressively than the uninsured.

The financial markets are similar. In recent years we heard of the “Greenspan put” which was the understanding that if the markets faltered the Fed would cut interest rates and bail us out. Bernanke has trumped that with emergency rate cuts only one week before the Fed’s scheduled meeting. As Morgan Stanley’s Steve Roach opined in an interview, “I thought someone had put a virus or a joke in my computer when I read the headline.”

The compensation structure for financial executives have led to excessive risk taking on behalf of investors by the financial engineers who would not be penalized for egregious errors of judgement. The departing CEO's of major investment banks have walked away with ten's of millions of dollars despite costing shareholders billions.

The ambitious willingness to lend to anyone with a pulse and a house may ultimately create the greatest confluence of effects of moral hazard we have seen in many years. Looking at the structure of credit creation we see the grouping of the hazards of unregulated “banking.”
The complexity of securitization and the inclusion of multiple incentivized participants is a prime example of the disguising and enhancement of risk rather than management.
With the stimulus package one would argue it is, “hair of the dog,” policy. If bigger deficits, negative real interest rates and incentives for lenders to lend and borrowers to borrow can be rekindled we might just avoid this recession – by digging the hole deeper.

As investors there will be opportunity when fear peaks, but the longer term problems are deep and will require a much more flexibility than the past generation has been accustomed to.

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
Arthur SchopenhauerGerman philosopher (1788 - 1860)