Ruminations on Moral Hazard

I hate to start with apologies, but I’m clearly a little late to this guest-blogging gig. I knew that would be the case—Thursday morning 10 minutes or so after the market opened I headed north from Hartford, Ct, on my way to Grand Lake Stream, Maine, about two hours northeast of Bangor, to a gathering of economists, money managers, and assorted hangers-on, for a weekend of talking markets and economics while fishing, eating, drinking wine—pretty much every second except for those precious few that were spent asleep. I thought I’d find time to dash off a note or two, but the weather, which miraculously didn’t drown us while we were out on the water casting for small mouth bass, perch, and pickerel, inundated us the rest of the time, to such effect that internet service was extremely spotty, and the vigilance required to catch the moments of service distracted too much from the food, wine, and conversation to be a viable alternative.

The curve balls, though, started appearing Sunday morning on the drive south, and provide I suppose an object lesson for investors, in what they say about both the ability to predict the future—often, in my experience, vastly over-estimated—and as important, the ability to price or value it accurately, once having predicted it. Mordecai Kurz of Stanford’s theory of endogenous risk writ large, if you will. While driving south to the Bangor airport, huddled in terror on the floor of my car while Barry Ritholtz of The Big Picture fame demonstrated everything he hadn’t learned at some driving school, hurtling down fog-enshrouded hills and careening around curves, moose jumping out in my imagination around every terrifying corner, I regained cell phone service, and called my wife, from whom I learned that her step-sister had died the night before. Now this was hardly unpredictable, or a surprise, but somehow I didn’t think through the ramifications when offering to help Yves out during her absence. So now I’ve got siblings coming in from around the country, all of us shattered by the untimely and heartbreaking death of a great woman in her prime, to deal with over the course of the week.

The future which I didn’t predict at all involves my internet service, which has slowed to something like early dial-up, for reasons which only my Cox repairman can divine, and he ain’t showing up until tomorrow, when with luck an easy solution will appear.

So the future’s not predictable, and even when we can predict it, pricing it presents a whole additional host of difficulties. One thing that’s been on my mind a great deal over the last 12 months or so, say from that first 50 basis point rate cut that the Fed laid on us in August last year, or in the weeks prior to that as I tried to suss out what the Fed might do at that meeting, and how the markets might respond, which plays straight into the prediction game, is the subject of moral hazard. Of course, the subject’s been much in the air, and increasingly so, as we’ve lurched from one emergency to the next, most recently several weeks ago with the weekend rescue of Fannie Mae and Freddie Mac.

I was very critical of the earlier Bear Stearns, or JP Morgan, if you prefer, rescue in mid-March. It wasn’t, and still isn’t, completely clear to me that the world would have come to an end if Bear had declared bankruptcy; I can’t even say with assurance that Bear was bankrupt when it was forced into the embrace of JPM, with the taxpayer potentially picking up the tab for the liaison.

However, I can’t say the same about Fannie and Freddie; their demise would seem to have catastrophic implications for the larger financial world and the real economy, and couldn’t be allowed. And the fact that they were on the brink seems pretty clear to me as well. As Jim Bianco, among others, has pointed out, Fannie and Freddie, as part of their penance for their accounting malfeasances earlier in this decade, are required to show fair value balance sheets as part of their financial statements. Accompanying these balance sheets, they put out multiple pages explaining why the investor should pay no attention to them, that they don’t paint a true picture of Fannie and Freddie’s financial health. I’d venture to say that the two institutions would prefer investors not look at those balance sheets for another reason—they show both to be insolvent, or so close as to make the thought of investing in them the diciest of propositions.
And yet the two sport a combined market cap of more than $15 billion, hardly bankruptcy territory, and the world’s largest fixed income investor, Pimco, has made a very public and very large bet on their debt securities.

Of course, one other reason that Fannie and Freddie couldn’t be allowed to go the way of all flesh is the foreign holders of their debt. Mike Panzner of Financial Armageddon has a post up now on the subject (, and certainly the rumor is that Treasury Secretary Paulson was fielding a series of concerned phone calls from foreign central bankers and finance ministers who strongly suggested that Fannie and Freddie’s debt securities better be money good. (On that subject, an astute and experienced market participant over the weekend in Maine remarked that if Secretary Paulson answered such a question in the affirmative, or at all, for that matter, it was a violation of Fair Disclosure regs; as a possessor of material inside information, he could not pass that information only to some holders of Fannie and Freddie’s securities before announcing it to the public at large.)

It should be axiomatic under circumstances such as these that equity holders get wiped out. Bear shareholders received $10 more per share than they deserved. Yet, for the moment at least, there’s that $15 billion of market cap, which exists only because the government put the taxpayer at risk to defend the agencies’ obligations. Given that the taxpayer is at risk for Fannie and Freddie’s potential failure, shouldn’t he also own any potential upside in the firms’ share prices? Private profit, socialized loss, indeed.

And what of the debtholders? In an ordinary bankruptcy, they’d be scrambling for position to win the scraps. Instead, in this instance, we have the unseemly appearance of Bill Gross and Paul McCulley using their bully, er, bullish, pulpits on cnbc to pound the table for agency debt. This is a moral hazard bet, pure and simple. And there are lots of them out there at the moment. Roughly two Fridays ago—and that chronology may be slightly off—I was an amused bystander to an impromptu email debate among several friends about buying Wamu debt, on the theory that it would shoot from the (I believe) 40 cents on the dollar at which it was trading to par at the moment it was forced into the arms of JPM, or BAC, or one of the other remaining few “good” banks, over the weekend.

Don’t misunderstand me; I find nothing wrong with an investor making the calculation that the government will follow the morally hazardous path in any given circumstance, and betting upon that perception. It’s an entirely legitimate exercise; alpha grows in mysterious ways. But surely it takes moral hazard to a whole new level, and if I were presiding over this trainwreck, I’d worry about the fact that bigtime and very successful investors were pricing the future based solely on the perception that the government so feared the ramifications of the failure of a large financial institution that it would not let that happen, unintended consequences be damned. It surely is no way to run a bond market.

PS My lawyers suggested that I make mention of the fact that I’m the general partner of a hedge fund, and that it’s not inconceivable (lawyerly phrase that, huh?) that I might have positions in securities that I talk about here. As it happens, I’ve got no positions in any securities issued by Fannie or Freddie, or Wamu, JPM, BAC, or Bear. That could change at any minute, of course, but if you trade on anything you read here, you’re on your own.

PPS I note, although I haven’t read the article yet, that the New York Times has a prominently displayed article on Richard Syron and Freddie Mac on its website.

Given the SEC’s Christopher Cox’ interest in shutting down people who trade in false rumors in order to push stock prices around (JPM’s Jamie Dimon wants them all sent to Gitmo.), I’ll note in case he missed it that on the Friday of the Fannie-Freddie meltdown, preceding the weekend rescue, in the late afternoon, as the market as a whole seemed on the verge of tumbling off a precipice, Mr. Syron announced that the Fed had opened its discount window to Freddie Mac. Although it later did just that, Syron’s statement was untrue; the Fed had not yet opened the discount window to them. The market took off like the proverbial scalded dog. Presumably the Fed received news of Syron’s false statement, but couldn’t scramble quickly enough to get out a correction until a good 20 or 30 minutes after the market closed. Messrs Cox and Dimon, the ball’s in your court.

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  1. Murph

    Scott great post, thank you…

    One point – WaMu debt holders should be wary of the warm embrace of BAC – as Countrywide debt-holders are nervously learning… !

  2. Anonymous

    Scott: Nice piece, great points.

    It is interesting to note that most agency/govy spreads are somewhere around the center of their historic range. In 1998 ten year FNMA debentures traded at +120 to tens, the middle of last year spreads moved out to +66 and currently they trade roughly +65. At their 2006 narrows they were trading +30ish. Not a lot of opportunity there. MBS on the other hand are trading very close to their historic wides.

    I was glad to see that you described your fishing as casting. If you had described it as catching, I would have had to call you on it. ;).

  3. rc whalen

    Re: BAC/Countrywide, note that BNY/Mellon acting as trustee for one of the bon issues just sued BAC The fun begins. Read our earlier posts on the Kobayashi Maru for background on why the CFC bond holders are not bankruptcy remote.

  4. Marcus Aurelius

    Well written. BR would probably have slowed down if you’d puked in his glove box.

    My only other comment regards the assumption that the American taxpayer will foot the bill for propping these securities up. The American taxpayer has no way (and no intention) of paying his own personal debt – much less that of the Federal Government. In the end (and no one knows when that will be), a hyperinflationary spiral might be the only way out.

  5. Barry Ritholtz

    I was driving Scott’s A6, so any pukage would have resulted only in an opening of windows and no stopping.

    Ironically, Scott admitted that I drove no faster than he did on the way up, but one’s perspective changes as soon as you move to the Passenger seat.

    Besides, this was an automatic, not a proper manual shift, and contained none of the tweaks that make the S or RS version so much fun to drive. And besides, I barely had the hammer down.

    For the record, it is not at all true that Scott screams like a 10 year old girl. I estimate 12-14 years old is more accurate . . .

  6. Scott Frew

    Anonymous of 8:06 AM. If the truth about the fishing has to come out, it would be that I got hits casting, but no fish in the boat. Had to resort to worms, a humiliating defeat, to get lunch.

    Murph and RCW–absolutely right, as Chris has pointed out very nicely at Institutional Risk Analytics.

    MA–No issue whatsoever with your point about who’s footing the bill. Hyperinflationary spirals, sadly, and terrifyingly, do not seem outside the realm of possible outcomes here. Whether we get to that brutal end game or not, the question of where the pressures get vented is a really interesting and important one. The dollar would certainly seem to be candidate number one.

    BR– A slight difference in the two driving experiences might include the fact that you were whistling down the road through some rather amazing little fogbanks. One does not leverage up and go long into the teeth of a bear market, at least if one does not want to end up wretching at the sight of one’s pnl, into the glovebox or elsewhere.

  7. rc whalen

    Here's the link to the Bloomberg story about BNY/Mellon suing BAC behalf of one group of CFC bond holders:

    The other creditors cannot remain indifferent to this filing. My guess is an involuntary bankruptcy, as we've predicted for some time. No other way to sort the creditors. But the kicker is that BAC still appears to have the $110bn asset bank unit escounced inside the Countrywide vehicle, so a filing means BAC loses the bank to an FDIC receivership. Or maybe that's why Ken Lewis has not moved the bank yet. More soon.

  8. S

    Hyperinflation could be an outcome but massive deflation will follow. The question seems on of timing.

  9. Anonymous

    Spot on about Pimco manipulation and pandering. Pimco is obviously a hedge fund in trouble and they love to talk up Fannie and Freddie!

    They also like us to forget the reality which you point out: “…required to show fair value balance sheets as part of their financial statements. Accompanying these balance sheets, they put out multiple pages explaining why the investor should pay no attention to them, that they don’t paint a true picture of Fannie and Freddie’s financial health. I’d venture to say that the two institutions would prefer investors not look at those balance sheets for another reason—they show both to be insolvent, or so close as to make the thought of investing in them the diciest of propositions.”

    Pimco need to go under, along with Fannie and freddie!

  10. Anonymous

    thank you for your comments as far as the Pimco big wigs and their comments on CNBC I don’t believe a word they say they are only promoting there own position or shorts they are to big to be subjective

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