Moral Hazard

In a speech before the SW Graduate School of Banking, Dallas Fed's Richard Fisher comes out swinging, blasting his boss Ben Bernanke and his policy of globalized moral hazard: "Let me make my sentiments clear: It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system. It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises." And just in case listeners missed the point, he followed up: "Just this morning, the Washington Post summarized the impasse that inevitably blocks treatment of the TBTF pathology. In an article on preparation for this weekend’s Group of 20 talks on bank reform, it was noted that “some” participants “remain hesitant to lean too hard on banks they consider vital to their national economies.” This hesitancy only perpetuates the problem: The longer authorities delay the process, the more engrained behemoth financial institutions become; the more engrained they become, the less extricable they are. And so the debilitating disease of TBTF spreads. What appears “vital” becomes “viral” and grows ever more threatening to financial stability and economic stability."

When a major mainstream media like Forbes compares BP with Goldman Sachs and recommends investors to buy Goldman stocks, you know the world is in total moral hazard and deserved to be doomed as Marc Faber always said.

In the current environment, where the market's Advance/Decline line is swinging with greater daily amplitude than ever before, the only thing glaringly obvious is that nobody has any clue how to trade pretty much any asset class. Which is why the following presentation by Morgan Stanley's Jim Caron does a great job at summarizing at least some of the core fundamentals in this new, "new normal" where corporate risk no longer exists, only to be replaced with unprecedented sovereign risk and pervasive moral hazard. It is a must read for anyone who dabbles in any market even remotely connected to credit (which implies everyone): 112 pages of no-nonsense (if somewhat biased) goodiness.

Game theory causal relations are now superseding simple myopic "in-a-vacuum" economic variables. Are you prepared for the paradigm shift? David Einhorn is (and so are we).

The reform bill is a joke. It reforms nothing, it fixes nothing, and it will not prevent the next much bigger crash from happening (with or without Goldman's Supplemental Lack of Liquidity Provider assistance) - just two items that need to be pointed out: $6+ trillion in GSE debt - untouched, $400 trillion in IR swaps: untouched. This is reform? However, if you care enough to know what a bribed and corrupt Congress and Senate have "reformed" here is a useful cheat sheet courtesy of the New York Times.

We read a Bloomberg article today that dissected the poor performance of Goldman’s trade recommendations to their clients: "Seven of the investment bank’s nine “recommended top trades for 2010” have been money losers for investors who followed the New York-based firm’s advice, according to data compiled by Bloomberg from a Goldman Sachs research note sent yesterday." We thought it was appropriate to dig up a previous guest post in our Commodity Intelligence series dealing with the moral hazards of flow trading.

In today's note by David Rosenberg, the economist quotes a reader letter which provides a unique perspective on how hyperinflation arises: it is not so much a monetary supply/demand phenomenon, as it is one of faith in a currency, any currency. With the world stuck with the USD as a reserve currency, the question is how much more monetization and QE (and make no mistake, the Fed will be forced to do more of both of these activities) needs to occur before people give up on the greenback. And for all those who question what could possibly take the place of the dollar as the world reserve currency, we would like to point out that any country that has a massive stockpile of resources, an even more massive producing class (as opposed to consuming), a clean sovereign balance sheet, and a society hell-bent on being far more capitalist than the US, would likely make a great target. One specific country in Asia comes to mind. However, this will not occur before the next global economic collapse as century-old habits are difficult things to break. Once the economic reset button is pushed half way once again, and the US-China vassal linkage is broken, look for fund flows to redirect promptly across the Pacific.

Yesterday we highlighted the passage of the Cornyn Amendment to FinReg which essentially makes US participation in IMF loans to countries which have greater debt than GDP very difficult if not impossible. The amendment has received little if any press, until this morning, when Telegraph's Evans-Pritchard savages what it means for a now partially defunct Europe. "This is obviously aimed at Greece, which will have a debt of 130 per cent by the end of this year. The debt will rise to 150 per cent by the end of its the rescue/death package, leaving Greece in a worse position than before. The IMF share of the Greek bail-out is 30 times quota, more than double any other rescue in the history of the Fund. There is a very strong suspicion in Washington that the IMF is being misused by French chief Dominique Strauss-Kahn – French presidential candidate in waiting – to support ideological purposes regardless of economic logic or sanity. This can (and in my view most likely will) destroy the credibility of the Fund itself unless the US and Asians can wrench the institution back from the Europeans." As more people realize the ramifications of this Amendment, we expect the IMF to increasingly lose credibility as a backstop to any upcoming European risk flareouts.

Does anyone here remember the Latin American debt crisis in 1982? It was a lot like Greece....

In the FDIC’s own words: “The crisis began on August 12, 1982, when Mexico’s minister of finance informed the Federal Reserve chairman, the secretary of the treasury, and the International Monetary Fund (IMF) managing director that Mexico would be unable to meet its August 16 obligation to service an $80 billion debt (mainly dollar denominated). The situation continued to worsen, and by October 1983, 27 countries owing $239 billion had rescheduled their debts to banks or were in the process of doing so...

• The European Financial Stabilization Mechanism backstops EMU public finances without distorting incentives.
• The focus now turns to budgetary plans by individual countries, and the new rules on fiscal coordination.
• The ECB’s ‘interventions’ in sovereign bonds have so far targeted the smaller, weaker credits.
• Secondary trading in Spanish and Italian government bonds is slowly ailing; over time, this should help financial risk subside.
• The dispersion of EMU sovereign spreads will remain wide going forward, reflecting greater differentiation across fiscal positions.
• EMU GDP-weighted 5-yr government yield is now 2.4%, comparable to the US, and roughly 80% of Emu public debt is held within the Euro area (relative to only 52% in the US) 

Thought experiment: You are the head FX trader at French megabank Croc Monsieur & Cie. (HFT: CMC) For the past 5 years, your bonus has been getting paid primarily in company stock. In the last two weeks you have seen the stock of your firm plunge as the markets have finally realized that those idiots in the Fixed Income desk have loaded up to the gills with PIIGS debt which is now worth 60 cents on the dollar at best. And to top things off, the euro has plunged to multi year lows killing any chance of buying that New York Pied A Terre which seemed so cheap when the EURUSD was 1.50 a few months ago. So what do you do? Well, you short the living daylights out of the EUR, knowing full well that the EU, the IMF and the ECB will not let Europe crash. You sell, you sell on margin and then you sell some more, trying to get EURUSD all they way down to 1.20, to 1.10,  even to parity if possible, to make it all that more believable that the end of Europe is coming. And, lo and behold, on May 9 your plan succeeds: Europe agrees to bail your bonus out, by flushing $1 trillion under the pretext the money will be used to stabilize the periphery and the euro. Immediately the stock of CMC, and thus the value of your accrued bonus (several million worth), surges by a record 20% in one day. So you think: "How can I get an even greater bonus appreciation? Why - I will short the euro again. At this point I know that between myself and the other FX desks at all the other French and German banks we can easily take the euro down to 1.20 if not much lower. After all we are only trading against the very central banks that are keeping us alive. And when that happens Europe will have to print another trillion, then ten trillion, then one hundred trillion, all the while the stock portion of my accrued bonus surges. Brilliant." Brilliant indeed - Zero Hedge has received confirmation that several of the largest French banks are now actively shorting the euro to take advantage of globalized moral hazard, which with every ensuing bailout does nothing but make the bonuses of French FX traders surge. In other words, the very banks that Europe is bailing out are betting more and more aggressively with each passing day against Europe's own survival! Even George Soros has shed a tear of pride in how beautifully his initial plan to take on the BOE has mutated for the Bailout Generation.

I told you it probably wouldn't work. Now, you really have speculators lining up to put on the short trade of the a lifetime. Methinks those lines may start to get pretty long as well as I spy the Asian markets as well as the US and European futures drop like rocks in desalinated pond water. Asking 2 trillion euro, can I get a bid for 2 trillion euro, going... going... gone!

The bankruptcy of America is getting borderline hilarious, even as stock capitalization surges by about $1 trillion based on funny money to be printed by the ECB with the Fed's assistance. In the second coming of moral hazard, one piece of news that some may have missed is Fannie Mae's earlier announcement that the mortgage lender is now more bankrupt than ever before - the firm lost $13.1 billion in net income on $3 billion in revenue. "The first-quarter loss resulted in a net worth deficit of $8.4 billion as of March 31, 2010, taking into account a $3.3 billion reduction in our deficit related to the adoption of new accounting standards, as well as unrealized gains on available-forsale securities during the first quarter. The Acting Director of the Federal Housing Finance Agency has therefore asked Treasury to provide us $8.4 billion on or prior to June 30, 2010." Additionally, the Fed backstopped entity also announced that "there is uncertainty regarding future of
business after conservatorship terminated and expect this uncertainty
to continue." But since in America asset prices have not reflected fundamentals in over a year, nobody gives a rat's ass. And the political whores in DC feel like beating up anyone who even dares to mention this particular $7 trillion dollar question mark which is equivalent to 50% of total US debt, so expect no reform to happen here, just like nothing happened with HFT, until the markets hits 1 quadrillion or zero. For all intents and purposes, the two outcomes are equivalent.

Even as the immediate factor for the 1000 point drop in the Dow is investigated for the next several months by the SEC, a process which will likely not come to any reasonable market structure regulatory recommendation before the SEC is forced to analyze the next subsequent (and even greater) crash, the one primary fundamental cause for the sell off in stocks this week was the ever deteriorating situation in Europe. As the euro tumbled on Thursday afternoon, which we noted 20 minutes before the stock market crash began in earnest, as implied correlation algos went berserk, and as viewers were witnessing the near-warfare in Athens live, things just got too real for speculators (investors is so 20^th century). Various computerized trading platforms merely kicked on (or rather, off) after the initial panic had already set in, and liquidity evaporated, leading to the implosion in the market. And the primary reason for the initial market pessimism early on Thursday was the fact that even as the whole world was listening to Jean-Claude Trichet to say soothing words after the ECB's rate decision, the central bank president once again did not realize the gravity of the situation. And to speculators, long habituated to Bernanke's endorsement of infinite moral hazard and speculative mania, the fact that someone refused to play "ball" and leave open the possibility that failure is still permitted in our day and age was the last straw. Now, 48 hours later, we learn that the rumors, which we reported about the ECB preparing a bailout fund, were indeed true. Our sense is that at this point the ECB's action is "too little, too late" as contagion fear has already crept deep within the fabric of various overt and shadow funding/liquidity mechanisms. Additionally, the world is now convinced that Europe can only deal with problems retroactively, and who knows how big and unfixable the next problem will be: the ECB, which has lost most of its credibility after "inviting" the IMF to do a heavy part of the bailout, is about to become the laughing stock of global central banks. Trichet is seen merely as a powerless bureaucrat, caught between Merkel's electoral struggles and Bernanke's demands for contagion interception and implicit Fed supremacy over Europe. The contagion from the "isolated" Greek fiasco is rapidly spreading. Here are some of the ways in which markets are about to be affected.

Here are two accounts dissecting in detail the events from yesterday. One is from Dan Hinckley at Wild Analytics, the second from Dan O'Brien.