Tom A's Stock Picks

Moral Hazard - a Danger to our Financial System

Rating: 3.00 not yet rated(2 votes)    Vote:

You are logged in as | Logout

Lately Hank Paulson has drawn a line in the sand - no more bailouts - no more "moral hazard." The reasoning is, if market participants think the government will bail them out of their mistakes, they will become reckless, which is moral hazard. I disagree. The true moral hazard is created by a financial system that permits a small band of manipulators to make leveraged bets in favor negative outcomes in situations where they have no other stake in the matter.

To introduce my argument: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance creates an active desire for a loss to occur. As an example consider what would happen if someone were able to buy fire insurance on a house he didn't own, or to purchase life insurance on an enemy or a complete stranger. Moral hazard is created by the lack of an insurable interest in the life or property insured. Someone who buys fire insurance on a building he does not own wants the building to burn down: that's why he buys the policy. The motivation is arson for profit. Because of this, life insurance, as well as fire insurance, cannot be legally purchased if there is no insurable interest.

The relevance to the current market difficulties is this: credit default swaps are a kind of insurance, created to permit protection by those who are exposed to loss because of an interest in a debt or bond.. For example, someone who owns a bond issued by MBIA (MBI) can protect himself from loss by buying a credit default swap on that company. But there is no requirement of an insurable interest. The problem this creates is that speculators buy CDS protection on a company's debt and then put out rumors or distortions while shorting the stock. The results lately have been devastating. I regard it as the financial equivalent of arson for profit.

I first became aware of this phenomenon as a shareholder of MBI. William Ackman, of Pershing Square, sold the stock short and also bought CDS protection on the company. He owned none of their debt: the only reason to buy the CDS was to make a profit when its value increased, or best of all, to collect on it if he could engineer an insolvency. To that end, he and others spread grossly exaggerated estimates of possible losses arising from MBI's business of providing insurance on structured finance products.

Ackman's persistence and tenacity were extraordinary. When doubts about MBI's survival became sufficiently grave to draw regulatory attention, he had the gall to introduce himself into the debate, writing to NY Insurance Department Superintendent Eric Dinallo and proposing a solution that would have the effect of creating a loss on MBI's bonds. In point of fact, he was motivated by a vendetta arising from an incident in a previous life: he had tried the same trick before, while a principal at hedge fund Gotham Partners. Gotham Partners was liquidated, in part because of losses incurred while shorting MBI. How sweet, to get revenge and make a profit too.

In my previous blog on this topic, in December last year, I issued the following warning: " A determined group of negativists can short a companies stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors... Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard."

Recent events - the demise of Lehman (LEH), Bear Stearns (BSC), Fannie Mae (FNM) and Freddie Mac (FRE) - provide a chilling chronicle of moral hazard run rampant. In each and every case, huge profits were made by causing business failures that may have been preventable. The recent episode involving American International Group (AIG) which has not been resolved as I type this, is only the latest chapter.

General Electric (GE) credit default swaps have been trading at increasing spreads. GE is an industrial, perhaps, but has a very large financial services business. Perhaps the studious financial arsonists have identified a chink in the armor, a flaw which can be exploited to bring down another icon of American business. I saw a graph of their CDS spreads on TV yesterday, it was stunningly familiar.

At this point I am sad enough to wish that I was wrong.

To talk of moral hazard as emanating from the shareholders of a legitimate business, as if they were stupidly oblivious to the danger of attack by financial murderers, is stunningly inappropriate. In a law abiding society, most of us walk around unarmed. Most of us sleep at night in frame dwellings, secure in the belief that we will not be incinerated by an arson attack. However, in the financial arena, that is no longer the case. Any business that is not armored and fire resistive is an instance of moral hazard, a victim looking to be the target of attack, and culpable in its own demise.

As Warren Buffet noted, derivatives are a weapon of financial mass destruction. These weapons are trained at the heart of American business.

Our regulators have been stunningly inept. The up-tick rule has been abolished. Niggling distinctions between "abusive" naked short-selling and acceptable naked short-selling become the basis for a tentative approach to possible regulation. A state official, Eric Dinallo of the NY Insurance Department, was the only regulator to come to the defense of MBI, when he finally wrote an article in the Financial Times, noting the illegality of Ackman's defamatory attacks.

Meanwhile, the huge credit default swap industry, a totally unregulated business of insurance, continues as an arena of toxic machinations. Here, in total obscurity, bets are placed: which of the remaining financial companies should be the next victim? Would you be comfortable if strangers could legally place bets on your longevity? Or on whether your house would burn down?

Paulson has been cleaning up the best he can, conducting the last rites and finalizing the effect of the short-sellers attacks. He administers the coup de grace, placing the shareholders of FRE and FNM in a position where the short-sellers will never have to cover, and legitimate shareholder's losses become permanent. This actually creates further moral hazard, as short-sellers can rely on Paulson to complete their work and make the damage permanent and fatal.

I have been writing to my congressmen, as well as the appropriate regulatory bodies, and suggest you do the same.