|Moral Hazard. For the last several months I have been doing a good bit of research trying to obtain some insight into inter-relationship between the Federal Reserve, the government, and the large money center NYSE member banks. In my reading I kept coming upon the phrase 'moral hazard'- as in “we want to avoid a moral hazard". I tried to find the definition as they defined within the context of what I was reading - no luck. These guys seem to have their own code words. |
Recently I started reading Robert Rubin's book, 'In an Uncertain World'. As Secretary of the Treasury during the Clinton Administration, I thought I would try to get in the mind of one of the principals of the group we call the Plunge Protection Team (PPT). In the book he writes about his service at the White House. The book starts off with the Mexican Bailout and discusses that bailout and those that followed from the perspective of Mr. Rubin. After the first few pages he uses the term and defines 'moral hazard'.
MORAL HAZARD - A problem whereas investors, after being insulated from the consequences of risk by intervention, might pay insufficient attention to similar risk the next time, or operate on the expectation of official intervention.
We traders know this government intervention more as the 'Greenspan Put'.
'Private Counterparty Surveillance' is another phrase that I read several times. This is basically the large NYSE member banks, a couple of well connected hedge funds, and that form the 'Counterparty Risk Management Policy Group'. The one financial member of this group that is not a bank or a hedge fund is General Motors Asset Management. I guess with $300 billion in outstanding paper they want to be sure GM has a seat at the table.
Now bailouts have been around for a long time. Going back a bit I remember the Chrysler bailout. Did you know that Alan Greenspan was against the government bailing them out. Wow! Did he change his tune in later years or what!
What we also know is that we had a series of bailouts in the mid to late 90's that started out with the Mexican bailout. Robert Rubin of Goldman Sachs was sworn in as Secretary of the Treasury on the evening of January 10th, 1995. That same evening an emergency meeting was held to finalize a plan to bail out Mexico. I guess this could not be done until the well connected Rubin was in office. The administration waited until Rubin was confirmed and sworn in to move ahead. Greenspan's "irrational exuberance" speech, Long Term Capital Management (LTCM) bailout, the "Asian Flu" economic crisis and Y2K followed. All contributed to what we all now know as a 'moral hazard'. In 1999 the 'Counterparty Risk Management Policy Group' (CRMPG) was formed to address the issues with LTCM and to develop policy that would protect the financial world from another threat to the financial markets such as the LTCM incident.
Now fast forward to 2002. In May of 2002 the SEC appears to have fears that a major bank – one of two that clear government paper – may become insolvent due to derivative issues. The possible problem bank is JP Morgan. By the end of the year CRMPG recommends the foundation of a new bank be put in place just in case. The new bank would be a coordinated effort of the members of the CRMPG. The Federal Reserve and the SEC approve.
Also in 2002 it just so happens that we see a big jump in the use of program trades. The major players are also members of the CRMPG. Those without large proprietary trading units such as Citigroup, start them. Citigroup is quoted as saying something along the lines that due to ‘new’ innovations they see less risk in trading.
Remember JPM’s “problems”. Suddenly they went away. A ‘stealth bailout’ is put in place. About year later the Wall Street Journal reported concerns that JPM was making a lot of money in the "risky" business of trading their own capital. They said, "Profits have been increasing recently due to a small and low profile group of traders making big bets with the firm's money. Apparently, an eight man New York team has pulled in more than $100M of trading profit with the company suggesting it is a result of better market conditions and not greater risk." Program trading was running at about 25% of all shares traded on the NYSE in early 2002. Today program trading is running near 60%.
Then, in September of 2002 Alan Greenspan gave this speech. The link: federalreserve.gov Here is an excerpt;
Greenspan: “Owing to persistent advances in information and computing technologies, the structure of our financial institutions is continuously changing, I trust for the better. But that evolution in financial structure has also meant that supervision and regulation must be continually changing in order to respond adequately to these developments. In today's markets, for example, there is an increased reliance on private counterparty surveillance as the primary means of financial control. Governments supplement private surveillance when they judge that market imperfections could lead to sub-optimal economic performance.”
“I trust for the better.” Sounds like he is not real sure.
“increased reliance on private counterparty surveillance as the primary means of financial control.” Greenspan here acknowledges the CRMPG and endorses their actions to control the markets.
“Governments supplement private surveillance…” Governments – as in more than one? If you look at the members of the CRMPG you will find some foreign banks included. We are not looking at a group that deals solely with the US markets. Any market that could be contagious to the greater good is subject to control by the CRMPG.
In 2004 Greenspan acknowledged concerns about derivative growth. All markets had seen strong growth in the previous five years. In the OTC market, the notional outstanding of equity-linked derivatives was $4.5 trillion in June 2004, having tripled in size over the previously five years (source: BIS). The listed options market has also shown strong growth. For example, in 2004 the combined open interest of equity index options contracts on was around $3 trillion notional, double that of 1999. Turnover, at $200 billion notional per day in 2004, was triple that of 1999 (source: BIS). Data for the retail structured product markets is less comprehensive. Estimated issuance in Europe was around €100 billion in 2004. Around half of the issuance was in Italy, Spain and the UK (the other major European markets are France, Germany and Switzerland). On this basis, the market has doubled in size from 2000 to 2004. Greenspan called on the major players to meet with the Fed and discuss their exposure. Out of this meeting came the request for the CRMPG to report what actions it felt necessary for the markets to remain stable.
The CRMPG filed their report in July of 2005. Here are some selected excerpts with my comments.
The report can be found here. crmpolicygroup.org
CRMPG: “The primary purpose of CRMPG II — building on the 1999 report of CRMPG I — is to examine what additional steps should be taken by the private sector to promote the efficiency, effectiveness and stability of the global financial system. As practitioners, the members of CRMPG II recognize that periodic financial disruptions and shocks are inevitable. However, the Policy Group also believes that it is possible to take steps that would be capable of reducing the frequency of such shocks and, especially, to reduce the risk that such shocks would take on the contagion features that can produce systemic damage to the financial system and the real economy.”
Again it appears the CRMPG mandate is to control the markets. How else are they to reduce the frequency of periodic financial disruptions.
CRMPG: “since we know that financial disturbances and even financial shocks will occur in the future, and we know that no approaches to risk management or official supervision are fail-safe, we also know that we must preserve and strengthen the institutional arrangements whereby, at the point of crisis, industry groups and industry leaders, as well as supervisors, are prepared to work together in order to serve the larger and shared goal of financial stability.”
If you read through this whole document it is all about working together for the greater good. On the surface, that sounds all well and good. However, free markets do not work this way. Their collusion at their highest ranks to secure the financial stability of the largest financial institutions could be at odds with the investments of smaller institutions and may be at odds with the small investor’s long term investments and goals. When LTCM failed many of us could have not cared less if you were not a shareholder of one on the banks that bailed them out. The bailout was simply put in place to save their own skins and the investors they serve.
CRMPG: “It is acceptable market practice for a financial intermediary’s sales and trading personnel to provide their sophisticated counterparties with general market levels or “indications,” including inputs and variables that may be used by the counterparty to calculate a value for a complex transaction. Additionally, if a counterparty requests a price or level for purposes of unwinding a specific complex transaction, and the financial intermediary is willing to provide such price or level, it is appropriate for the financial intermediary’s sales and trading personnel to furnish this information.”
Sounds like a formula for collusion and manipulation to me. How would you like to be the other side of the trade with these guys in one of the pre-arranged trades.
CRMPG: “Following execution of a complex transaction, the financial intermediary will often maintain communication with the counterparty in the interest of maintaining good client relations. As part of
this communication, the financial intermediary, although under no legal obligation to do so, may wish to alert its counterparty to any observed market change that it determines may challenge the underlying assumptions or principal drivers that motivated the counterparty to establish the original position.”
No, I did not make this up. We know from above that the big banks are being encouraged to share information. We know there are two sides to each trade. Again, how would you like to be the less connected investor. Let’s read Greenspan’s thoughts excerpted from the same speech as referenced earlier;
Greenspan: “There should not be much dispute that markets function best when the participants are fully informed. Yet, paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth.
No one can deny that fully informed market participants will generate the most efficient pricing of resources and the most efficient allocation of capital. Moreover, it could be argued that, if all information held by individual buyers or sellers became available to all participants, the pricing structure would more closely reflect the underlying balance of supply and demand. Thus full information would appear to be the unambiguous objective. But should it be?”
But should it be? Who is he trying to kid! As a small investor I would like to have as much of an equal footing through the knowledge available as the next guy, no matter how connected they are. We require public corporations to provide open and full disclosure with the public, why should the CRMPG be allowed to collude to rig the market against free market principles?
In closing – the CRMPG has to be in the market daily. Current derivative exposure of the major NYSE banks makes it necessary. The CRMPG report gives them the outline to execute their strategy in collusion at the expense of ultimately the small investor that gives them the fuel to increase that trading returns. Moral hazard has led to moral decay at the highest ranks of our financial institutions. Move over PPT – the CRMPG is at the wheel now.
A link for the most current CRMPG report is here.
Notice how the report is addressed to the chairman of Goldman Sachs. Notice that Goldman Sachs had much imput into the report and the CRMPG is Chaired by a Goldman Sachs guy. Also make note that the current Secretary of the Treasury just came over from GS as well as an new appointee.