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Moral Hazard, part two

Blog entry posted by anciendaze, Aug 1, 2011.

While I don't pretend to understand the current budget deal, I will hazard some observations about things noticed in the previous week. We had a House plan from Republicans, a Senate plan from Democrats, and a proposal from the Tea party for a balanced budget amendment, plus an analysis by the Congressional Budget Office (CBO). The bottom line is simple, rounded to the nearest trillion, the numbers in play did not agree. (In a corporate setting, this would suggest none of those involved have much idea about what is actually going on. It would also provoke calls to attorneys and federal regulators, if not a shareholder revolt and a hostile takeover.)

One nugget from the CBO analysis is the actual effect of the infamous bailout. This is said to have increased the national debt by only about $250 billion (I'm rounding), roughly the entire NIH budget for a decade. The amazing thing here is that the authority to do this was approved in a matter of weeks. Most of the legislators involved could not possibly have known exactly what was going on because we have considerable evidence the Secretary of the Treasury was caught off guard, as were the CEOs of many of the firms at the center of the storm.

How could those in charge of these firms not have known? The answer is that most liabilities were not shown on their balance sheets. Risk management was treated as only one 'silo' of expertise in most firms, and the theory behind it was considered arcane. Besides, their risks were being monitored by multiple independent rating agencies.

We now know the reasoning involved in those risk models was so abstruse almost nobody inside the firms with the greatest risk understood just how vulnerable they were until various dominoes actually started toppling. We also know highly-paid hotshots at big firms profiting from the expansion of risk successfully gamed the risk models in use by credit rating agencies.

One way of evading scrutiny was by creating other entities which did things the parent firm did not want to put on its own balance sheet. These were called Special Purpose Vehicles (SPV), Special Investment Vehicles (SIV), conduits, etc. In some cases these merely hid things from investors. In other cases they hid things from industry groups. This latter trick evaded an international attempt at self regulation later called Basel I. (Basel II was so weak as to be worthless, precisely because those who created it were aware Basel I had been gamed.) A last category of tactics evaded laws peculiar to one country, by operating in conjunction with firms in other countries not so constrained; in particular this applied to the U.S. Glass-Steagall Act of 1933, which had built firewalls between banks, insurers and brokers. (That act was repealed in 1999. Unfortunately, by the time it was repealed it was almost a dead letter which merely complicated business for U.S. firms that obeyed it. An attempt to restore it has failed.)

All the vehicles I've mentioned above created a 'shadow banking system' where over a trillion dollars in debt hid from scrutiny. Is that the bottom of the barrel? Unfortunately, it is not.

One word often associated with the disaster is likely to be 'derivatives'. This suggests to some a heavy mathematical basis, and some derivatives do use unfamiliar mathematics. This is not, however, the fundamental meaning of a financial product called a derivative. There is a parallel with the more familiar options market centered on the Chicago Board Options Exchange (CBOE).

If you know you will need to buy tons of cacao beans to make Hershey bars in six months, you don't want to leave them sitting in the cellar that long. You also don't want to be at the mercy of a supplier who realizes he can shut down your factory if you don't meet his price. What you do instead is to buy a contract for the delivery of said beans when you will need them, at a price you can afford.

If you aren't sure exactly how much you will require, you can purchase an option which will allow you to buy a given amount at a set price. If you need them, they will be available. If you don't need them, you will not exercise the option, but you will only be out the cost of the option, and not stuck with tons of rotting beans. That option is a product derived from the commodity.

If you know anything about the ambiance of normal business at the CBOE, you might have qualms about extending similar activity into previously sedate areas of finance. In fact, what took place was even worse.

Most of the market in financial derivatives was not an open market with a centralized clearinghouse like the stock exchange or CBOE. Such things as credit default swaps (CDS) were based on bilateral contracts between two parties, and the details were considered proprietary information. It wasn't until the crisis forced all the people in charge to sit in the same room and tell each other how their risk was linked to the risk of others in the room that the sum total exposure became more or less apparent. Until that moment, many involved didn't know which firms were 'counterparties' to the agreements which protected their competitors in case another firm defaulted. When things got to the point they needed to come clean to survive, it turned out most counterparties were already in that one room. Instead of diffusing risk, they had concentrated it in a select group of firms.

In still another area of obscurity, it wasn't until these firms started being asked to increase their collateral backing a loan that lenders found out just what collateral they were expected to accept. Every day now I see evidence that surprises hidden the packages of assets traded back and forth during the hasty and desperate attempts to forestall financial Armageddon are still being uncovered. (If you don't believe me, check on recent news releases from Bank of America, MSBC, UBS, Credit Suisse and Goldman Sachs. Don't expect politicians to be better informed than those who actually manage day-to-day operations of these firms.)

Even here we still haven't reached the heart of financial darkness. In addition to contracts with strong parallels to financial instruments in wide use, there were 'bespoke' financial products. These were contracts custom tailored to particular institutions and situations. When you think about such agreements being interpreted by sharp attorneys, (some of whom have been known to redefine 'is',) you get a feel for the stability and resilience of the resulting house of cards.

I could write another article on the mathematics underlying the risk models in use during that period. The simple explanation is that they were flat wrong, even without deliberate obfuscation and chicanery. I'm not talking about the parameters of the models, I'm talking about the fundamental theories.

How does this bear on the political deal which inspired this series? First, it suggests checking for things which might not be shown on the balance sheet. Second, it places emphasis on risk management practices. What models lie behind estimates? What actions will be triggered by later crises?

The answer I'm afraid I see is that there has been no risk management with useful models we can analyze. The actions planned are apparently "We'll deal with that eventuality, when and if it arises, by passing appropriate legislation."

(Don't expect highly-compensated executives to simplify operation of a corporation so that it can be handled by anyone who is paid less, and, likewise, don't expect legislators to create laws which can operate smoothly without constant intervention requiring new legislation. Both groups owe their importance to their personal indispensability as deal makers.)

All of those likely to read this are currently all but invisible on federal balance sheets. We are part of those hidden liabilities nobody is talking about. The risk of spread of possible infectious agents, which officially do not exist, is not part of any risk model.

The obvious question now becomes what to do about the present situation, since we have a dearth of time machines to alter the past. I'm getting to that, but I have a little more to say from this soapbox. Unfortunately, this post is getting long, so we'll take this up next time.
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."
  1. Enid
    I'm with you anciendaze - and guess the moral hazzards in big business and Wall Street are much more complex than those day to day. But you are unravelling here nicely.
  2. anciendaze
    Isn't moral hazzard part of life ...can we have a definition please ?I tried to state in the first part that the term 'moral hazard' has a special meaning on Wall Street. It specifically refers to the risk you take when you reward imprudent behavior, especially in those cases where risks and rewards have been separated.
  3. Enid
    Isn't moral hazzard part of life - found in everything from academia to gov to incapable next door neighbour (should it happen). Must look up the definition of morals in various philosophies - pretty sure it has the human element (most religions) - truth with a small T, and honesty (maybe even compassion if possible) will be there. Cort's the philospher - can we have a definition please ?
  4. markmc20001
    "The risk of spread of possible infectious agents, which officially do not exist, is not part of any risk model. "

    Exactly!

    Can't wait for the next blog.

    Markmc20001