The Moral Hazards of This Week's Events

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The Moral Hazards of This Week's Events
by Jack Crooks
09-20-08

I applaud you if you've made it through this past week with only a few scratches and bumps in your trading account. I know for a fact that plenty of traders got their lunch handed to them.

Thanks to what I call the "visible hand" theory of central banks and the U.S. Treasury, times like these make it even harder to get positioned and stay positioned without being whipsawed.

So without trying to pump too much analysis and too many forecasts into your head while the markets still seek out direction, let's do two things today:

1. Go over the initiatives taken this week to stabilize financial markets, and

2. Discuss the moral hazard tightrope that the Federal Reserve and U.S. Treasury are walking.

Week in Review: The Markets' Wild Ride

If you have money on the line in these markets, then you know it's been a less-than-pleasant week of trading. There have been wild ups and downs. There have been more swings than you could find on the neighborhood playground. There has been a steady, if not growing, stream of worry. And there has been an equally steady stream of intervention hoping to relieve such concerns.

If you didn't have a chance to keep up with how things played out from day to day, let me do a quick and dirty recap:

Sunday: The Federal Reserve pumped a bunch of money into the system, increased the amount it will provide in its lending facilities and further liberalized the collateral it will except in exchange for loans.

Monday: Lehman Brothers declared bankruptcy. Bank of America took control of Merrill Lynch. And AIG's fate hung in the balance.

Tuesday: The Federal Reserve denied the markets a much anticipated interest rate cut. Instead, it followed with a two-year, $85 billion loan to bail out AIG.

Wednesday: The Treasury announced a finance program where it would auction off Treasuries, separate from what it already offers. The proceeds will go to the Federal Reserve to use for "initiatives."

Thursday: Central banks around the globe decided to join the party. They declared efforts to pump nearly $250 billion into the global system to avert a financial train wreck.

Henry Paulson spearheads a new $1.2 TRILLION bailout initiative.

Friday: We learned of a new initiative, spearheaded by Treasury Secretary Henry Paulson, to put together $800 billion in a new-fangled institution and $400 billion more at the FDIC. The money will be used to take crappy assets off troubled balance sheets and grease up money markets.

Prior to this week, steps taken to stabilize the market were considered ineffective. By the looks of it, though, this week's actions tell me these guys don't want to fail in their efforts to restore order ... again. But the condition of credit markets is far from cured.

Plus, there's another issue that the Fed and Treasury might have to wrestle with down the road ...

Moral Hazard: It Isn't Their Problem Anymore; It's Ours

"We cannot protect all risk in the market, and we should not do it at the risk of the taxpayer."

— Richard Shelby, Alabama Senator

"Moral Hazard" is a pair of buzz words circling lunch tables, office cubicles and board rooms around the world. Why? Simply because the Fed and Treasury are taking matters into their own hands, trying to put an end to the losses wreaking havoc on the global financial system.

Taxpayers could be left footing the bill.

However, what scares me about these interventions is that some could create a humongous burden on the taxpayer.

The two-year $85, billion loan from the Fed to AIG this week is an attempt to provide a controlled environment to deal with the pain, spare the financial system from the effects of extreme counterparty risk, protect the real economy and keep the bill off the taxpayer.

So what if the burden of this financial mess doesn't end up in the taxpayers' lap? Could there still be moral hazard?

Good question.

Because what kind of precedent is being set? These are banks and institutions that took on toxic derivatives and securitized debt. They fattened up when times were good, but come crying for help now that the going has gotten tough. How many more will follow expecting the same treatment?

Perhaps this is the real issue.

Best wishes,

Jack

P.S. For regular updates on the currency markets, remember to check out my blog at: http://blogs.moneyandmarkets.com/blog/currency-corner.

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