Central banks’ hazards
The oldest dilemma for regulators is how to prevent their actions in protecting the integrity of the financial system from affecting the behaviour of those they regulate in the opposite ways to those intended.
It’s called “moral hazard”. The classic and legitimate fear is that regulators actually encourage banks and other financial players to take silly risks, by showing that they’ll always intervene to reduce the costs for the market of such imprudent behaviour.
Those concerns about moral hazard lay behind my uneasiness about how much cash the has been pumping into the banking system.
Of course, I understand that the ECB has a target for overnight interest rates. So in one sense it was rational for it to provide tens of billions of pounds of incremental short-term lending to Europe’s banks, to prevent that overnight rate from settling too far above its target of 4 per cent.
But the reason for the rise in those short-term interest rates was nervousness among lenders about which of them might be holding something very explosive and nasty in the frenzied game of pass-the-parcel of horrible financial risk – which stems ultimately from sub-prime lending in the US.
Or to put it another way, in providing all that cash or liquidity to the market, the ECB (and to a lesser extent, other central banks too) was bailing out banks – and, indirectly, hedge funds – who should have known better.
The danger inherent in the ECB bailing them out is that when this particular market storm is over, those banks and hedge funds will take on even greater risks and do even sillier and more opaque deals, safe in the knowledge that when it all goes wrong again – as it will – the ECB will always prevent drama turning into crisis.
On the other hand, there is a separate imperative for the ECB. There are growing signs of softness in the eurozone economy. And the sudden reduction in liquidity in the banking system and rise in short-term rates could have turned that softness into a more serious slowdown in economic growth.
It would have been unfair for Europe’s consumers and businesses to pay a big price in the form of slower growth in their income for the imprudence of those who lent to US homebuyers with poor credit histories.
Understandably, the ECB – and to a greater extent, Europe’s politicians – would want to avoid that.
Unfortunately, we are not out of the woods in terms of the impact on the real economic world from the financial mayhem. There’s a continued flight to quality going on, with the more marginal markets in Asia being . That has prompted fresh falls in the larger, more liquid stock markets like London’s. Underlying all this is the continued reluctance of lenders to provide credit to all but the safest borrowers.
So eurozone consumers and businesses – and British ones – may yet pay a real economic price for the excesses of players in financial markets.
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I agree in general with the moral hazard problem but I dont suppose you get the funds for free from the ECB or Fed. they can ask for guarantees or collateral from the principals of the hedge fund with liqudity problems, thus the yacht,the skiing lodge in Aspen and mistress' Fifth Avenue appartment is at risk. Essentially these guys have been giving two fingers to the regulators for the last five years and the whole point of this exercise apart from preventing systemtic collapse is to teach them who is boss. bearing this in mind the hedge fund crisis has more to run particularily as the investors are supposed to be rich and sophisticated. If they loose say 20% of their net worth over the next 6 months no one in Washington will shed a tear.
This whole crisis appears to have a very familiar feel to 1998 when Long Term Capital Management went under. Their business was illiquid bonds which were highly leveraged and were using complex financial models to decide what to buy and at what price - as the quantitive hedge funds appear to be using today. LTCM came unstuck because their models failed to predict that when a market goes into freefall it is almost impossible to sell the assets they held because no one wants to buy and that this crisis will not be in one market but across all of them.
I also remember reading that LTCM had made the same judgement regarding the IMF bailing out third world debtors - I believe they intervened in South America a couple of years before - but when the Russian and south east Asia crisis hit in 1997 the IMF was powerless to cope with the impact. The crisis with LTCM was eventually dealt with by the major investment banks on Wall Street having to join together to effectively wind up the company and split up what assets it still had to cover the enormous losses suffered. If that had been the case then, when the Fed had refused to get involved, why are they getting involved this time? Is the crisis much wider and worse then that of LTCM?
Banks are always the first to panic while preaching to everyone else not to. Of course, while they shift their money out of the market in question, everyone else holds the bucket like a dunce.
And inevitably we, the public, pay for those kinds of moves. No surprise there.
The extra help the ECB & Fed have offered has set a precedent for condoning the excessive leveraging now in situ.
This leveraged 'play money' requires hard cash to compensate whenb things go wrong.
No one wants to handicap potential growth but most of the 'growth' has been by playing with the tax system, then trying to refloat off hugely indebted companies.
Surely it is better to cap the leverage available to work with and require with any new derivitive product issued that there must be a counterbalancing product available .
Will it handicap growth? No but the positive thing is that those crying out for capital for their businesses will have a better chance of sercuring it.
The days of recklessness are over and a new framework can be established with incedible ease.
Its hard not to milk a situation if the prevailing climate allows but now
lets cut the greed factor of leveraged investment banks hogging all the capital in the system and help businesses across the board use desperately needed capital.
Just as a matter of interest I wonder how this ECB intervention sits with the general EU rule on state aid?
Any EU law experts out there?
Well said, but was it really silly on the part of those being bailed out by central banks?
Fund managers are highly paid, highly accomplished risk takers that usually work wonders in market terms. The lure this time has been the higher interest rates associated with sub prime debt repayment.
The moral hazard for me is that whilst it has always been an accepted practice to soak the rich we now find it acceptable to soak the poor. This is the bedrock of feudalism and autocracy.
Introspection is the name of the game right now and greed must be high on the agenda.
I think, it is more of "Moral responsibilities" than hazards , which could do wonders to all quarters of life i.e. less of greed, corruption, unfilled commitments, + high integrity and social responsibility could avoid any recessions.
How about this: bailouts must be paid back from future excess profit. So if an investment makes 10% profit when the base rate is 5% half of the profit made is paid back to cancel the bail out.
The bail out is 1 year interest free and after that first year, accrues interest at the base rate.
This should mean that such incidents don't criple the bank and since there's still *some* profit to be made, the long-term viability is not reduced as long as sensible investment strategies produce good profit margins. If the highly paid "Fund Managers" can't manage this, then maybe they shouldn't be highly paid or fund managers. If they can only make the large profit margins by stupid gambling, this is wiped out by having to keep paying back the bailout.
From david reid: ... no one in Washington will shed a tear.
In theory that would be true, but I fear a lot of the politicians' most important contributors come from this class.
Before any gets too self-righteous about the ECB and the banks, consider the BoE's policy over the last ten years - by keeping rates too low, they encouraged over-borrowing and stoking of asset prices, especially housing. As soon as the inflation signals get so bad that action must be taken, the whinging goes up from the risk-taking house owners in UK about how bad it is that rates are going up and there is political pressure (as most of the BoE Monetary committee owe their jobs to the government) to move rates as little as possible and to cut them asap.
Why should we expect taxes on those, who make financial gains and not on those, who put money into non-productive bricks and mortar?
Surely it is an open secret that borrowing against inadequate or none existant assets has become rapant over the last ten years. All the Central Banks have done sofar is to try to induce a more orderly credit slowdown rather than have to markets slam on the brakes in a panic resulting in sliding about out of control to finish up heaven know where. The lure of cheap money and the chase after growth at almost any cost has suduced many from Governments down to the individual. It is going to take song strong nerves and a lot of courage to take the necessary tough and unpopular actions needed to get out of the present mess.
Many people posted comments on this issue are under some kind of impression that the central banks have "bailed out" hedge funds, investment banks, etc. The ECB lends huge swathes of money out every week in their repos; this time the demand was higher than normal so the ECB made some additional funds available. To do otherwise would have been highly imprudent.
Many hedge funds and banks have lost large sums of money through the credit markets and knock-on effects in equities, rates and foreign exchange. The traders in these products are well aware of their associated risks, and as such have simply had to suffer the gains (along with all of the many other types of investors, such as corporates, etc). However when anyone invests in such a product they certainly do not expect to take on any exogenous risk and losses caused by a central bank failing to act according to its mandate; certainly I don't expect that anyone in the UK with a mortgage would not be happy if they were told that they had to pay an extra 0.5% even though the BoE hasn't moved the policy rate.
Unfortunately, I think we are very early in the game as far as this financial crisis goes. Since it is a credit crisis, it is not like other times when banks or other financial institutions have failed. And there are few periods in history that can compare to the rise of hedge funds, which have not only drawfed the stock market in their value, but which are substantially nonregulated.
The spread of collateralized debt obligations(CDOs)throughout the world due to globalization means that the current system is far more complex than in the days when one country was comparatively isolated from a downturn going on halfway around the world.
I think that ultimately we may all be surprised as to where this crisis will go next, or who it will affect.
When people wanting to buy a house go to a bank with falsified documents or exagerated uncertified earnings, as happened in the US and the UK, banks lend them more than they can afford. What does this do ?
It enables them to get a property that is more expensive than what they can afford.
It helps stoke up house inflation as anybody can go to the bank.
It makes it harder for those genuine buyers to be able to afford a home to live in because speculators and fraudsters have helped escalate prices.
Add to that the fact the governments like the one in the UK can lie to people about the real Inflation by not adding House inflation...so it all appears within limits.
What do you think happens when payback time comes ?
-Those who borrowed more than they can afford, will risk or lose their homes at the slightest interest rate increase or unemployment...
-This affects the entire economy as banks become careful who to lend to and the entire system starts to suffer from reduced liquidity...
...until the ECB, Fed...start using their laser printers and creating money out of thin air then lending it at low interest rates to those who squandered it in the first place.
As you see now, heavy losses are still happening in share markets around the world. Mortgage lenders like Countrywide Financial and loads more are 5 minutes away from bankruptcy.
So that cash injection didn't work after all. Are they going to print more money now and thus reduce the value of the money you have even further ? or are they going to just watch the whole pack of cards collapse because if these companies go bust, others will follow suit and expect increased unemployment, increased reposessions...in all increased instability.
Whose lives are more affected ? sadly it's always those who can less afford to lose that do. The rich are ok.
So what can we expect ?
In my humble opinion:
more bankruptcies in the US and UK...
more people losing their homes.
more people displaced socially (divorce...)
more social injustice and increased level of rich-poor divide.
All this because of what ?
People's foolishness to borrow more than they can afford because if they didn't do it someone else will.
Bank's willingness to play the game and give people all the money they want
Government's collaboration with hedge funds and the like to rip people off and not even pay the minimum taxes.
I am expecting worse to come. they may hide the losses somehow but the fundamentals are still wrong and the numbers do not add up.
Attaining outperformance implies that someone somewhere is going to underperform. In the race for outperformance different players will have different sizes of 'edge'. Those with small 'edge' attempt to get outperformance by applying more leaverage than their counterparts with larger 'edges'.
In what is a competitive business of satisfying investors greed these players live ,or die by staying in the market more fully than prudence might wish for.
Ultimately you therefore get to a point where it takes only relativley small shifts in circumstance to make exits untenable. Volatility ensues and multiplies upon itself as that situation becomes more transparent.
The centarl banks hazard is to tread the line between allowing the more overleaveraged to take their pain and yet not let it go so wholesale that the man in the street get's cut by the situation. What they cannot do is simply step aside , it's a case of using judgement to applying the brake to keep the momentum of the situation from becoming too self perpetuating that it actually becomes unstoppable by anyone including the banks. For such a case think 1930's depressions.
I think a lot of people are really missing the point here.
This ‘capital crisis’, of ‘credit crunch’, or whatever other term is banded about, is not just isolated to the U.S. Sup-Prime market. This is a problem that is pandemic, throughout all western economies, and throughout all layers of those economies.
Quite simply, the value of money is not known any more.
Money has been too easy to acquire.
In my reality, houses are dwellings - somewhere to live and be with your family. They’re not investment vehicles, from which you extract a 15% yield each year, to spend on designer sunglasses and ski trips.
This is my reality because, if you take out the 15% increase in the so called ‘equity’ of the house, and you continue staying in the house, or even move to another, all that you have really done, is to BORROW more money.
For the last 10 years, I watched as people around me have truly believed that they really have made the money that they are spending on holidays, gadgets, wining and dining.
We have all, lost the plot.
The risk is that what the Central Banks are actually doing is Pump Priming.
For as this is a Credit Crisis it will be easy for the central banks to put money into the world economy but not so easy for them to take it out again.
The result can easily be the creation of a false economic boom, which can then turn into an International Inflation Crisis.
For no-one knows how severe the physical sub-prime crisis is and whether US house prices will recover from its current lows - once the reposessed houses have been bought on the cheap.
Also the Central Banks may well end up supporting financial organisations who don't need supporting - as this short term liquidity support is unfocussed.
Therefore in the end there might be too much money chasing too few goods, which as everybody knows is the classic perscription for inflation.
SW , that is pretty much the problem. There is money out there sat waiting for opportunity to be created out of this destruction. More of that is really not needed which is why as long as the banks stick to repos the situation should be manageable. However ,if they panic and make sizeable rate reductions then frankly you might as well grab it with both hands and buy gold ,commodities and anything else taht is strongly correlated with inflation.
Unfortunately ,those on fixed ,or inelastic incomes will end up on the wrong side of the equation as they have in the past.
"Kamal wrote:
When people wanting to buy a house go to a bank with falsified documents or exagerated uncertified earnings, as happened in the US and the UK, banks lend them more than they can afford. What does this do ?"
Nope, my mum and sister were done over by this. The person selling it wrote in base salary well over the one supplied by my mum and added completely spurious Bonus payments.
Why? So that they could justify the sale of the mortgage.
My mum didn't tell lies.
Mark,
Whilst I take your point the question begged by it is did your mother sign a contractual document that she knew contained incorrect information ? The document with her signature is an attestation that the contents are correct in all respects.
The problem is that a lot of people wanting a mortgage that they cannot qualify for will take the solution of signing off on data they know to be incorrect indeed many of them will have supplied such data. Their attitude being that today they get what they want and they don't need ,or want to think about tomorrow and what the consequences might be. It's all too human.
Well I sure hope Hank is right in his opinions but I have grave doubts about this growth thing, point 3. When I studied economics many years ago I was taught that growth come from productive investment in plant macinary etc and this also extended to the overall investment in infrastracture. Later I learnt there was a false type of growth practiced by business that wanted to make themselves attractive to potential buyers. This was achieved by cutting back hard in investment and even preventative maintenance on the one hand boosting sales by heave discounting to overload the distribution chain. Sure the Balance Sheet looked good but a careful look at 3 years P & L Accounts soon showed up what had been going on.
From my travels in the UK, France, Holland, Italy and in the USA it is my impression that the growth over the last 5 years has been more akin to the later than the former type of growth.
Mike,
We must have gone to the same school and got the same lessons including the one about matching short term finance to short term requirements and not to long term investments.
Summed up we've seen a lot of debt fuelled growth based upon consumption as opposed to increased productivity. If someone who actually lives on this planet can disagree with that then please do so ,but in specific detail please. The consequences of this are...the holders of the debt have now got a lock on future revenue streams. Which means that either the borrower has to redress their consumption to make the repayments ,or they have to wash the debt in some way perhaps globally by weakening the currency in which the debt is held.The latter is achieved by topically dropping the interest rates linked to the currency which signals that the currency is overvalued and will..yes, be worth less shortly.
Erm... Enough that I clearly understand my question, but can someone please explain why the world actually needs a currency let alone any currency? I fail to see why some number on a database or three dictates if someone has status or is on the street, be this an individual or organisation.