Moral Hazard occurs anytime the system encourages effective fraud or accounting magic that allows those in charge to benefit in the short run, leaving others holding the bag. Think about Enron, WorldCom, Ahold, Tyco, National Century, Salomon, Bludgett, Rigas, Martha, etc.  Anyone who reads the press can imagine hundreds, or even thousands, of people whose pictures belong in the post office, but not on stamps.

During the stock market bubble, the Fed moved to an easy money “free reserve” position in the banking and capital market.  Keeping interest rates artificially low, made it easy for “Wall Street Perps” to pull off that small $7 Trillion stock market heist.  At different times in our nation’s history, the Fed played the role of taking the “Punch Bowl” away when the party was getting out of hand.  Looking back at all the corporate frauds and the Wall Street “Spin and Steal” games, is there any way it could have happened without the Fed’s approval and facilitation?

Remember, the Fed minutes show Greenspan knew raising margin requirements would have thrown cold water on the speculative stock market fire in stocks.  Margin requirements were not raised because the Fed didn’t want to raise them!  Moreover, they now want to throw a party even bigger than the one after Long Term Capital collapsed, or at the end of the 2000 crisis, when banks were supposed to be out of cash at midnight.  Remember that scare?  The Fed is always looking for a good scare to justify “goosing the money supply”. 

How about deflation?  Take a look at your bills for insurance (health, home and car), home property taxes, gas, heating, college tuition, and anything the shrinking middle class might want.  The CPI is up 3% from April 2002 - April 2003, the dollar is off 30%, and the Fed gets away with actually talking about deflation as a threat.  Speculators will look back and laugh.  John Q Public will look back and cry.

Greenspan’s history as Fed Chairman suggests that when there is anything obvious that would suggest a prudent Fed Chairman might want to take the Punch Bowl away (like a stock market bubble or housing bubble), he casts around for an excuse to distract from  the obvious.  For the stock market bubble, the theme was “productivity”;  For the housing bubble, the theme is “deflation”.

In order to understand what is wrong with the system, one needs to focus on what used to be right.  The old economy rewarded saving and investment.  A balance between the need for funds and the use of funds was achieved by the concepts called credit underwriting and interest rate risk, and a return on capital as well as a return of capital.  Investors needed to rely on the credit worthiness of a borrower to be paid back.  Savers cared about their money. Lenders and portfolio managers were there to protect them and held to a prudent man rule.  Through careful underwriting, only the best projects that could pay the required return got financed. Reasonably high interest rates balanced the risk of repayment, and many credits were denied because, frankly, supplying those projects with credit was foolish and would result in loss.  In the Mid-1990’s, the Fed changed and so did the world. 

The new Fed Model is based on two simple rules: 1) Forget about actual cash savings, and 2) if two entities in the economy enter into a contract, make sure that the contract is financed. Indeed, everything gets financed.  There is no need to ration investments to the best projects and credits. Saving is not necessary because there is credit creation.  Since credit can be created without limit, credit underwriting is not necessary. All ideas deserve to be financed.  The Fed’s lack of knowledge or concern about credit underwriting is understandable because Fed officials are unlikely to have ever made a loan of their own money that they personally had to collect. 

Indeed, the only loan the Fed ever makes is by buying United States Treasury Bonds,         which the Fed knows will be paid. Old Treasury bonds will be paid because the Fed can always buy more New Treasury bonds with their own money (just printed up) to pay off the Old Treasury Bonds.  Since the Fed can print money, it can always pay itself off!  So, why would a central bank concern itself with  credit underwriting or whether investments are any good? Money can always be created to make the investments good!

The Fed’s New Economic Model allows the economy and asset prices, like stock and housing, to “break free” and rise without any concept of true value. Money and Credit can be created by Alan Greenspan’s will and spent to carry the world economy.  If easy money is always available, and all contracts will be financed, there is really no need for something so outdated and passé as savings, allocating credit, credit underwriting or due diligence.  Any systematic concerns about getting repaid are overcome, because there is really no penalty to Moral Hazard and speculative finance. The Fed will always signal the speculators when to get out or guarantee their returns.

For the system, money has become either totally free, or extraordinarily cheap, and available to all. When you think of it, how could the “dot.com scam” have been pulled off by Wall Street if money had been tight enough to require serious consideration of an investment’s value?  Now, after $7 Trillion was wiped out, what is the penalty?  At worst, a few “fall guy” stock analysts might be blamed, and a minor “speeding ticket” issued to the major Wall Street firms.  Cost benefit analysis shows hundreds of billions in profits, and a mere $1.4 billion fine.  Not a bad risk reward analysis for your newly minted MBA’s out learning the way the system really works.  Wall Street can offer reward without risk, and it’s clear the best money to be made is in Moral Hazard and speculative finance (just don’t keep the e-mails)!

Indeed, with Greenspan at the helm it is obvious he can’t run his New Economic Model without relying on Moral Hazard.  Example:  Automobile Companies. He desperately needs them to keep selling cars and they are desperate to book sales.  If the car manufacturer is fortunate to get someone to come to a dealer’s car lot and sign a piece of paper that says some day they might have to pay for the car, the auto manufacturer can book an accounting sale.  Forget loan underwriting.  The finance company of the manufacturer can bundle the loans into an asset backed security, and sell the security to a bond or money market fund, and, with an easy Fed, all such securities will be financed.  It doesn’t matter that used car prices have been cut in half because of  the 100-year flood of trade-ins and repossessions. A $3,000 cash back incentive really helps if a customer is broke. Buy a car. You can drive off with enough cash to pay your mortgage and car payments for a few more months!  Sign you name and drive away; it’s a sale! Losses for the car companies will be staggering if America does not find jobs.  Ford could fail in 2004. 

Sears is trying to sell their credit card portfolio.  Maybe they know that a lot of past sales were made to “dead beats” and the sales weren’t actually sales.  All this paper has been financed – does anyone remember how much of the technology equipment sales were made using vendor finance to companies who could never pay.  Corporate balance sheets might be getting stronger with easy money, but there is likely Half a Trillion Dollars of balance sheet equity based on past sales that were not real or will never be paid for.  Moreover, there is at least a Trillion Dollars of goodwill on corporate balance sheets used to support debt covenants which represents pure vapor, bogus sales, and over-paying for previous acquisitions.

Consider Housing. With $2.5 Trillion a year in new mortgages in 2002 – 2003, there is no question housing is the current bubble.  FNMA and Freddie Mac are running programs to sucker every renter into becoming a homeowner.  In higher quality apartment complexes, vacancy rates are up to 7%, and rising.  People are buying homes at record prices, not because they have credit that justifies the purchase, but because lenders will lend.  Effectively, there is no underwriting.  Rising home prices justify higher LTV’s.  The fact that homeowners traditionally were better credits, justifies making people homeowners, because this automatically makes them better credits!  No-one seems to remember when common sense ruled because people were better credits and they deserved to be homeowners.   Surely, you would not be promoted at FNMA by handing out historical information that indicates that year’s ago the requirement for a serious 20% down payment on a home purchase was prudent, because; 1) home prices didn’t always go up; 2) the cost of foreclosing and selling a house is about 10%; and, 3) if a buyer has 20% or more at risk, he might fight hard to keep his home.  

The Fed has just signaled it will cut interest rates again.  Moreover, the market has reason to believe the Fed will never really tighten monetary policy  until after the 2004 Presidential Election.  The banking system remains in free reserves.  Buy Treasuries and Agencies. The Fed has promised to buy long term bonds to fix their prices.  We now have another massive Greenspan put!  However, by 2005, either home prices will be falling and we have deflation, or we will have rising inflation and interest rates, and a real housing crash that will force the Government to nationalize the GSEs.

Credit underwriting? Fugidaboutit!  Let Moral Hazard Roll.  The GSEs must have over a Trillion dollars of very low down payment and sub prime mortgages either on their books or guaranteed in Agency securities. The GSE paper is “mystery meat” which explains why they are fighting so hard to give out honest data and to register their securities with the SEC. Many GSE loans are loans that would never be made by an investor lending their own money.  However, nobody cares because  GSE paper is by definition AAA.  So, every mortgage created will be financed. Most importantly, for the care and feeding of the housing bubble, financing any and all mortgages allows housing prices to rise.  Rising housing prices makes all loans good, even if the owner can’t afford to make any payments! FNMA’s motto is “REFI because a “rolling loan gathers no loss”.   For every Hedge Fund, Broker Dealer, and small or large bank, it’s “hold your nose, close your eyes, and buy Treasuries, Agencies, and even Junk Bonds”.  The Fed will finance anything and promise to buy the bonds if prices come under pressure.  Take the risk; be patriotic; save the economy.  The Fed will bail you out!  Doesn’t this encourage Moral Hazard? 

Think About It.  $5 Trillion in new home mortgages in two years is beyond extra- ordinary! There are over $100 Billion of mortgages where the 5% down payment  needed to qualify for a mortgage was made by a charity.  However, the developer who built the home gave the charity the 5% for the down payment out of their 30% profit margin.  In reality, there was no down payment, and the buyer has nothing at stake. Homeowners are sold on the idea that they should do a “cash out” refinancing and replace expensive credit card debt with lower cost tax deductible mortgage debt.  Certainly, many homeowners have taken advantage of this.  It’s a smart thing to do.  Yet, hasn’t anybody noticed that in 2002 single family mortgage debt increased $700 Billion. Of that total, $200 billion were “cash out” REFIs.  Common sense  suggests consumer credit, such as credit cards, personal loans, and auto loans  should have gone down significantly; however, consumer credit  actually increased to a new record level! 

For 2003, the totals look like they will be similar, with massive increases in mortgage debt, and a steady increase in consumer debt.  Moreover, the actual “cash payments” portion of personal income, as reflected by tax receipts recorded by the IRS, has decreased substantially over the last two years.  Over 2.5 million people  have lost their jobs!  Wouldn’t common sense indicate that the credit quality of consumer debt might be dropping?  

(Personal Income that can actually pay debt is far less than is reported. Most people don’t realize that The Bureau of Economic Analysis (BEA) includes in Personal Income around $750 Billion of non-cash “Imputed Income” including about $300 billion for supposed bank services that are not charged for,  $90 billion for people who own their own homes, and military personnel who received meals and clothes, etc.  Imputed Income is upwards of 15% of Personal Income, but reflects no cash payment. It’s “you scratch my back and I’ll scratch yours” income.  Imputed Income can not be used to service debt! )

You know that Moral Hazard rules and credit underwriting doesn’t matter when employment is down, income is down, delinquencies, defaults and bankruptcies are up, and the capital markets are wide open to accept all credits.  Look at the High Yield bond market.  The Fed has guaranteed liquidity and promised to give people in Money Market funds a negative real rate of return.  Individuals are pouring money into junk bond funds. Liquidity doesn’t make bad loans good, but it certainly can make bad loans bigger!  Liquidity pushes the stock market up as the speculator’s greed gets them to chase price momentum, and shorts are squeezed.

Does this behavior make stocks more valuable or does it profit professional speculators at the expense of the amateurs?   Greenspan wants people to take risks - no mater how crazy.  The precious savings of individuals are needed as “cannon fodder” to keep the economy and spending alive.  Right now, Greenspan needs you to take risks.  Moral Hazard and unchecked greed are Alan’s friends because he can use them to get you to make risky investments and spend your savings before inflation steals them away!

To conceptualize what is really going on, you should understand the new Fed Model.  Saving is simply fuel to be burned in the risk market. Real wealth is created, not by saving,  but by those with unlimited access to credit.  New spending and any investment can always be supported by the creation of new money and credit.  Every debt will be accommodated until it is refinanced or defaulted.  If it is defaulted, it will be replaced at least two times over with more bad debt.  Spending is not financed from cash-flows of income and earnings from investments that are the result of savings, but from the use of credit and money creation that is directed at widely held asset classes such as stocks, bonds, and housing.  The rise in wealth through the creation of credit can be used to drive spending.

The US hasn’t tried this model since the late 1920’s. This time around, the Fed claims they know what they are doing, and they have a new and improved printing press.  Indeed, the new pretty “colored dollars” the Treasury is about to introduce to the market are so beautiful that every central bank and foreign investor will want all we can print.  Fortunately, since Americans don’t save, the Fed will have some serious money  printing to do in order to finance our combined trade and federal deficits amounting to a Trillion dollars a year.  The Fed’s timing is perfect because they sense the world must be suffering from a serious dollar shortage – a truly sad affair for a World Reserve Currency like the dollar. 

The dollar shortage is serious for the US which has 23% of World GDP.   Foreign central banks hold only 72% of their foreign currency reserves in dollar assets.  China and Japan are desperate for more dollar assets!  Foreign central banks must need more dollars.  If they bought Euros or gold by mistake, the central banks wouldn’t have lost their citizens’ 30% on their massive dollar investments.  Japan alone bought another $20 billion in the first three months of this year. They must be desperate for more, so the Fed Chairman has promised to not only print up all the money America needs, but all the money the World needs!  One would think that  many countries must be desperately waiting for the Fed to end the brewing crisis caused by the shortage of dollars, that is the supposed cause of holding back world growth. 

Back to reality and the National Interest.  If Asia stopped buying dollars, the US trade deficit would shrink, more Americans would be put back to work, and George W. might be elected to a second term as President.  The Asians must view his re-election good for America, but bad for China, Japan and the other foreign central banks that will buy any and all dollars the Fed will print.  The Asians may help keep the dollar shortage alive, and urge the Fed to print more!  The United States only owe's the rest of the world $2.3 Trillion on a net basis.  In just a few short years, the Chinese and Japanese have moved all of their factories out of the US to Asia; they also might have accumulated enough dollar assets to buy America.  Besides, in a world friendly to Moral Hazard, everything is for sale! Perhaps some day the US will have a Federal Reserve Chairman who is appointed by a President who cares about US National Security.

You might notice that the New Economic Model is designed for speculators and a world dominated by leveraged finance. It’s a lousy model for middle class workers, who might want to save for retirement and a rainy day.  Why?  Asset prices fluctuate.  The Fed doesn’t have total control.  Indeed, the Fed announcing they are coming in with printing presses at full tilt may mean they are close to having their model wobble wildly out of control.  Stocks can only be held at double to ten times fair value for so long.  Housing prices will have their crash.  Speculators have to be nimble to grab other people’s money.  At least Greenspan has promised savers they will be robbed by inflation or by taking wild risks.

 The problem with running an economic model based on Moral Hazard and greed is that while the Fed will finance every loan or debt when it is first written, our recent experience has shown that there is such a high level of fraud, bogus accounting, and Wall Street Spin, it threatens the financial system. However, according to the Fed, any threat to the financial system is good news because it justifies more Fed easing!  See how important Moral Hazard is as a policy tool!  Where would the Fed be without it?  Indeed, as long as money remains virtually free and easy, “The Wages of Sin Remain Extraordinarily Good” at least for Wall Street speculators.  However, the markets can have very big “air pockets” and individual firms and loans can suddenly vanish overnight.  When the Federal Reserve makes money a free good (like air and water) a lot of people want to grab as much as they can for as long as they can.  Maybe the people are just human, and The Fed wants to prove it’s God. The Punch Bowl is back.  The Fed Chairman wants to make sure the markets don’t sober up on his watch!

Lets’ all welcome back Mr. Moral Hazard for another encore performance!

-- Posted Thursday, 15 May 2003 | Digg This Article