The Weekly Report

By: Mick P | Sun, May 4, 2008
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Welcome to the Weekly Report. This week we look at moral hazard and I show you how it's about to unleash forces that no Central Bank or Government can control and we look at next weeks trend indicators and targets.

I have spoken about moral hazard before, especially in relation to the current actions carried out by the Federal Reserve and the Bank of England after the bailouts of Bear Stearns and Northern Rock. To avoid moral hazard arising, strict controls have to be placed upon the facilities that are created and the use of the assets supplied from those facilities. A failure to control the results of centralist intervention will encourage the very behaviour that caused the original problem.

Let me be blunt. There is no risk to the financial sector that is so great that could justify invoking a moral hazard. If a bunch of banks and investment houses collapsed under the strain of unserviceable debt or losses so great that creditors required compensation, so be it. The pain would be enormous and the recession deep but the US economy and importantly the US financial sector would re-emerge stronger, leaner and fitter than at any time since WW2.

As we know such an event will not be allowed to happen, the Fed and the US Govt are working together to ensure that credit markets at least allow maturing debt to be rolled over, giving time to the banks and investment houses to rebuild their capital reserves. It is a 2 pronged attack, the Fed keeps the banks functioning and the US Govt drops money directly onto consumers in an effort to encourage spending or re-finance mortgages that have become too burdensome. These measures have no time limit, they can be repeated and increased until the day occurs when banks tell the regulators "all is well".

The groundwork for an episode of moral hazard is laid out but not yet constructed as long as the facilities are controlled and the assets applied to the task at hand.

What would initiate construction? The loosening of control, the allowance of a facility to be used for a purpose other than its original intention would see the foundations poured. That loosening has now occurred.

The expansion of the Term Auction Facility comes as no surprise, it has been stepped up since its inception and will probably increase further. However the inevitable reaction to the Bear Stearns bailout has now occurred. The Term Securities Lending Facility has been expanded to allow an increase of lower rated asset backed debt beyond commercial and residential mortgage backed debt.

A reminder:

Quite right too, the swapping of assets on a 1 to 1 basis if they had equal price would not affect reserve levels. Ahh you see the hole in that argument too? In fact there are 2 holes, firstly the assets swapped are not equally priced, "program eligible collateral" is only swapped because it is useless. With no one willing to accept it as collateral on lending there is no choice but to use the TSLF. In other words assets that should be priced at zero (thus lowering reserves) are swapped for fully priced assets. Only by refusing to mark to market does the Fed assertion of no increase in reserves ring true. Secondly it is this refusal to mark to market, allowing the TSLF to operate as a Conduit /SIV where toxic debt is parked to take it off the balance sheet that is allowing a moral hazard to occur.

The expansion of eligible collateral is a step into a minefield. "Primary dealers may now pledge AAA/Aaa-rated asset-backed securities". The worry is that this new collateral is not secured on a physical asset, ABS is a complex structure of intertwined pools of debt and receivable payments, grouped together and collateralized by cash flows from underlying assets. It is the mix and match of the various debt that allows the ABS to receive a rating which is normally higher than the underlying debt would achieve alone.

Security is a misnomer in the world of derivatives. We now face a situation were Primary Dealers are expanding their borrowings using top rated debt that has been swapped for debt that could (and is) reliant on credit card debt, unsecured loans, auto loans and even private revenues from ventures. This will now allow an expansion of Dealers activities beyond the rolling over of maturing debt.

The TLSF was not "sold" to the financial world and the public as an investment vehicle, it was advertised as a method to "promote liquidity in the financing markets for Treasury and other collateral and thus foster the functioning of financial markets more generally." Nowhere do I see the words expand, replace or reinvigorate. This is an extraordinary facility introduced to allow the market to function because of this:

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Mick P

Author: Mick P

Mick P (Collection Agency)
About Collection Agency

An Occasional Letter From The Collection Agency in association with Live Charts UK.

For some years now I have written an ongoing letter, using macro-economics, to try and peer into the economic future 6 to 18 months ahead. The letter was posted on a financial bulletin board to allow others discuss its topic.The letter contains no recommendations to buy or sell, indeed I leave that to all the other letters out there and to the readers own judgement. The letter is designed to make us all think about what may be coming, what macro trends are occurring and how that will affect future trends and how those trends will filter down to everyday life and help spot weak or strong areas to focus on for trading or investing.

To contact Michael or discuss the letters topic E Mail mickp@livecharts.co.uk.

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