Whatever Happened to Moral Hazard?
"...If you thought the bond market couldn't get any crazier, you haven't seen the price of East European junk today..."
"It was risky," says a junk-bond lover in London. He was telling Bloomberg about the day he lost 30% on his bonds in Kremikovtzi AD.
The Bulgarian steelmaker said last month it would post a loss for the year. "Investors were alarmed," report Sebastian Boyd and John Glover for the newswire - no doubt with a straight face. For when Merrill Lynch first sold Kremikovtzi bonds worth $427 million last April, the company forecast a $34 million profit.
"People thought they were getting paid for the risk," the poor fund manager goes on. Or rather, he thought he would get paid for the risk. The finest minds on Wall Street and in the City just picked up $40 billion in year-end bonuses between them.
His investors, on the other hand...what are they getting paid for the risk? Not much, as it happens. But the game must go on all the same. Right up until it stops.
Junk bonds in Europe, according to Merrill Lynch's own data, now yield just 2.3 percentage points more than government debt. Back in 2001, the gap was 16.5%. Junk bonds only one grade above default now pay just 4.6 percentage points more than government debt. Six years ago the gap was 42% wide.
But who cares about words like default or risk? "Investors are clamoring for junk bonds," reports Bloomberg. They've got to get yield from somewhere, remember. "Sales of the lowest-rated [European] debt jumped 45 percent in the past year [while] investors poured a net €1.7 billion into high-yield corporate bond funds, double the €864 million in 2005."
"People are having to go further and further down the ratings scale to get yield," says our junk-loving friend. A bond manager at Insight Investment Management in London, he runs $94 billion in assets. And with everyone rushing into Eastern Europe in the search for yield, each Dollar he puts into junk only helps to push prices higher, sending yields lower, pushing him another step down the ratings scale in search of return.
This, in a nutshell, is moral hazard at work in the financial markets today. You might remember the phrase from when Sir Alan of Greenspan backed the bail-out of Mexico's Peso Crisis...then the Asian Debt Crisis...and then the Long Term Capital Management Crisis.
Save one crazy risk-taker, went the theory, and everyone will expect you to bail them all out. In the 21st century, the "Greenspan Put" has worked to push all assets higher by slashing interest rates - at the US Fed, at the Bank of England, the ECB and the Bank of Japan. If prices turn lower, everyone thinks, interest rates will fall again. Soon. To stop prices falling. Which they can't, of course, because of all this cheap money.
Independent Strategy, a London-based consultancy, picks up the story:
"The bond markets assume that any increase in yields (= fall in bond prices = rise in the long-term cost of capital) will be of short duration, because that event would rapidly produce enough deflation in both asset and transaction prices [i.e. stocks and consumer prices] to make yields fall below where they are now. Central bankers would do their damnedest to make this happen too."
Any risk is worth it, in other words - even junk bonds on the verge of default paying only bank rate above Treasuries - just so long as the risk never shows up. The world's monetary masters will wash away any problems. In fact, they're hosing the markets like crazy already!
You will recall that Amaranth Advisors, the Calgary hedge fund that blew up last August, lost $5 billion on its natural gas derivatives. Yet no one blinked. The Federal Reserve had struggled to pump much less than that into the US financial system when Long Term Capital Management went south eight years before. But liquidity now washes around so freely, who cares if a little cheap money splashes over the side and gets everyone's boots wet? Come on in, the water's lovely.
The 1998 collapse of LTCM, notes one short history of the affair, "threatened to bring about widespread systemic failure. A consortium of US-led international banks collaborated in rescuing [it], but at the peril of reinforcing the 'too-big-to-fail' moral hazard which might encourage other large financial institutions to be tempted into over-risky business."
But that history was written five years ago, however, and a half-decade is a long time in Quantum Finance - the 21st century science of making money appear out of nowhere. The peril of rogue traders risking too much on derivatives...or buying junk bonds in Bulgarian steel mills...is no peril at all. Not with worldwide derivative contracts totaling $340 trillion, a massive 802% of the world's annual economic output. Not with the global market in bonds and other securitized debt worth $59 trillion. The system's too big to fail, right up until it does.
According to data from the Bank for International Settlements, it would take more than 110% of all the money in the world to settle those bonds in cash today. Derivatives outweigh official national currencies more than six times over! But money, whether it's a Federal Reserve note, free credit online or gold under your bed, doesn't come into it anymore. Not now that risk-free money can be magicked out of a Bulgarian steel mill on the verge of bankruptcy.
"Bibbi-di bobbi-di boo!" as the Fairy Godmother says.
And if your prime brokers get nervous about all those new CDOs, CLOs or CPDOs you want to sell off the back of the junk bonds you've bought, just keep selling the Yen instead. The carry trade never carried so much so lightly. The Bank of Japan's zero interest rate policy has been the greatest liquidity pump in the history of the world.
Yes, Tokyo's interbank lending rate may have risen to all of 0.75% per year, but the Yen still looks and smells just like free money to any professional investor with enough sense to short it.
Meantime, across the Pacific, the moral hazard of expecting the US Federal Reserve to bail out every last risk has come to underwrite both the stock and bond markets. "Yields are now so low on most assets," Independent Strategy goes on, "that the only reason to invest (and forego current consumption to do so) is if asset prices inflate further. That needs more and more liquidity to buy the existing stock of assets at ever higher prices.
"This is the logic of the US Treasury market. As the bond market sets the pricing of much of long-term capital and is thus the water well at which all other asset bubbles drink, this logic is self-fulfilling: it is true for as long as it is true."
In short, the "Fed Model" of pricing equities - developed in the early 1990s to make schmucks buy stocks every time bond prices rose - has ceased to be theory. Stocks must go up when bond yields go down, because all that free money from Japan has to go somewhere. It's become an immutable law of the universe, defying gravity, bending light and turning pumpkins into horse-drawn carriages all at the same time.
Quantum Finance, in fact. And as Independent Strategy says, it will prove true for as long it proves true. Right up until it doesn't.