Greenspan on Moral Hazard

Posted by urbandigs

Sun Nov 7th, 2010 09:07 AM

A: I haven't linked out to Yves Naked Capitalism in a while, and this felt like a good opportunity. Although I found this link on NC, it was originally published on Washington's Blog.

Via Washington's Blog, "Even Greenspan Admits that Moral Hazard and Fraud are the Main Problems", (hat tip Naked Capitalism):

Specifically, Greenspan said today in a panel discussion at a Fed conference in Jekyll Island, Georgia (where the plans to form the Fed were originally hatched):

Banks operated with less capital because of an assumption they would be rescued by the government, he said. Lehman Brothers Holdings Inc. wouldn't have failed with adequate capital, he said. "Rampant fraud" was also an issue, he said.

Lack of Trust

"Fraud creates very considerable instability in competitive markets," Greenspan said. "If you cannot trust your counterparties, it would not work."
Its funny how Greenspan's conference was on Jekyill Island, home of the so called secret meeting that ultimately created the Federal Reserve. There is a lot of truth in these statements from the former fed chief. Dick Fuld had chances to raise capital, and he and/or his team made pure bets when they loaded up on CMBS prior to failing. I'm highly confident that they were sure the fed would NEVER let them fail; they were wrong and many people call this the biggest mistake of the crisis - I call it one of the better plays of the crisis and something that had to occur. Even with Lehman failing, the world did not end. The problem is that only 2 years later, it seems as if the fed & the gov are guaranteeing everything and that no big firm would ever be allowed to fail again.

The article continues:
"As leading economist Anna Schwartz, co-author of the leading book on the Great Depression with Milton Friedman, told the Wall Street journal in 2008: The Fed ... has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."


Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement."
Now this was 2 years ago, so you have to go back into time & place when reading these statements. It was a solvency issue back then, that became a liquidity issue when no financial firm trusted which counterparty was about to go bust and who held the most trash on their balance sheets. Today, the market DOES know how to value the toxic crap that is still being held and hidden on and off banks balance sheets, but there is no trade at these levels. As Barry Ritholtz likes to say, there are no toxic assets only toxic prices. I guess this can apply to mis-marked bank assets too.

Given the fed engineered carry trade and bank recapitalization environment, why would banks sell at low bids when they can chip away and carry trade their toxic assets closer to the reflating bids with time? Think about it. If the bank carries an illiquid toxic bond at 50, when the bid is 20, why not carry trade and make $10 a year for 3 or 4 years and write down the asset a little bit more each time around, while still being able to show a profit; or minimal loss. As long as the environment doesn't change, and the fed made it clear it won't, in time you would have written the illiquid toxic bond down to market. So, the buyer raises the bid to 25, and 30, but the bank still doesn't sell. Food for thought.