The Genie in the Bond Market

Economists and insurers like mathematical models. Nothing gets their glee going like predictability. People, on the other hand, are to math what ice dancing is to show ponies. (Don't look for a relationship, because there isn't one.)

In college, I - along with other aspiring financiers, arbitrageurs and general good for nothings - learned about moral hazard. To wit: the idea that a person who has bought insurance will behave more riskily than he otherwise would because he has insurance. It's a common problem in insurance circles.

Oddly enough, it's also a common problem in life. Once you buy into the system and stand to make a profit if you cheat the system, why not cheat? (Maybe you have ethical qualms about cheating. That's why you don't work in finance.)

Back in the late 1990s, a group of itinerant Harvard professors and a few Nobel laureates came up with the "Efficient Market Hypothesis." EMH was just about the worst thing to come out of Chicago since the winter weather report. The economists could hardly have been more excited than if they'd gotten elephants to tap dance, which in fact might have been less risky than what they proceeded to do. Several prominent economists left academia (and there's a reason that UChicago squirrels these folks away far, far from the real world) and started managing billions and billions of dollars using EMH.

The greatest drawback to EMH was that it was didn't work in the real world. The economists found this out to their chagrin when they started a hedge fund, made spectacular returns, leveraged themselves into the year 2050, and lost their shirts (as well as the shirts of everyone else involved.)

At the time, the Fed organized a bailout worth about $3 billion, which while staggering doesn't even approximate the current U.S. debt. But this was during the Clinton adminstration, salad years for the national account. The only real problem was the risk of moral hazard. After all, if the Fed started bailing out hedge funds, where would the trail end? And what, oh what, about moral hazard, the tragic effluvium of human nature injected into this otherwise perfect soup?

Why does this matter now that Long Term Capital Management (the failed hedge fund) has come and gone? Here's a fun fact. After engaging in some of the riskiest behavior in the (admittedly short!) memory of modern finance, one would expect the partners from LTCM to go into quiet retirement, perhaps give up a golf membership or two to show solidarity with the people they let down.

Ha! Promptly on the heels of liquidating one near national disaster, the partners at Long Term went onto to start another hedge fund, identical to the first. All the same people signed up as partners, they even kept their fancy Greenwich offices. Now, JWM Partners manages nearly $3 billion in assets, roughly the amount of the bailout less than a decade ago. Sure, somewhere, someone went crying into a world of pain. But it certainly wasn't the traders at Long Term, even though their failure was (odd as this may sound) their own fault.

But why pick at these bones? I say this on the eve of another momentous bailout, the Treasury bailout of Fannie and Freddie, those twins of leveraged tragedy. The fears are the same: letting Fannie and Freddie bite the dust will send the entire housing sector and indeed the entire American economy and then the world economy and then the known universe into a blazing nova.

Pardon. But. Remember how, at the bottom of it all, these things are always someone's fault? And the heads at Fan and Fred will go blue in the face talking about how they they didn't take on unnecessary risk, and how it wasn't their fault that short-term money failed, and that they had no one to unload their long securitions upon. They might even tell you that they weren't trading subprime securities, and maybe they weren't.

But somebody was. Where is that somebody now? Greenwich? New York? Where will that somebody be in ten years, when the US capital account has gone the way of a deflated Whoopie cushion?

Moral hazard, indeed.