Moral Hazard

Just like in 1998 with the Long Term Capital Management bailout, central bankers have recently shown a willingness to intervene in the financial markets during downturns. And just like in 1998, the result will be the creation of a moral hazard. Based on what happened in 1998, the following sequence of events should happen:

  1. high volatility decline in the equities markets / acute levels of fear and panic far above baseline
  2. a turning point where the Street concludes that the Fed will save the day
  3. furious rally follows
  4. the moral hazard created from bailing out poor decision makers results in even poorer decisions in the next couple of years
  5. mania sets in
  6. blowoff top
  7. tough love from the market

I firmly believe that the excesses of the markets from late 1998 till early 2000 were the result of the moral hazard created by the 1998 LTCM bailout. Markets need poor decision makers to fail in order to work properly. It's part of the process. Those who take excessive risk and engage in reckless speculation should suffer the consequences. Else, the ones who are wise suffer. And when the wise suffer, perverse incentives are created and everyone suffers.

Larry Kudlow said last night...

I have come to believe now the Federal Reserve should be pumping in tens of billions of additional cash into the economy right away. The bond market and the credit freeze-up are telling the Fed to ease...It's time for the Fed to start doing what the Europeans are doing and the Canadians are doing. Let them take more collateral as they pump in more reserves. I want them to buy subprime mortgages, I want them to buy jumbo mortgage loans. I want them to buy asset-based commercial paper so good healthy commercial credit-worthy banks and lenders don't get crushed as the baby is thrown out wit the bath water

...once again proving that if there are no atheists in foxholes, there are very few free marketeers in market downturns.

I believe today we're at or very close to step #2. In 1998, I owned puts when the Fed saved the day. Today I know better. The Fed once more play the part of heroes. There's blood in them streets. This is the time to wade into the darkness. This is the time to be a contrarian. This is the time to grows balls of steel and ride the coming moral hazard tidal wave.

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dang skippy

Couldn't have said it better myself. The perpetually escalating moral hazard created by the Fed is going to eventually lead to a possibly catastrophic collapse of this whole system they've built on artificial and distorted signals. Not good.