Moral Hazard
Here we go again
Note to readers: The story of the Tsinghshan hedge trade on the LME, described at the bottom of this post, is still very much a story in progress. I will periodically update the archived version of this post with links to more news stories as they break, but I will not revise the original text.
In my Financial Services course, we have just completed our insurance module and we will soon move into our study of the 2008 global financial crisis. One of the themes common to both course modules is that of moral hazard, the phenomenon by which the existence of insurance or third-party reimbursement of financial losses tends to incentivize risk taking activity, which in turn increases the probability or magnitude of such financial losses.
In the insurance industry, the availability of subsidized flood insurance incentivizes the construction of homes in flood-prone areas. In the financial services industry, the precedent set by government bailouts may incentivize firms to take more risk in the future, knowing that the profits from good outcomes will flow to themselves while the costs of extremely bad outcomes may be offloaded to taxpayers or others. Even Fed monetary policy can have moral hazard implications, as with the so-called Greenspan put and the subsequent adoption of quantitative easing in response to the financial crisis and the covid pandemic.
I have been thinking about moral hazard recently, most notably as a result of Russia’s invasion of Ukraine and the imposition of international economic sanctions which threaten to destroy the Russian economy and destabilize the global economy in ways that have yet to become fully apparent. But what does the Russian invasion of Ukraine have to do with moral hazard?
Well, at one level very little. International financial support for Ukraine following the invasion would not be a good example of moral hazard. The actions of Ukraine did not cause the Russian invasion and no other country currently in Russia’s sights is likely to risk provoking Putin’s ire because of the possibility of subsequent international aid. And the vast majority of firms and individuals that will suffer from the war and international sanctions, including those in Russia, played no role in facilitating Putin’s actions and did not behave irresponsibly in reliance on the possibility of getting bailed out down the road. And so moral hazard may not seem to be playing much of a role here.
But is this entirely true?
Consider first the many firms and financial institutions who deliberately chose to do business with Russia, and in some cases directly with Putin and his cronies, despite the obvious risks of doing so. Some of these folks made a lot of money doing business with Russia Inc over many years. But the game has now changed and many of these firms have announced that they are closing their Russian operations, for the time being at least. The financial consequences to these firms will some cases be substantial, as with certain multinational oil companies and European banks. It should go without saying that these Russia-related losses will be borne fully by the firms that incurred them, without the prospect of any sort of public support. No bailouts, no moral hazard. Simple enough.
Now consider those firms who perhaps more responsibly chose not to do business with Russia in the first place, but who will nevertheless suffer significant financial harm as a result of the war and its aftermath. Putin’s invasion of Ukraine has triggered economic sanctions which will devastate the Russian economy and disrupt global trade in critical commodities. The war has already fueled big increases in commodity prices and extreme volatility in the financial markets. And the consequences are being felt across the world by business firms, financial institutions and individuals who did not consciously take on Russia risk and may be unprepared or unable to absorb the resulting losses. Here the case for some kind of public support might seem to be stronger, with fewer obvious moral hazard concerns. But is this correct?
In discussing moral hazard, we often ask whether and to what extent specific actions of excessive risk taking contributed causally to the particular events which triggered the financial losses. In the financial crisis example, bailout expectations by banks might well have contributed to excessive risk taking across the banking industry—risky and illiquid trading positions, high financial leverage, reliance on short-term funding, trading in complex and opaque derivatives, etc—which in turn generated systemic risk and triggered the failure of several large banks and financial institutions. This is a classic (and very real) example of moral hazard in action.
Contrast this, however, with the covid pandemic—where expectations of a supportive public policy response did not contribute in any way to the incurrence or spread of the virus and will not likely do so in the future. And so the public policy response to covid would not seem to be a good example of moral hazard. But is this entirely correct?
Let me challenge this limited view of moral hazard in the covid example. I do not believe that the public policy response to covid has contributed in any significant way to a reduction in responsible risk management practices with regard to future public health emergencies, although this is not really my area of expertise and perhaps I am missing something. But in the financial realm, I have no doubt that the actions of the Fed and the Treasury in response to the covid pandemic—flooding the economy with cash, driving down interest rates to zero, purchasing trillions of dollars of UST bonds, extending cheap or forgivable loans to businesses regardless of credit quality, and sending out all those stimmy checks—contributed directly and significantly to increased risk appetite among investors, companies and the general population. Think about meme stocks, cryptocurrencies and more importantly the “great resignation”. None of this would likely have happened but for the covid bailouts and a big boom in the stock market.
Please do not misunderstand me. I am not saying that these covid relief programs were unwarranted. Some of them may have been misguided, excessive, or implemented poorly, but that is not my point either. My point is that many of these programs were financial “bailouts” in some sense, warranted or not, and they had clearly foreseeable and material impacts on risk appetite in the capital markets and in the real economy. And the resulting post-bailout “risk on” attitudes of economic decision makers likely contributed significantly to the vulnerable state of the global economy and financial markets in the run-up to the Ukraine war.
Over the past several decades we have all become accustomed to the benefits of a generally peaceful post-Cold War world and a benign globally interconnected economy with low interest rates, low labor costs, low energy and commodity prices, low inflation, reliable supply chains and just in time delivery. And we have also become reliant on the safety net of government bailouts of various sorts when things go badly wrong, as they inevitably do from time to time. As a result many of us have become somewhat immune to the financial consequences of risk in its various manifestations and we have let lapse some pretty basic risk management practices. We have speculated excessively in the stock market; we have run some of our most critical businesses with vulnerable supply chains, large amounts of financial leverage and too little liquidity; we have purchased incredible quantities of ever cheaper consumer goods at Walmart and Costco, driving many miles to get there in our gas guzzling pick-up trucks and SUVs; and we have financed it all with unprecedented amounts of government largess, public debt and money printed by the world’s central banks.
If this sounds like a political rant, please forgive me; it was not meant to be. I am trying to make a serious point here, which is that we have all become increasingly vulnerable to “stuff happening” across the world, of which Russia’s invasion of Ukraine is only the latest example. Our vulnerability is the direct result of deliberate choices that we have all made over many decades—as consumers, investors, business executives, voters and elected leaders.. And so perhaps even those of us who consider ourselves generally prudent risk takers may have some culpability for the precarious situation in which we all now find ourselves, reliant on cheap money and critical supplies from unpredictable and irresponsible regimes like Putin’s Russia.
Now, back to the financial news.
Today’s blog post was triggered by a story in Friday’s WSJ by James Mackinstosh, who reported on a great example of moral hazard in action at the London Metals Exchange. The story involves a large Chinese nickel producer, Tsingshan, which last week faced $8bn in paper losses and a $1bn cash margin call on its large nickel futures trading position at the LME. Tsingshan was engaged in hedging the price of nickel produced in its own operations, not in speculative trading per se. But Tsingshan executed its hedging strategy in the futures market, which entailed substantial leverage and basis risk between the quality of its own nickel production and that of the physical delivery requirements of the futures contracts it was trading. And Tsingshan took on its large positions without sufficient cash on hand to meet the potential margin calls which would be imposed by the LME in the event of an unusual increase in the price of nickel futures.
Tsingshan was caught short when the price of nickel futures traded on the LME unexpectedly doubled in a matter of hours in response to the impact of the war (Russia is a major producer and exporter of nickel). Had Tsingshan not been able to meet its margin call it would have been in deep financial trouble, taking down with it a number of LME brokerage firms who did not have enough capital to absorb the losses incurred from trading with this one large and highly leveraged customer. In the end Tsingshan was able to raise bank funding and solicit commercial support to meet its margin calls, resolving the problem at its end. But before this happened, the LME had to make a real time decision on how to keep things from spiraling out of control on the exchange itself.
So what did the LME decide to do? It decided to halt trading on the exchange, a reasonable and not uncommon response to extreme market volatility. But it also decided retroactively to cancel all of the previous trades which had generated the large loss for Tsingshan and its brokers. Yes you read that right. The LME retroactively cancelled all the previous trades. This reversed the losses for Tsingshan but also wiped out the profits earned by Tsingshan’s trading counter-parties, who had risked their own capital providing liquidity in the market. Tsingshan and its brokers were let off the hook financially, but only because the LME decided to take the money out of the pockets of those on the other side of the trades. Needless to say, this is not how things are meant to work in the capital markets.
So how did the LME justify its decision to cancel the trades retroactively? Here is what LME Chief Executive Matthew Chamberlain said publicly: “Clearly these are unprecedented times and they have called for us to take action we would not wish to have taken…. We faced a choice between ensuring the overall and longer-term financial stability of the market, and the shorter-term trading profits of those participants who had traded on Tuesday morning.”
But isn’t this is how all financial bailouts are rationalized, however ill-advised they may be? No one in a position of authority ever says “We bailed out these firms because they were big and powerful and we got scared and panicked.” Instead the argument is always “We had to bail out these firms despite their irresponsible or even reckless behavior, because our failure to do so could have brought down the entire system.” If you doubt me, please watch again the film version of Too Big to Fail.
The particular circumstances which generate bailouts are always described as “unprecedented”, which is often not true and which does not in any case justify the use of taxpayer money to rescue private firms from the consequences of their own financial folly. I have no doubt that a doubling of the nickel price on the LME in a matter of hours was highly unusual, although I doubt it was truly unprecedented. And it should not have been entirely unexpected either, at least not two weeks after Putin invaded Russia and a week after international sanctions were imposed on Russia. Both Tsingshan and the LME should perhaps have seen this coming and begun preparing for it before the proverbial s—t hit the fan, particularly given the size of Tsingshan’s leveraged position and the limited amounts of capital employed by LME brokerage firms.
“Moral hazard is something I take very seriously”, said US Treasury Secretary Hank Paulson during the 2008 financial crisis. And so should we all. But when the US government decided not to bail out Lehman, chaos ensued, threatening to bring down a number of large financial institutions and with them the entire global financial system. Twelve years later when the economy tanked during covid, in the worst economic contraction since the Great Depression, the government bailed us out and the economy and the markets quickly rallied to new heights. And when Tsingshan’s large hedge position went bad, the LME decided retroactively to cancel the trades, letting one big customer and several brokerage firms off the hook but sticking others with the bill.
Unfortunately, the lesson that many of us will take away from these experiences is not that moral hazard is corrosive and bailouts are to be avoided, but that we can rely on governments and regulatory authorities to have our backs when times get really bad and our risk positions move against us.
And so we are where we are—in a truly bad spot with the Ukraine war raging on to no apparent end, a major humanitarian disaster unfolding by the hour, and the global economy in serious trouble And although we rightly blame Putin for invading Ukraine, we should also perhaps take another look in the mirror. We too contributed to the vulnerable state in which we all find ourselves today.
Moral hazard, here we go again.
Links:
The Moral Hazards from the Nickel Market Disaster, James Macintosh, WSJ, March 10, 2022
Tsingshan and its Banks Agree Nickel Hedge Standstill, WSJ, March 14, 2022