Moral hazard argument can be hazardous to your health - more investors question governments will never let their largest banks fail

From Shahriar Shahida, Chief Investment Officer, Constellation Capital Management LLC, New York. This article is a reflection on the current dislocation in the credit markets and the danger of moral hazard as the government deals with this crisis.

Emerging markets investors are no strangers to the pitfalls of investment themes that are merely based on Moral Hazard. This is primarily due to the fact that the decisions by the international community to provide bailouts for sovereign nations have been highly erratic and unpredictable. Mexico, South Korea and Turkey made the cut, but Russia did not. The havoc that surrounded these financial crises has been well documented. The good news, at least for the time being, is that as a result of this baptism by fire, investors in the emerging market debt have learned not to blindly base their investment decisions on the song and prayer that sovereign states will always be bailed out by their richer friends.

Unfortunately, this valuable lesson has fallen mostly on deaf ears as it relates to investment in debt obligations of the largest financial institutions in G7 countries. This perceived insulation from the risk of default of a large financial institution, may well be one of the main factors contributing to the current credit crises. This zealous belief in the moral hazard of a large bank failure, led many investors to conclude that the probability of such an event is close to nil, and as such, as early as Spring of 2007, most of the members of the “too big to fail” club were able to feast on the generosity of their respective investors by issuing billions of dollars senior as well as subordinated debt at or close to LIBOR. What’s more fascinating is that investors barely differentiated between senior and subordinated debt. In so doing, they accepted a mere ten basis point spread for buying five year subordinated, as opposed to, senior debt.

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Moral hazard argument can be hazardous to your health