Moral Hazard & Systemic Risk

Either it is intended or unintended consequence, as early as the intervention in Bear Stearns, now it has created an expectation as market participants are expecting a government bailout as it fails under current market forces. Lehman Brothers was able to maintain short-term borrowings, and the series of bail-out including Citigroup, hence the over-concentration of these borrowings in the Reserve Fund has led to its ‘breaking the buck’ and that may once again prompt unnecessary systemic panic in money markets.

The intervention may reduce the CDS spread, and it is not surprising given the role of the government in reducing risks faced by the creditors as well as equity holders, but the risks now are assumed by the government and the potential blow-out in government finances can be long term and systemic.

Short-term, the news may spark a rally in financials and the sustainability of this rally will depend on expectations that Fed policy will be easier for longer. Risk is that Fed is rapidly expanding its balance sheet in a form of quantitative easing without a good match from traditional Keynesian stimulus, which essentially will reduce the effectiveness in turning around the economy.

Without that part of the equation, the amount of excess reserves at the Fed will continue to rise and that will neutralize faster-than-expected earlier works to jump start the economy. Under normal circumstances, the amount of excess reserves at the Fed is roughly US$5-10bn, but last week the excess reserves were US$634bn and it would not be surprised if it hits above US$1.5trn and removal of these excesses could potentially take more than 5 months.

The massive amount of quantitative easing, while is not a major concern now, it is likely create periodic waves of concern over inflation in the market and would force players to take shelter at shorter duration for Treasury hedges. It may defeat the purpose in driving business investment intent towards longer tenure of Treasury and commercial papers. The underlying issues have not changed. So far, we are only seeing Fed err on the side of caution, add slightly to many reserves and merely renting its balance sheet space to other financial institutions while it continues to lose money (subsidizing) in a negative carry trade.
Fed should not assume that it has unlimited access to financing and capital raising ability.