Moral Hazard in the financial land of OZ

Moral Hazard in the Financial Land of Oz or,
How a frog got boiled slowly


Moral hazard is defined as: “ when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk”.
You may ask: what does this have to do with the second title in the heading?

Well, I remember from my biology class this experiment (and this experiment should be part of every MBA program to illustrate moral hazard)
A frog immersed in a hot pot of water, will jump out as its senses indicate the contrast and hence danger of the hot or boiling water—the frog’s senses serve as a protective mechanism.
A frog immersed in a cool pot of water will remain in this pot even if the water reaches boiling point—the protective mechanism we talked about earlier failed. The mechanism could not distinguish a contrast, as the water warming gradually did not trigger the protective mechanism—fatal for the frog.

Currently, this hazard is starkly illuminated in the Goldman Sachs (GS) situation, he bank bailouts, the rating agencies and their AAA ratings of junk, the Euro-zone country debt issues. There are likely to be more (take derivatives for example). I will say more on that later.


The principal issue is that in all cases agents have acted as though risks where minimal, minimized, or non-existent.
GS hedged their exposure against what is now a junk CDO market. Rating Agencies have manipulated their assessments (massaged is the more sexy term) until a cheesy bond, CDO, or other debt instrument looked like a bearer bond with interest on steroids. Countries, assuming their bigger, more solvent and financially prudent brothers—Germany, France—would bail them out. The banking crisis of course has shown what happens there.
This raises the following questions:

1. Are banks too big too fail?
2. Are country economies too big to fail?
3. Has anyone defined Fail?
4. Has moral hazard been addressed?

1. Banks are not too big to fail. Letting them fail and then recreating some similar functioning entity—without the debt burden—in my view now would reduce moral hazard. Or the bank is nationalized with debt write-off of toxic assets
The prime example of this is the incredible profitability of some banks shortly after the banking crisis, which could lead a bank to assume things are back to normal. But normal was what lead to the banking crisis.
Letting banks fail—no matter what size—would send the message of: “take excessive risk and you may fail!”


2. Country economies have always taken some options such as devaluation, default, and other mechanisms to extricate from debt servicing problems.
The issue in the Euro-Zone is primarily that some countries did not manage their budget very well (in some cases they may have concealed or dressed up the problem) and now the day of reckoning has come.
Greece as the first country needing action has the option of defaulting, which would affect its credit rating to raise debt and, ultimately would be forced to spend less.
A rescue plan would simply increase the moral hazard of spendthrift—the legal remedy is of course declaring bankruptcy.
A devaluation of the currency would have a similar effect, as imports would now decline and exports for trade purposes become more attractive—painful if you want to buy a BMW but eating Kalamata olives would still work. The problem is Greece does not buy in Drachmas anymore so the problem can be solved only through default.

3. Failure, if we use the Frog analogy, can and likely has occurred before we realize what is failure. In other words because we ignore moral hazard for all sorts of reasons (Greed, ignorance, false assumptions…) the system is failing well before it breaks down.
Hence a way to determine or highlight failing parts of financial systems may give us the warning signs before all hell breaks loose.

4. Has Moral hazard been addressed in the scenarios mentioned. He answer right now is a resounding NO!

Post 9/11 is the border really more secure? Border security is a myth!

Border Insecurity Part I:

In 2005, I traveled on company business to Seattle. At that time I was an Australian Citizen, who was a landed immigrant in Canada. As part of entering US space, I was given a Visa Waiver, was photographed, and fingerprinted. On my return I was to surrender the little green card to a Canadian customs officer.
On my return I was waved through the checkpoint and I forgot to stop and hand this little piece of paper back. I did not receive a phone call or other message urging me to surrender this piece of paper.
In 2006, I repeated the trip but was now a Canadian citizen entering US space. I was not questioned about my whereabouts during 2005 and early 2006; technically I had not reported leaving the US, which was due to my lack of diligence with respect to the little green paper in my Australian passport.
In November of 2006, we (my family) did a road trip to California, and it was only then that the now offending Visa Waiver caused me to laugh, and cry.
The US officer at the border told me I had to supply all manner of documentation to demonstrate I had left the US as stated on the Visa Waiver. This I did.
This of course was an absurd way of solving things:
Here are the absurdities:
I had left the US twice already: in 2005 and 2006; remember to get into a country you must have left it!
I was not stopped in 2006 to explain my lack of due diligence on the paperwork—the only reason that this came to a head was the officer seeing the offending piece of paper in my passport.
the documentation I had to provide could have been manipulated by an associate in Canada to indicate my bogus presence
No follow-up or border alert was placed on my file to solve the issue—nobody raised issues with my poor paperwork.

Border Insecurity Part II:

Last June, I had to fly to Australia on urgent family business. I took a bottle of moisturizer, and a container of petroleum jelly, with me in a mandated zip-loc bag—the bottle was more than 100ml! The container of petroleum jelly was not. This bag was visually inspected in Vancouver, Los Angeles, Sydney, and on my return was inspected in Perth, Sydney and San Francisco.
It was only in San Francisco that I had to relinquish the offending items, because they exceeded size specs for containers.

This raised the questions:
How stringent are these luggage checks?
How much variation in adhering to rules is there? Not in San Francisco, but OK elsewhere?
If you have similar experiences of absurdity, of "catch 22",
e-mail me your experiences

Why should I bother to save Energy?

Why should we bother to save energy? What difference does it make? And why replacing some light bulbs may not make a difference!
First of all, I agree that global warming is man made. It is the developing nations, who are responsible, and only developing nations through their example can bring this worrisome trend under control.

When I read the suggestions of turn off the lights, if it’s yellow let it mellow, share a ride, dry your clothing in the sun…,
I am increasing depressed by the nagging conclusion: “This is not going make a dent in our greenhouse gas binge!
Most of the suggestions above, and many others by the way, are great suggestions for being energy frugal. Why won’t these make a difference?

Because most of our greenhouse gas generation (G3) is from transportation, energy extraction, and power generation.
If we wanted to shut down G3, then our economy would grind to a halt; never mind that we all would very quickly begin to starve, could not go to work, etc…

So if someone suggests to me to do the honorable thing again, I am going to walk away.

The debate’s focus on alternative energy is good, but the crux of our looming environmental crisis is our inability to curb our G3, as well as being able to substitute low emission energy generation.
It is good when we talk about electric cars. It is good when we talk conserving resources, the environment, keeping the environment clean, conserving animal and plant species. But if that electricity comes from coal, oil, LNG or any other fossil fuel that is bad, if we cannot capture CO2 effectively.

If we talk hydrogen generation and storage the solution must be with the end in mind: Will H2 creation and storage create more GG?

So by all means save energy, however it will not solve the problem of more and increasing CO2 —and other greenhouse gases—in the atmosphere.

Our governments need to put the hammer to the perceived idea a clean environment is not compatible with good economics. We must also find ways to have the current CO2 producers be economic producers when it comes to cleaning the environment.
For more provocative thoughts check out the website of the Rocky Mountain Institute
So what should governments do to curb the problem? And why government?