Thursday, May 18, 2006

Governor Kohn on the Fed and Risk Management.

A must read by Fed Governer Kohn on risk management in modern markets. He highlights the Fed's response to the stock market crash of 1987 and to the LTCM liquidity crisis of 1998. My favorite quote from the article is:

"Naturally, the Federal Reserve’s response to these crises also had several common elements. We publicly acknowledged that a crisis was under way, and through this recognition and our follow-up actions, we sought to reassure participants that we were doing what we could to limit the possible systemic effects on the economy. The hope was that such reassurance might encourage a return to risk-taking."

However, Governor Kohn admits as follows:

"A third principle is that the actions taken to prevent a crisis should not raise the odds of creating more problems in the future. In particular, the problem of moral hazard is a significant concern. If market participants begin to rely too much on regulators and central bankers to manage possible future crises, they may act in a way that has the effect of raising the risk of a financial crisis."

It's actually a remarkable speach. He states how capital markets have become exteremely important to the economy, thus, he argues, protecting them is vital. So my take on it is as follows: "Gordon Gecko" is out there in the market, playing with risky instruments such as derivatives. At first he's making a killing and all is well. Then there is a "market event", such as the Russian debt default, which leads to uncertainty about the credit worthiness of the counterparty and the price of the underlying asset. In such times of uncertainty, there is a flight to safety i.e. Gecko screams sell, sell, sell. However, other like-minded gamblers also scream sell, hence there is a problem with liquidty and the asset prices fall and credit may become unavailable. Because of the high leverage in Gordon's positions (perhaps 100 to 1 or more), there is not enough liquidity in the system to close all of his positions. In previous investing eras, Gordon and his bankers would "LOSE MONEY", and valuable lessons would be learned. However, since it is the Fed's job to "protect the market", the Fed floods the market with liquidity, credit is restored to the gamblers and all is well. Hence, there is this "moral hazard" of bailing out gamblers. Governor Kohn readily admits to the existence of the "Greenspan Put", and the potential moral hazards it creates. But alas, Governer Kohn argues it is safer to err on the side of bailing out the gamblers than the moral hazard this gamblers' insurance creates.

Greenspan Put


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