Moral Hazard's
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Moral Hazard's Lesser Known Twin
by Stephen Duneier
First published February 18, 2015
Remember when there was some concern that the bailouts that occurred amidst the financial crisis would result in moral hazard? Turns out, we needn't have worried, but it does beg the question, "Why didn't it?"
To review, moral hazard is defined as a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk. While this is a widely accepted definition, it's nonsensical. After all, if the costs are not borne by the party taking the "risk", then from their perspective no risk exists, undue or otherwise. If the potential for reward isn't simultaneously erased too, the risk / reward relationship becomes so extreme as to be irreconcilable. As a result, the rational decision maker must elect to take action. In fact, from this one participant's perspective, the only logical decision is to go all in. This describes what is meant by moral hazard. The moral hazard exists, because although it is the only logical choice for that participant, it is the wrong one for the greater good. The system as a whole is taking the undue risks.
Since for the most part, bailouts did occur without exacting any toll on the equity of those who were bailed out, it makes sense that it would encourage riskier behavior among investors going forward. However, this hypothesis requires that one essential assumption holds true. It must set a precedent, and the players must believe that it has. Therein lies the flaw in the expectation for moral hazard. At least in this case.
If instead of a crisis, just one company had run into trouble and was bailed out without any cost being borne by its equity holders, it would be inconceivable for moral hazard not to have arisen. However, so many bailouts were required thereby creating extreme stress for the system as a whole, and exposing the fragility of it all. In fact, it has created such hardship for the sovereign saviors that it calls into question the ability of the system to absorb any future cost, regardless of its desire to do so.
As a result of this combination of fragility and inability to backstop risk, rather than seeing the risk / reward relationship staying at the irreconcilable extreme that had favored risk taking, owners of wealth (aka capital) believe it has flipped to its polar opposite. By extension, the controllers of that wealth, namely CEOs, fund managers and allocators see it that way too. At least that’s what their behavior implies.
In other words, from each individual’s perspective, the potential cost associated with taking risk has skyrocketed to unimaginable levels, while the reward has collapsed to nearly zero. Therefore, it is only natural, in fact it is perfectly logical that these decision makers would elect not to take any risk. However, it is the wrong decision for the greater good. As a result, the system as a whole has almost no potential for reward, and ironically, that puts it all at risk.
Come to think of it, it sounds an awful lot like the definition of moral hazard, but from the end of the spectrum we rarely consider.
Incentivizing Inefficiency
Behaviors don’t just change on their own. They are a function of incentives. Shift the incentives, you’ll adjust the behavior. Since market price action is a reflection of behavior patterns en masse, it’s important for investors to recognize how incentive systems have changed.
Let’s begin with the shift from paying for performance to paying for administration. Prior to the financial crisis, the investment industry was in its heyday. New hedge funds were launching with hundreds of millions under management on a weekly basis, older funds were ramping up both management and performance fees, and jobs on the sell and buy-sides were plentiful. All of which encouraged risk taking among participants across the spectrum. When a trader or fund blew up in spectacular fashion, ironically it was often seen as evidence of his/her ability to manage large AuM. With jobs so readily available, traders and PMs could take risk with confidence, knowing that if it didn’t work out with that firm, another job could be landed with relative ease. On the other hand, if it did work out, the payoff would be huge. The system was rigged in favor of the cowboy.
Then came Bernie Madoff, record wealth, lower returns, technological innovation, and eventually the financial crisis. Volume collapsed, risk takers were suddenly reviled by the public and the sell-side job market dried up flooding the buy-side with traders. Just as non-financial companies began focusing on cutting costs to prop up their bottom lines when sales growth faltered, so too did investors. They pushed for lower fees, beginning with performance before tackling management and administrative.
Fund managers were now incentivized to focus on asset accumulation over innovation and returns, resulting in less performance differentiation. Allocators turned their attention to benchmarks rather than absolute returns, and investment managers responded by doing the same. As a result, many fund-of- funds struggled to earn their fees. At the same time, wealth disparity was heading ever higher, creating a whole new class of mega-wealthy investors and the simultaneous explosive growth in the number of family offices and wealth management firms. Here, ever greater focus could be put on reducing costs by investing directly with the largest funds at heavily discounted fees and maximizing portfolio efficiency from a tax perspective.
Along the way, each player has responded to some outside force with perfectly rational behavior, optimizing their decisions for the balance of risks versus rewards as they currently exist. The result is one of the most risk averse investment environments any of us has ever experienced, with fear and despair at near fever pitch, even if few would characterize it as such.
If history has taught us anything, it is that moments like these are rife with opportunity for those who can maintain objectivity and see the world as it actually exists. By understanding why decisions are being made and acknowledging that people are actually behaving very logically we improve our ability to do exactly that.
To review, moral hazard is defined as a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk. While this is a widely accepted definition, it's nonsensical. After all, if the costs are not borne by the party taking the "risk", then from their perspective no risk exists, undue or otherwise. If the potential for reward isn't simultaneously erased too, the risk / reward relationship becomes so extreme as to be irreconcilable. As a result, the rational decision maker must elect to take action. In fact, from this one participant's perspective, the only logical decision is to go all in. This describes what is meant by moral hazard. The moral hazard exists, because although it is the only logical choice for that participant, it is the wrong one for the greater good. The system as a whole is taking the undue risks.
Since for the most part, bailouts did occur without exacting any toll on the equity of those who were bailed out, it makes sense that it would encourage riskier behavior among investors going forward. However, this hypothesis requires that one essential assumption holds true. It must set a precedent, and the players must believe that it has. Therein lies the flaw in the expectation for moral hazard. At least in this case.
If instead of a crisis, just one company had run into trouble and was bailed out without any cost being borne by its equity holders, it would be inconceivable for moral hazard not to have arisen. However, so many bailouts were required thereby creating extreme stress for the system as a whole, and exposing the fragility of it all. In fact, it has created such hardship for the sovereign saviors that it calls into question the ability of the system to absorb any future cost, regardless of its desire to do so.
As a result of this combination of fragility and inability to backstop risk, rather than seeing the risk / reward relationship staying at the irreconcilable extreme that had favored risk taking, owners of wealth (aka capital) believe it has flipped to its polar opposite. By extension, the controllers of that wealth, namely CEOs, fund managers and allocators see it that way too. At least that’s what their behavior implies.
In other words, from each individual’s perspective, the potential cost associated with taking risk has skyrocketed to unimaginable levels, while the reward has collapsed to nearly zero. Therefore, it is only natural, in fact it is perfectly logical that these decision makers would elect not to take any risk. However, it is the wrong decision for the greater good. As a result, the system as a whole has almost no potential for reward, and ironically, that puts it all at risk.
Come to think of it, it sounds an awful lot like the definition of moral hazard, but from the end of the spectrum we rarely consider.
Incentivizing Inefficiency
Behaviors don’t just change on their own. They are a function of incentives. Shift the incentives, you’ll adjust the behavior. Since market price action is a reflection of behavior patterns en masse, it’s important for investors to recognize how incentive systems have changed.
Let’s begin with the shift from paying for performance to paying for administration. Prior to the financial crisis, the investment industry was in its heyday. New hedge funds were launching with hundreds of millions under management on a weekly basis, older funds were ramping up both management and performance fees, and jobs on the sell and buy-sides were plentiful. All of which encouraged risk taking among participants across the spectrum. When a trader or fund blew up in spectacular fashion, ironically it was often seen as evidence of his/her ability to manage large AuM. With jobs so readily available, traders and PMs could take risk with confidence, knowing that if it didn’t work out with that firm, another job could be landed with relative ease. On the other hand, if it did work out, the payoff would be huge. The system was rigged in favor of the cowboy.
Then came Bernie Madoff, record wealth, lower returns, technological innovation, and eventually the financial crisis. Volume collapsed, risk takers were suddenly reviled by the public and the sell-side job market dried up flooding the buy-side with traders. Just as non-financial companies began focusing on cutting costs to prop up their bottom lines when sales growth faltered, so too did investors. They pushed for lower fees, beginning with performance before tackling management and administrative.
Fund managers were now incentivized to focus on asset accumulation over innovation and returns, resulting in less performance differentiation. Allocators turned their attention to benchmarks rather than absolute returns, and investment managers responded by doing the same. As a result, many fund-of- funds struggled to earn their fees. At the same time, wealth disparity was heading ever higher, creating a whole new class of mega-wealthy investors and the simultaneous explosive growth in the number of family offices and wealth management firms. Here, ever greater focus could be put on reducing costs by investing directly with the largest funds at heavily discounted fees and maximizing portfolio efficiency from a tax perspective.
Along the way, each player has responded to some outside force with perfectly rational behavior, optimizing their decisions for the balance of risks versus rewards as they currently exist. The result is one of the most risk averse investment environments any of us has ever experienced, with fear and despair at near fever pitch, even if few would characterize it as such.
If history has taught us anything, it is that moments like these are rife with opportunity for those who can maintain objectivity and see the world as it actually exists. By understanding why decisions are being made and acknowledging that people are actually behaving very logically we improve our ability to do exactly that.
About the Author
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC
In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC
In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.