Journalism in the Public Interest

The Dukes of Moral Hazard: The Dangers of Quantitative Easing

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Across the world, there are booms. Chinese Internet companies are flourishing. Energy companies are finding new sources of power. Commercial real estate is coming back.

Unfortunately, this isn’t happening in the real world, which is still crippled by sagging economies, but in the investing one.

If there’s a doggy stock, a dodgy loan or a slice of a complex credit security made to a questionable borrower — hedge funds want it now. Companies with junk bond ratings are flooding the markets with new issuance. If private equity firms bring a money-losing company saddled with debt to market, investors are eager to snap it up.

Thank the Federal Reserve. The central bank has embarked on its program of “quantitative easing,” a second round of experimental monetary policy in which the Fed buys up assets — like longer term government bonds — to bring down interest rates, which is supposed to spur lending and borrowing, thus reigniting the economy.

Nobody knows whether it will work to bring down the intractable rate of unemployment. But it has already worked in one significant way: the speculative juices of the markets are flowing.

What’s going on? As a Fed official explained it in a recent speech, one supposed benefit of the Fed policy is that it will add to “household wealth by keeping asset prices higher than they otherwise would be.”

So it’s levitation-by-decree. When the Fed moves, financial assets receive the opposite of collateral damage: universal blessing, deserved or not. Lower rates may or may not help more people find work. But there’s no doubt that the central bank has already helped the Henry Kravises and Lloyd Blankfeins of the world.

The Russell 2000 stock index, which is made up of smaller companies, has risen about 21 percent since September, when investors started to anticipate that the Fed would intervene in an aggressive fashion. A tiny Chinese Internet stock, China MediaExpress Holdings, is up more than 250 percent since mid-September. The private investors that own Harrah’s, the money-losing casino company, are bringing it public, and investors are going to gamble on it despite a crushing debt load.

Then there are something called B notes, bonds backed by commercial real estate loans. B-note holders are on the hook for the early losses if the loans go bad. They are as hot a commodity as everything else. Never mind that there’s a huge oversupply of commercial real estate in this country. Or that Wall Street just went through a disastrous episode for complex structured financial products of exactly this sort.

Without knowing a thing about finance, here’s how to tell it won’t work out well. Wall Street is the great master of the euphemism. The Street doesn’t call them junk bonds; they are “high yield.” Here, something isn’t just Triple A. It’s “Super Senior Triple A.” So when the best investment bankers can do is to dress something up with a lowly “B,” you know it’s trash.

Leverage, meanwhile, has made a glorious return. Interactive Brokers, a discount brokerage firm, has been running an advertising campaign that displays money spewing from printing presses. The firm will lend (for certain special customers) $566,000 for every $100,000. Ah, borrowing heavily for the purposes of trading in volatile markets. Maybe some Bear Stearns or Lehman Brothers bankers can explain the wisdom of this.

All of this is Finance 101. The cheaper money is to borrow, the more it makes sense to take a bigger risk with it.

But that doesn’t make it more palatable. It feels like an ominous replay of recent Federal Reserve emergency actions, which led to bigger and bigger bubbles. The Fed brokered the rescue of Long-Term Capital Management, bailing out the investment banks that had lent to the collapsing hedge fund. The Fed pumped money into the economy to save us from the Y2K computer bug. The Fed tried to rescue the economy from the bursting of the Nasdaq bubble, helping to create the housing bubble.

It’s like the exhausted “Saw” movie franchise; this isn’t just a sequel. It’s more like the third iteration of the second reboot — harder core, baser and for serious liquidity heads only.

Is this the price society has to pay for a better economy? Do we care if some hedge funders get rich as long as unemployment goes down, fewer people get thrown out of their homes and household debts are less crushing?

That would be a worthwhile tradeoff. But it’s far from clear that the Fed can get any real traction with its policies.

Over the past year, I’ve been investigating some of the more egregious conduct that occurred in the bubble years. In this column, I’ll be monitoring the financial markets to hold companies, executives and government officials accountable for their actions.

A main focus will be the spectacle of returning speculation. It’s commonplace to lament Wall Street’s lack of a historical memory. But there is something different at work. Professional investors have learned the lessons of the financial markets’ serial bubbles and learned them well.

The lesson is: When the next one comes, I’m going to get mine. I’ll just get out early this time.

Scott Belford

Nov. 10, 2010, 3:32 p.m.

The last line is good.

Michael M. Thomas

Nov. 10, 2010, 4:35 p.m.

Big fan. Keep it up. I’m going to forward you a story you could do something with.

Victor Faessel

Nov. 11, 2010, 12:59 a.m.

“A main focus will be the spectacle of returning speculation.”—Yes, please, please do it. Nice start.

As for the margins issues you can already see the effect at work taking a look at Campbell Soup or Walmart
As fo the ‘externalities’and the global backlash against
QE2, I recommend the reading of a conference given
recently in Berlin by Prof.Michael Hudson:
‘U.S. “Quantitative Easing” is Fracturing the Global Economy

Edith A Cresmer

Nov. 11, 2010, 10:59 a.m.

It’s interesting that the title of this same article in the New York Times is less scary, After Fed Rescue, Speculation Makes a Comeback.

Alfred Thompson

Nov. 11, 2010, 11:06 p.m.

Forget Bush’s tax cuts, QE1 and QE2 are the biggest tax hikes in history. Not only is the printing press eliminating the need for taxation (and the political pressure behind it), it also gives the federal government unlimited and unchecked power. Check out Peter Schiff who predicted the 2007 (2008) crisis back in 2006 and is on the forefront of the movement to bring back responsible fiscal policy. Monetizing debt (aka quantitative easing) devalues the dollars we all have in our back pocket. It is especially a tax on the poor!

Quantitative Easing is a tool of monetary policy, but it is not sufficient to help us escape the economic quandary we find ourselves in, fiscal policy tools are needed as well.  To the extent that QE devalues the dollar, that is the intent so as to make our goods cheaper to buy on the international market.  President Obama wrote an op-ed in the NY Times on Friday Nov 5,2010 titled, “Exporting our way to Stability,” which indicates to me a weak dollar policy is the path chosen.  However there are other ways to devalue the dollar that doesn’t fuel rampant speculation or the casino economy.  I wish one of those methods would have been employed instead.

Jesse Eisinger

About The Trade

In this column, co-published with New York Times' DealBook, I monitor the financial markets to hold companies, executives and government officials accountable for their actions. Tips? Praise? Contact me at .(JavaScript must be enabled to view this email address)