- It’s funny how moral hazards have been discussed less and less since 2008, but it looks like they are at their highest since then.
- We’ll discuss a few examples of current moral hazard issues and how to position yourself in relation to such situations.
In today’s article, I’ll discuss how moral hazard is growing but nobody seems to care which is usually the way things are as nobody cares while things are good.
I’ll conclude today’s article with a way to take advantage of moral hazard.
Moral Hazard Is Growing
A company called WeWork, which leases office space to start-ups, has recently achieved a private placement valuation of $20 billion with $2 billion in revenues and no sign of profit.
Now, how can a company that’s just leasing office space reach such a valuation? Well, it’s because the management is marketing it as a revolutionary business model for millennials. The funny thing is that IWG PLC manages five times the square footage and has about one-eighth the market value. IWG’s value is around $5,600 per desk while WeWork’s is around $135,000. In 2010, WeWork was valued at only $45 million.
In our current market, we’re starting to see more bubbles forming as there seems to be plenty of money around. I have to wonder, are we seeing companies like WeWork exploding because there is real value there, or is it simply because there is so much money available? If it’s the latter, then the value of a company like WeWork is much lower than it appears to be.
WeWork is a private company, so the risk related to it going bust or being fairly valued is all carried by those who have invested in it. But we’re already talking about moral hazard when pension funds or related firms buy into such companies or buy into IPOs, just like when Fidelity bought into Snapchat just prior to the IPO and lost money on that deal.
Another interesting situation last week was PIMCO’s European portfolio fund manager, Geraldine Sundstrom, calling the Spanish issue with Catalonia just a “local issue” that has no potential for spillovers.
Now, what is a manager who’s obviously long European bonds supposed to say in such a situation? Well, she has to protect her own position and therefore, all issues in Europe will be local for her until one actually isn’t. This could lead to huge losses for PIMCO’s clients which are mostly pension funds.
Remember, an asset manager makes money on the amount of assets they manage, thus saying that there is more risk would lower the assets under management and consequently, fees.
More than half of the 15,000 fund managers in the U.S. don’t have a single cent invested in the funds they manage. So if such funds experience huge losses, the managers won’t be significantly impacted.
Staying in the bond sector, Austria recently launched a 100-year bond at an interest rate of just 2.1%. The interest was around $6 billion even though the initial plan was to sell just $1 billion. Now, buyers of a bond like this are usually pension funds but my question is, who in their right mind buys such a bond. I can bet you that over the next century, interest rates and Austrian bond yields will be much higher than 2.1% and thus the bond will mostly carry a loss. But who cares? The pension fund manager who bought the bonds and the broker who sold the bonds will get their bonuses and respective fees while the retiree who will want to enjoy their pension 20 years from now will easily see the value of this holding at just a fraction of what they paid. But again, who cares?
Going to monetary politics. The fact is that never in history have we had such a long monetary easing experiment and nobody knows how will this work out. However, let me ask you, what will the consequence be for Janet Yellen if all that she has been preaching in the last few years is completely wrong and will have a terrible cost for future generations?
There will be no consequence because she is now 71 years of age and about to lose her job and thus will soon fall into oblivion. Similarly, Mario Draghi, the European central bank president, is 70. Will it matter to him if Europe goes bust 10 years from now as a consequence of current ECB decisions?
It’s clear that moral hazard is growing, but no one wants to discuss it as long as things in the economy go well.
Google searches on moral hazard have been declining in the last 9 years.
The problem is that sooner or later, the economy will turn south and as always, someone (tax payers – thus, us) will bail out the companies deemed “too big to fail” while the managers involved will mostly have no skin in the game and will have been investing their fat bonuses over the last 8 years in various places around the world.
What Can We Do About It?
The sad thing is that there isn’t much we can do about all this other than to follow the trend.
Being a contrarian just in the name of principle might sound noble, but would be detrimental to your portfolio now. Therefore, we have to position ourselves to take advantage as much as we can of the situation as long as the trend is positive, protect ourselves from the downside, and take advantage of the downward trend when all the bubbles pop.