By Ian Morley
Contrary to the belief of my pet Labrador, I am not Jesus Christ—even though to him I may appear to perform the occasional miracle with food, water and dead bones. We have few moral dilemmas, although I trust him not to eat my food when I’m not looking and I suppose he expects me not to eat his either. Our relationship has a certain symbiotic symmetry. I provide him a home, food and water and in exchange he takes me out for walks, guards the house, lowers my blood pressure and is still happy to see me at 2am when I return home in a joyous state. The same cannot be said for my relationship with my bank, which seems to be there for me when I don’t need it, and not there when I do. The antithesis, in fact, of what most people would determine as a moral relationship. Many would say that you have a commercial relationship with a bank, not a moral one. And it’s precisely at this point of commerce and morality that the concept of moral hazard sits so uncomfortably exposed.
There are various definitions as to the meaning of moral hazard. It is, in my experience, one of those things that is felt, tasted and smelled more easily than it is defined. You know it when you see it.
Long before the term gained its current popularity and ubiquitous inclusion in all articles concerning banks or the credit crunch, I had raised it as a specialist consultant retained by a law firm. I was asked to opine on the fairness of a fund manager’s remuneration. I pointed out that in addition to a golden hello and guaranteed bonus, the manager was taking no personal risk with any of his own money and yet was due to make ascending levels of reward for the return on any gains he made managing his clients’ money. I called this moral hazard. At the time the lawyers had never heard of the term and went scrambling to their law books to find meaning and precedent.
To me it was fairly simple: if you give someone great reward for taking risks with someone else’s money, while at the same time they are not obligated or even not allowed to risk their own money ,you create an asymmetry between their personal reward (large or enormous) and their personal risk (small). This is moral hazard, and reflects the way many of our large investment banks were run and the egregious rewards for those running the in-house proprietary desks. Many of them felt they played the casino brilliantly and deserved the rewards they got, but in fact they partially owned the casino and made up the rules. Like our Prime Minister here in the U.K., Gordon Brown, many of them were too full of arrogance and hubris to realise that they were doing well by leveraging (taxing) a rising market and not realising that they were the unintended beneficiary of growth, not the cause of it!
The nature of moral hazard inside banks stands in mostly but not universally clear distinction between the very limited moral hazard that exists inside hedge funds. There is some, but it is not manifest as it is with banks.
A few weeks ago I was kindly invited by the London School of Economics to speak on a panel concerning corporate governance. The other outside speaker was Lord Myners. The audience turned out to hear him, not me. I have a strong personal and ethical sense about such issues and a fairly strong pushback when they are forced on me by a nanny socialist state preaching adherence to political correctness. It was for precisely these reasons that when the session got to bankers’ remuneration, I was as about as apoplectic as Arthur Scargill might be at Margaret Thatcher’s birthday party.
The audience was, I think, a bit shocked. This is broadly how I expressed my position. I explained, as above, the result of moral hazard inside banks. I then suggested that the hedge fund community has been vilified for the actions of others, mostly the bankers. What hedge funds did was to call time on a game of leverage and unrealistic values by shorting the stories we no longer believed in. We did this knowingly, with our own money and that specifically entrusted to us by our clients to make such investment decisions. When we get it wrong we lose, and often lose most as we are commonly the largest investors in our own funds. When we gain we keep part of the rewards, called a performance fee. This is not moral hazard but a balance of interests. To be fair, it’s not totally balanced. Past performance fees are not normally paid back against recent losses. In some cases managers try to reset them. In a Darwinian world, many investors discovered the paucity of manager due diligence and bull-market leverage masquerading as talented alpha skill. Most offenders are now gone from the market and have moved on to some new scam. The secret of capitalism is that only one side of the mirror shows entrepreneurs and success. The other side must show failure and disappearance. Otherwise it’s socialism, where failure is the fault of others or circumstance and must be subsidized.
And so, with the banks, we privatised their gains and socialised their losses. We have mistaken that much-overused term “talent,” and heard it supported with argument and financial excess that the most Luddite trade unionist could only dream of. We will reform nothing in substance and allow it all to happen again in a few years time, albeit in another form as the bankers find a way to offer cheap debt and nonsense credit once more. We may hate the banks, but we think we need them. We do hate the hedge funds but think we can live without them. Yet the hedge funds’ role is to make money for their investors by judging the levels of temperance and excess in markets. They are often the first to expose the moral hazard of others and bring the whole party to a grounding halt. For that reason alone, they are a force for good economics against the prejudice of ill-informed attack. The banks have learned nothing, as the bonus rounds reflect. And why should they, when moral hazard remains at the core of their very existence?
Ian Morley is chairman of Allenbridge Hedgeinfo, a pension consulting firm. He was the founding chairman of the Alternative Investment Management Association (AIMA). The views expressed are personal.