Readers Respond to Moral Hazard-CAC

Readers Respond to Moral Hazard-CAC
David R. Kotok
February 24, 2012


Many thanks to readers for their notes about moral hazard and the collective action clause (CAC).  Some of the emails are of particular interest.  A few follow, as we continue our discussion of moral hazard.  We will add comments to some.

When reviewing these comments, readers may want to think deeply about this question of moral hazard.  Most of the comments posted are from skilled professionals.  So here is the question: is it moral, amoral, immoral?  Remember that most moral hazard is legal, since it is created by government, and government writes the laws.  Remember, we are defining moral hazard as the risk that develops when a government action distorts market’s risk-reward symmetry.  The price for that shifting of risk is ultimately paid by the government (taxpayers) or the government is dishonored.  Maybe both!

Dana wrote:  “CAC has been used to great success very recently in Ireland to crush the sub bondholders of Anglo Irish and Allied Irish banks. Our fund owned some of the AIB sub bonds. The Irish pension fund had put a large portion of their assets into preferreds and equity of AIB. In order to allow the pension not to take a loss and get money out of the sub bondholders (who were senior to the pension holdings) Mr Noonan changed Irish law to allow for CACs, then used it to force bondholders to accept his “voluntary” exchange offers. I believe the Anglo sub bonds were the first to go. They offered 20c for the bonds, then put in a coercive clause whereby they could ‘vote’ to have the remaining bonds called at .01c for the holdouts. Then he moved on to AIB, offering the subs 30c ‘voluntary’ with no coercive clause. When that didn’t work to his satisfaction, he used the new law to make the remaining bonds zero coupon for 40 years. Then he finished off the AIB subs with a 20c bid (no accrued, since they were not officially zero coupon) with 0.01c coercive hammer. I suggest you give Mr. Noonan a ring and congratulate him.”

Hal noted that the use of the term, as searched in Google, is at an all-time high.  The search spanned two centuries.

Ramiro offered:  “I couldn’t agree more with you on this issue. Furthermore, I believe this could have significant implications for the rest of the European sovereign debt market.”

Paul wrote: “I agree CACs are as ugly as they sound.  But, their sole purpose is for foreign-currency sovereign debt.  You don’t need them for private debt, since there are bankruptcy laws and procedures.  You don’t need them for own-currency sovereign debt, because they can always print. And that’s the real issue in Europe.  They took a perfectly good own-currency sovereign market and turned it into an unstable foreign-currency sovereign market.  They need CACs because they cannot come up with a robust mechanism to support and restructure Euro-area sovereign debt. Another issue for Paris.”

Readers will note that Paul’s reference to Paris is the GIC meeting at the end of March.  CAC, moral hazard, European debt issues, and monetary policy are the agenda.  See:, if interested in attending.

Mary Ann asked: “What if they pre-determine the terms of the CAC? Could you then price risk?”  Our thoughts, Mary Ann, are maybe so.  You would need to know that the terms cannot change.  The presently discussed structure is not resolved.  A key point is the adjudication of disputes.  Greece is currently tantamount to a bargain with the devil.  Using this metaphor, the judge in a lawsuit against the devil is the devil.

Don brought the issue to America:  “The problem is there are no morals, trust has completely disappeared. Quite sad when government portrays half-truths as acceptable. Anyone who thinks this so-called Greece bailout is going to work is a nut cake, as you call it. This is only the beginning and the USA will not escape unscathed.”  Don, we regret that America is the champion of moral hazard.  Lehman-AIG caused the world to lose trillions.  Lehman was a primary dealer with the Federal Reserve.  Its chairman sat on the NY Fed board while our present Treasury Secretary was the NY Fed president.  Even after Lehman and MF Global and others, the Fed has not discussed (in  public) the restoration of surveillance units in primary dealers.  They were removed in the early 1990s.  So the price of moral hazard in the LEH case was about 2 trillion dollars.  Then Dodd-Frank, etc. was enacted.  We do not yet know the final price tag of moral hazard related to the Fed’s primary dealer supervisory failure and the post-Lehman aftermath.  Enough said.

Andy sent this: “I happened to catch you on Tom Keene’s show and was as floored with the implications of this move.  The most frightening thing is that our current (hopefully not for much longer) administration seems to be rapidly moving in that direction. Nothing they propose is what it seems.  I am very impressed with the work of your firm and your high regard in the financial community (in addition to your fishing skills)  and wish you much success in helping to get things back to a sanctity of contract and rule of law. Without it the whole world becomes chaos.”  Thanks Andy.  I’m working on the fishing skills and hope to keep you posted.

The last one is from Jay:  “The Troika is guessing that this may be a one-off, and bless this ‘retroactive’ application.  And will CDS’s be triggered with this chicanery?  Your point about suing them is obvious and another point I’m glad you made.  Once they set precedents, it comes down to reputation.  And we are short of this right now.

“As we embark on yet another year of monetizing debt, printing money, manipulating the yield curve in multiple (Twist, QE2) ways, issuing moratoriums on debt foreclosures,  I’d say the leaders have just pissed away any reputations their forefathers fought so hard for, and the courts established after years of judicial prudence, to instead engage in ‘volatility suppressions’ {See Nassim Taleb, ‘Black Swan of Cairo’} to avoid taking the required medicine.  In short, you should be arguing, why can’t Greece take their required medicine? Because the world will come to an end?  If the troika and Fed don’t like the way things are going … they WILL change the rules.

“And if a retroactive CAC is issued by Greece, you may find arguing that it couldn’t happen anywhere else very difficult in light of our leaders, policymakers most recent actions and reputations.  Your list of eligible sovereign debt investments may quickly get smaller if it is retroactively introduced, and no CDS trigger happens.”

We again thank the many readers who emailed.  Moral hazard is here.  The issue for investors is to identify the forms and to try to manage the risk.


David R. Kotok, Chairman and Chief Investment Officer

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