The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.NEW YORK ( ChrisMartenson.com) -- After the shot across the bow in 2008, you might have expected regulators and market participants would use the experience to change for the better, to become more prudent and to reduce the sorts of risky behaviors that almost crashed the entire system. Unfortunately, you'd be wrong.
LTCM and Moral HazardIn 1998, there was a firm called Long-Term Capital Management (LTCM, as it is commonly referred to today), staffed by the best of the best, including one of the very top bond traders that Wall Street ever produced as well as two future Nobel laureates. LTCM boasted of its use of complex models that were supposed to generate outsized returns while operating with a risk-minimizing profile that, mathematically, was only supposed to experience severe losses so infrequently that the periods between them would be measured in the thousands of years. Unfortunately for LTCM, their models badly underestimated real risks, and their leverage was such that their original $1 billion in capital turned into total losses of $4.6 billion in a little over four years, nearly dragging down the entire financial system in the process. While this experience has much to teach us in the way of market risk, hubris, and the dangers of leverage, it really needs to be understood in terms of the rise of moral hazard on Wall Street. The main lesson that Wall Street seems to have learned from the LTCM disaster is that if the wipe-out was big enough, the Federal Reserve would swoop in and rescue things. Message received: Go big or go home. Take on as much risk as possible, secure in the knowledge that if things got bad enough, the Fed would simply print up what was necessary to make all the players whole again, with perhaps one core player or institution thrown under the bus for the sake of appearances. Fast forward to 2008, and that exact experience was replicated perfectly, thereby reinforcing Wall Street's perception that it is best rewarded by chasing big risks and big returns. And if things didn't go as hoped, the good ol' Fed would always be there to push the reset button.
Back to the FutureThis is why today, instead of having been reduced, financial risks loom larger than ever. It's why the next downturn will be just as bad -- if not worse -- than the last one. Nothing has been learned, and nothing has been changed. The most basic of human behaviors, the tendency towards moral hazard (so well understood by the insurance industry) has been completely overlooked by the Fed. Once again, that institution, entrusted with so much, has been exposed as being rather intellectually shallow, or at least devoid of common sense. I'll leave you with this: The very same Fed that could not and did not see that a housing bubble was forming is now equally complacent about corporate bond yields touching all-time record lows across the entire spectrum, right down to CCC junk that sits one skinny notch above default. Stocks are for show, but bonds are for dough -- and with bonds now priced for perfection if not for something even better, there's no room for error. Even the slightest hiccup -- say, one brought about by a renewed global slump as is already underway in Europe and Japan -- will cause massive losses to bond portfolios, and we will, yet one more time, be reminded that indeed there is nothing new under the sun. Central banks cannot print us all back to prosperity, and insolvency cannot be cured with liquidity. All that remains is to assign the losses to someone. And right now there are plenty of very well-connected and powerful individuals working feverishly to assure that those losses do not fall upon them.
Big Trouble BrewingWhat the Fed, in cahoots with other central banks, has managed to engineer is a spectacular rise in the price of financial assets. Stocks, bonds, and all of their associated brethren such as options, futures, and derivatives have all been magically elevated. To put this into context, not only are stocks at nominal all-time highs, but bonds are too. Bonds, however, are very different from stocks, and the fact that they are also at all-time highs should really be viewed with much more concern. The bond market is enormous and dwarfs the equity markets by over 2 to 1, or 3 to 1 if you include non-securitized loans in the mix:
Yield-to-worst in junk bond market hits record low
Mar 13, 2013
March 13 (IFR) - The yield-to-worst in the US high-yield bond market has fallen to a record low average of 5.56% this week, as investors flock to higher-yielding but riskier products.
With interest rates hovering around record lows, investors have found themselves rushing down the credit ladder in search of bonds offering more return -- and more risk.
CCC rated bonds - the riskiest investments at the very bottom of the credit spectrum, just one notch above default level - have rallied the most.
"It's definitely risk-on behavior, where you are trying to get exposure to the most yield possible," said Drew Mogavero, head of US high-yield trading at Barclays.
"The safer segments of the market, BBs, have rallied to pretty low-yielding levels," he said. "So people are looking out to CCCs and other higher-yielding names."
Bond yields and prices move in opposite directions. As investor demand has driven up prices, yields have tumbled. Yield-to-worst indicates the lowest potential yield on a bond without the issuer defaulting.
Lower All Over
Broken down by ratings, the yield-to-worst on the Barclays Double B index is also at its lowest ever (4.24%), as is the level on the Triple C index (7.43%).
The only segment of the market that didn't close at a record low on Tuesday was the Single B index, which is 5.46% versus the record low of 5.39% set on Jan. 24.