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Saturday, December 29, 2007

Ten Virgins and Moral Hazard

source: WSJ 

Wisdom, Folly in Turmoil

The kingdom of heaven will be like 10 virgins who took their lamps and went out to meet the bridegroom. Five of them were foolish and five were wise. The foolish took their lamps but did not take any oil with them. The wise, however, took oil in jars along with their lamps.

The foolish ones said to the wise: "Give us some of your oil; our lamps are going out." "No," they replied. "There may not be enough for both us and you."

--Matthew 25, abridged

The biblical parable of the 10 virgins is sometimes used to make a financial moral: Those who don't take precautions have to face the consequences. "Wise" ones end up paying the price. Here's a retelling of the story for modern times:

[Breakingviews]
All Invited: Left, Citigroup ex-CEO Charles Prince; at right, former Merrill Lynch CEO Stan O'Neal.

The first virgin was Stan O'Neal. He ran Merrill Lynch, an investment bank. He took big bets with its cash. For a few years, he made good profits. But then the bets turned sour and the firm took an $8.4 billion hit. Luckily, Stan had a nice board. It said he could take all his stock awards and benefits from previous years -- without any deduction for the new losses. Stan retired with $161 million in his back pocket.

The second virgin was Rock, also known as Northern Rock. The British bank borrowed lots of money short-term because it was cheap and lent it out for long-term mortgages. It pocketed the spread. That was very profitable for a few years. But then funding dried up. Fortunately, when Rock ran out of money, a charming man from the British government named Alistair Darling provided £56 billion ($111 billion) through loans and guarantees, an offering of almost £1,000 from every man, woman and child in the land.

The third virgin was Charles Prince of Citigroup. He played a clever game of lending money without it appearing on the bank's balance sheet. Better still, he copied Rock's trick of borrowing cheap short-term money and investing it in better-yielding long-term assets. Chuck was so happy he couldn't stop dancing. But then the music stopped. Chuck lost his job but not the fat bonuses he'd collected in previous years.

The fourth virgin was Fannie Mae. She was in the business of lending people money to buy houses. But she was imprudent with her sums. She didn't put aside enough cash to back those loans. She's not too worried, though. If worst comes to worst, Fannie's rich uncle, Sam, will be sure to come to bail her out.

The fifth virgin was called Hedge. It was a nickname from his favorite game: "Hedge I win, tails you lose." He ran a fund. The deal with investors was that every year he made them money, he'd keep 20% of the profits. For several years, Hedge made a packet. But then, in one big bet, he lost much of his investors' money. Of course, he didn't refund them 20% of the losses.

There were five other virgins. They worked hard in industry rather than finance, saved rather than borrowed, paid their taxes, didn't speculate on subprime mortgages and didn't run hedge funds. They didn't get fat bonuses, either, during the bubble or during the crunch. They weren't running risks -- or, at least, that's what they thought. The snag is that, after the Federal Reserve's Ben Bernanke and his French cousin, Jean-Claude Trichet started spraying around cheap cash to bail out Stan, Chuck, Fannie and the like, inflation started seeping into the economy. That eroded the real value of the "wise" virgins' savings.

In the Bible, the bridegroom allows only the wise virgins to come to the wedding feast. The foolish ones are shut out. In this financial version, all 10 virgins are invited. The bridegroom looks around the room and scratches his head. Which are the real fools?



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Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454
www.pauldeng.com