Home » Money » Moral Hazard

Moral Hazard

Back in 2009, there was a lot of talk about the “moral hazard” of bailing out big financial institutions.  The concern was that, once bailed out, the banks would learn that no matter what happened the Federal Reserve and government would be there to cover all of their bad loans – and thus make more.   In short, providing insurance for default makes it more likely that it will occur.

The term is something like a pop psychology term for the system of socialized risk that defines our entire financial system.

With the benefit of hindsight we can now ask whether or not the bad loans stopped after the big bailouts of 2008.  Did large financial institutions change their behavior and start to behave?  The answer, increasingly, appears to be no, there has been no substantial change in lending behavior since the bailout.  The “moral hazard” appears to be very real – big bets on big risks have continued without much change.  And that’s not only why there is a new crisis but also why serious policy changes must take place.

The term “moral hazard” is far from new.  In 2002 the International Monetary Fund (IMF) examined in detail whether their bailouts of nations and big banks actually encourages risk taking.  They found that it did, although they were not sure about the magnitude of the problem.  As they stated at the time:

As long as further evidence is needed to establish the magnitude of moral hazard, such action should proceed cautiously, weighing the possibility of moral hazard against other implications of the availability of IMF financing in alleviating the effects of crises.

Fast-forward to 2008 and the need for rapid bailout.  Caution was clearly thrown to the wind and enormous amounts of money were made available to financial institutions in trouble – damn the “moral hazard”.  How big has the effect been since then?

The poster child for the problem is MF Global, the investment house that made big bets on European sovereign debt in a clear belief that it would not be allowed to fail.  The counter argument against this being a case of “moral hazard” run amok is that they were a rogue organization, riddled with bad behavior and excessive risk taking.  But there is evidence that they were far from alone, with many big banks taking a lot of risk long after the bailouts.

It took a Freedom of Information Act request that went all the way up to the Supreme Court, but the some actions of the Federal Reserve since 2008 have been made public by Bloomberg.  A total of $7.77 trillion was sunk into institutions that were declared “healthy”, raising the question why they needed so much in emergency loans in the first place.  Profits from this action totaled at least $13 billion for the banks.

This is far from a partisan issue, with icons on the left and the right weighing in on the topic (although each stresses different kinds of “moral hazard”).  The disclosure prompted this statement:

“When you see the dollars the banks got, it’s hard to make the case these were successful institutions,” says Sherrod Brown, a Democratic Senator from Ohio who in 2010 introduced an unsuccessful bill to limit bank size. “This is an issue that can unite the Tea Party and Occupy Wall Street. There are lawmakers in both parties who would change their votes now.”

More disturbing than keeping Congress in the dark is how so much of this escaped the usual scrutiny from the Federal Reserve.  The Governor of the Minneapolis Federal Reserve (one of 13 people who should have had control over the situation), Gary H. Stern, said that he “Wasn’t aware of the magnitude.”  Clearly no one was watching what was going on.

The moral hazard is playing out very differently in Europe, where the Italian crisis is quickly coming to a head.  Strong action by the European Central Bank (ECB) has been slow to come in part because German Chancellor Angela Merkel insists that a framework of control be in place before any big bailout occurs.  Can they act in time to save the big institutions?  Is the sovereign debt crisis moving beyond Europe to Japan, among other nations?  The need for quick action is now being weighed against the moral hazard and the gears of bureaucracy are slowing things down.

The latest revelations about how the US system has handled the crises so far are making the case for caution around the world.  Something will have to change.

In the meantime, the world’s financial system remains almost paralyzed.  There will be no easy way out as the old regime will fall, one way or the other.  Will those who worry about “moral hazard” win and make major changes to how things are done?

27 thoughts on “Moral Hazard

  1. The scope of the bailouts so far is breathtaking. How do you write $7.77 Trillion and make it seem like a real number? The possibility of more coming is just unbelievable. There is a moral hazard and something has to be done about it.

    • We don’t know what the total worldwide tab will be, but it’s looking like it will wind up at least $20 trillion before this is over. We could write it $20,000,000,000,000 to show how big it is, but … wow …

  2. Throwing money at these banks and now indebted nations is not a solution. There has to be another way to do this and not have a complete collapse.

    • I don’t know what to do about sovereign nations, but that’s up to the Eurozone. As for big banks, I have said all along that the FDIC has the right model. They are funded by insurance premiums assessed on all the institutions, but if they need more they can borrow it from the Feds and pay it back with higher premiums going forward. When an institution fails, they swoop in and take it over, completely eliminating the old management and re-opening within days (sometimes it all goes down over the weekend). There is usually a forced bankruptcy, meaning that shareholders get nothing and all the golden parachutes are wiped out. Cold, clean, and professional – the institution remains but the people who ran it into the ground are out.

      The only other thing I’d like to see is more emphasis on possible criminal charges for mismanagement. Certainly, that won’t happen all the time, but that’s OK. The point is that there should be some personal risk for those at the top (they at least lose all income and pension) even if the institution remains. And it should pay for itself – the industry has to shoulder the risk, not the taxpayer.

      • The FDIC nodel is decent, but insurance premiums need to be quintupled to come anywhere close to pricing for risk.

  3. A couple points I’d like to make:

    1) Germany is trying to resist the ECB from issuing bonds because it would raise the German cost of borrowing, correct? But isn’t it just a matter of time before the German bonds are impacted by the spreading sovereign debt crisis of the PIIGS?

    2) Damn, I want to know how bad the French banks, and some U.S. ones (i.e., Goldman) are into Greece for. Is there any way to discern this, apart from calamitous financial worldwide meltdown?

    • My understanding is always a bit limited, but I’ll do my best.
      Germany appears to be opposed to the ECB intervening dramatically because ECB lacks the charter and procedures to do so and because the Germans want fiscal prudence in the nations getting bailed out as a price. What they really fear is that ECB (and by extension Germany) is turned into a giant piggy bank that can be raided more or less constantly to prop up nations that can’t or don’t bother to manage themselves. They have become sticklers for government control and a limited ECB charter until they have everything in place.
      How bad are French banks? I didn’t include this because I have no idea. Société Générale has been accused of being on the edge of collapse, but is now suing the UK paper that printed that story. Some have backed that story, others refuted it. It’s a big mystery at this point. The only clue we have is that there appears to be a flight away from French paper, meaning that at least some people who know are nervous. But then again, they probably should be no matter what.
      How deep is Goldman into this? They are into everything, so they are in very deep. What we have no idea of is how many Credit Default Swaps they sold against whatever position they or anyone else has. Those derrivatives are the real problem waiting out there once there is a default, and we won’t know until it happens. Scratch that – based on experience so far, we’ll know about 3 years later. I have a gut feeling that JPM is in very, very deep and that MF Global was just a front for them, but this is totally unsubstantiated.

      • Right, but ultimately even Germany doesn’t have the financial wherewithal to continually absorb the financial erosion that the PIIGS are causing–it seems to me they are delaying the inevitable. It was my understanding the Eurozone members where supposed to keep their deficit spending in check, but there was never a trigger to make sure that would happen.

        What has, and continues to, amaze me is how cavalier the approach to sinking huge sums of money in unstable pools remains; it’s as if nothing matters to the financial health of the rest of the economy. It’s the “I got mine” approach to investing. And if they run into trouble, they’ll just threaten to destroy the global economic architecture…or else. Absolutely criminal.

      • That’s just it – Germany senses that this isn’t the only time they’ll be on the hook. I think a real permanent solution that puts this behind us would be acceptable to Germany, but they see it happening again. The member nations were supposed to stay within deficit targets and so on, but Greece found a way out – they simply lied about the state of their finances and everyone let them in the interest of unity. Germany is pretty uptight about things because there is a long habit of looking the other way that they want to break.
        Keep in mind, however, that while it’s easy to fault Greece for bad behavior they were under military dictatorship until (I think) 1974 so they have always been a special case. Rather than codify that special case everyone just looked the other way. No more.
        But the attitude in general comes off as pretty damned cavalier. The real story in the Bloomberg piece on how much the Fed loaned to JPM, etc, is that they would not have done that without a certain level of panic behind closed doors. Publicly, they want us to think they have it all under control, but their actions betray a very different state of things. And the Minneapolis Fed Governor didn’t even know how much they were doing? That’s serious “hair on fire” panic, IMHO. The cavalier attitude is what we get publicly and yes, it should be galling.

    • If Greece didn’t follow the rules before what will make them do it this time? It seems to me that if Germany has a problem they should have had it a long time ago. They may not appreciate that they are being dragged down but they signed up for this a long time ago. I think you are right that printing a lot of Euros and inflating their way out of this is the only thing that makes sense because everyone is to blame for the mess they created. They should all share in the pain.
      Having said all that we should never bail out a company without taking over a relative share of its value. If the government or fed or whoever gives an investment house money worth half its value it should get half the stock as collateral. That carries more risk than a simple loan or bond sale but gives the government more control. Assessing the value could be difficult the way some of these companies keep assets on the books at inflated value but that can be worked out.

  4. The ‘moral hazard’ is more than dependence it is corruption It is a system where influence makes a huge difference to your wallet. The real issue is corruption and who gets the bailout money. I can’t get it and I bet you can’t either no matter how bad your investment choices are. That is the problem with this kind of system both in the US, Europe, Japan and wherever.

    • You’re right, it is corrupt. The people who pay for it are those who work for a living (given how tax rates fall at upper incomes). The whole system is now set up to reward influence at the expense of actually working. Corruption at its worst, IMHO.

  5. Your comment-

    “…The people who pay for it are those who work for a living (given how tax rates fall at upper incomes). The whole system is now set up to reward influence at the expense of actually working…”

    Says it all for me. 😐

    • Well, I can’t think of what else it comes down to. I was going to get into the politics of this more later, as I ran out of room in the explanation – but the comments have taken over. Just as well.

  6. I for one am sick to death of all this fraud and corruption. If you are trying to tell us that another big bailout is coming I say that we let them fail and go from there. Things have to change one way or the other and if it means taking it all down than so be it.

    • Things are coming to a head soon, I think, and we’ll see. It may have to get very bad before it gets better. A total collapse might be necessary before we fix anything. That’s the lesson of Rome, IMHO – not the final collapse, the many times it fell apart but was able to rebound (Vespasian!).

  7. Pingback: Fueling the Future | Barataria – The work of Erik Hare

  8. Of course they didn’t change their behavior. Why would they, when it was rewarded so generously? A few dozen top bank managers and directors sitting in federal and state prisons might have wrought a change…..

    • I completely agree – the institutions might need to survive, but everyone at the top should damned well have the fear of the DA deep in their black hearts. There may not be enforceable laws on the books that would make this a real possibility, but if I was looking at reform I would make sure that this was a part of any new system.

  9. Pingback: When Failure is an Option | Barataria – The work of Erik Hare

  10. I want bankers in handcuffs and orange jump suits and massive personal asset forfeitures. Michael Milken and Ivan Boesky’s fines need to look like chump change in comparison.

    The scary thing is how cheaply our politicians sell out.

  11. Pingback: Ron Paul | Barataria – The work of Erik Hare

  12. Pingback: Leaving Goldman | Barataria – The work of Erik Hare

  13. Pingback: How to Not Stop a Bank Run | Barataria – The work of Erik Hare

  14. Pingback: Jubilee | Barataria – The work of Erik Hare

  15. Pingback: Dodd-Frank, a Non-Issue | Barataria – The work of Erik Hare

  16. Pingback: With a Moslem Beat? | Barataria – The work of Erik Hare

Like this Post? Hate it? Tell us!

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s