Wednesday, September 24, 2008

Moral Hazard and the last few months

I'm not sure where to start since there's so much going on... so I'll just do a bunch of posts and see how many I can get though over the next few hours.

As Congress debates (aka does the political posturing dance) the bailout plan, I have to say I'm pretty much sold on it. Is it perfect? No. In fact, if it was only one company, I'd be all against the bailout. But seeing that we're talking about some really big and important companies, I don't think the government really has a choice. And Gary Becker agrees with me (or more like I agree with Gary Becker).

But as Becker points out, what the bailout does is create a huge moral hazard problem. And by huge, I'm talking $700 billion huge. The lesson learned by these companies is that they can continue to take on bad risks and over expose themselves... and if things don't work out the government will be there to bail them out. As Becker points out, "On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, A.I.G., and Lehman Brothers have been almost completely wiped out, so they were not spared major losses." But on the other hand, these companies have been allowed to survive even though they had been acting irrationally (i.e. stupid and over exposing themselves) and while a lot of people lost their jobs and a lot more lost a lot of money, they didn't lose all their money. As Becker continues, "bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that
are not available to equity participants."

So what has happened is that it looks like the Bush Administration (with an assist from Congress) has created one of the biggest moral hazard problems in human history. Sure, I could go back in history and find other times when the government bailed out a private company or deemed a corporation as too big to fail, but what has taken place over the last few months is unprecedented. I'll say it again, $700 billion dollars of tax payers money will be handed out to a bunch of companies who going under because of their own short sighted stupidity... in other words it's their own fault. But the government is riding into hopefully save the day... at the cost of $700 billion.

(And no one really can imagine how much money $700 billion is, but $700 billion is more than the GDPs of the Netherlands, Taiwan, and Poland; in theory the U.S. government could just buy these conturies instead of bailing out those companies).

But back to moral hazard, it does bring up an interesting debate that Richard Posner sort of digs into... how much blame should be placed on the government? In the case of Fanny and Freddie... a lot. Everyone at both of these quasi-private companies knew that the U.S. government would bail them out of they messed up. And that's what they did. They had nothing to fear... if they could deliver insane profits for a few years it was worth it because they were never going to go down.

However, in the case of Bear Stearns, Lehman Brothers, and A.I.G., it's very hard to place any blame on the government (unless you want to argue about deregulation). There was little prior history or prior history to suggest that the government would come to the rescue of these companies if they went belly up. And I don't think if the Fed and Paulson knew that crisis would only get worse that they would have bailed out (i.e. forced JP Morgan/Chase to buy) Bear Stearns.

Anyway, a great piece from Becker and Poser on what has happened.

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