Monday, September 22, 2008

The Phantom Moral Hazard

There are a thousand theories about why American markets are in such turmoil, and ten times as many about what we need to do. Here's one of the craziest.

Some economists and many conservative pundits say we should let financial giants fail, because if we save them, future executives will feel safe with even more risky behavior.

This so-called 'moral hazard' is a principle of economics that applies in some cases, but it's awfully hard to see it here. Let's see what's happened to the wealth of these executives as their firms prepare for bailout.

Stock value for CEO's of rescued firms ($ millions)

CEO Firm 2007 value Last Friday
Greenberg AIG 1,250 50
Fuld Lehman 827 2
Cayne Bear Stearns 1,060 61
Sullivan AIG (ex-CEO) 3 0.1
O'Neal Merrill (ex) 128 40
Mudd Fannie Mae 26 0.4
Syron Freddie Mac 11 0.1

Look at, say, James Cayne, former head of Bear Stearns. I'm not asking you to feel sorry for him - he's still got $61 million in stock there - but note that up until last year, he was worth nearly a billion dollars.

Can you imagine a CEO saying, after the bailout, "I know I should do more to manage risk, or I might lose 95% of my personal worth, my job, my title, control of the company, and the respect of my peers, but at least the government will keep things from getting too bad" ?

Sounds silly, doesn't it? So is the argument that the government is doing too much.

No one is removing the risk from the financial markets. We're just taking steps to ensure that when Wall Street stumbles, the rest of us lose less than, say, some CEO's.


  1. This is absolutely correct. Even if the government was to "rescue" every failing company, we'd be "rescuing" it on roughly the same terms as Bear Sterns got rescued, or AIG. The downside that's already occurred, not to mention the substantial downside still ahead of us under any scenario, will do plenty to convince CEO's that they don't ever, ever want to do this again.

    Now, of course everyone will eventually forget, if our economic system survives. A new generation will eventually arise -- but it took a long time for us to forget the lessons of the Great Depression (my grandfather still lives like he did in 1933), and I suspect the lessons of this crisis will be remembered for quite some time as well.

  2. Good point about recovery, Ken (my grandfather, too, retained from the Depression a great distrust of banks).

    The sad thing about moral hazard arguments is there is one in this financial crisis... just not the phantom one people fear from a bailout.

    When banks became able to easily bundle and sell their mortgages, it divorced them from the risk of failed payments. The original issuer could earn money from initial fees, then sell the loans and be done with them... earning the same money regardless of whether the loans are repaid or go into default.

    By requiring banks to hold a portion of their riskiest loans - a proposal floated by several economists - it would keep the risk where it matters: with the bank deciding whether or not that loan should exist in the first place.

    Why don't we hear more about that? One reason might be that it's a blend of political views: it requires government regulation to make the market do its best.