Moral Hazard & the Demise of Lehman Brothers

John Authers’ Financial Times Article stating that the decade of moral hazard has ended provides a chance for us to look back on Lehman Brothers' (LEH) demise and the idea of moral hazard in a globally integrated society.  On the 16^th Authers stated that:

In hindsight, this behavior by banks was obviously irresponsible. The authorities' actions over the past weekend will doubtless be debated even longer than the LTCM rescue 10 years before, but that is the context for their decision. Lehman Brothers bankruptcy will not end the credit crisis. But it ends a decade of moral hazard. Nobody will again assume that the government will bail them out if they lend foolishly.

While I would concur with Mr. Authers that the Lehman Brothers bankruptcy marks an end of an era, I would differ with him on the era that ended.  I strongly believe that the failure of Lehman Brothers marks the end of lightly regulated financial markets both here and around the world.  In the future, starting with the AIG (AIG) bailout, the U.S. government will be an active participant in not only the financial markets but financial companies as well.  

Furthermore, the very idea of moral hazard as it applies to a market or industry is suspect.  If markets and industries are properly regulated, moral hazard should not occur.  When it does occur the individuals who are involved, namely the employees of the company in question, face substantial risks should they undertake certain actions that attempt to pass risk up the food chain.  The fact that Lehman’s management understood the actions that it did and still lost hundreds of millions of dollars for themselves and billions of dollars for their employees should not be overlooked. 

The failure of Lehman Brothers pushed the world very close to the brink, all in an attempt to teach financial markets a lesson.  I hope that the Bush administration realizes that there is a fundamental difference between eliminating common stock holders equity and terminating management teams and the placing of firms into bankruptcy to teach not only shareholders and management a lesson but the bondholders, customers and counterparties as well.  In placing the bondholders, customers and counterparties at risk, the Federal government allowed an intolerable amount of risk to be placed on the financial system.      

The free market neo-liberalism that drove the world for the last several decades is dead and it is time that the Bush administration understands this and begins to implement aggressive policies that will save America’s financial system.  Unfortunately, I fear that the failure of Lehman Brothers, coupled with a failure of AIG, if allowed by the Federal government, will mark the beginning of a prolong decline in the U.S. economy and the start of deflationary era similar to Japan’s predicament in the 1990s.  We can only hope that the Federal Reserve’s bailout of AIG goes through.  Even if it does, there will surely be a crisis around the corner whose severity we can barely imagine. 

During the Great Depression Herbert Hoover was accused of doing too little, I fear that history will repeat itself if the Bush Administration does not step in to support the financial companies of America.  The problems created by this administration, and its predecessors, through a chronic lack of regulation of the financial markets are what led to the failure of Lehman Brothers and the other disgraces that have marked our headlines this year.     

At whatever the financial cost, America’s institutions must be protected by proactive government intervention to assure the continued prosperity of our country.  In a world that is increasingly integrated, we cannot rely on a good cop – bad cop form of moral hazard where we punish the financial market and the people of the world for the incompetence of a select few.  It is clear after the events of the last several weeks that sound institutions in conjunction with free markets, and not free markets alone, are the path to sound economic development and societal progress.    

Disclosure: None

Comments

[Jason Rines...:]

President Bush cannot get anything done with this Congress. When the President defeated the Democrats movement to 'end the war' which was Harry Reid's and Nancy Pelosi's mantra, they hated this man much more then they loved this country. It is moral decay and rotten to the core. Citizens are not protected under law, judges do WHATEVER they want. Now onto business because this is a investment sight:

Businesses must step back for a moment and reevaluate there value proposition to the market, whether it be discounting, adding serving or taking a big axe to there corporations. We're going back to brick and mortar basics. Washington must spend real time on one big push on upward mobility for the economy, in 2009 that means cheap energy and skilled job creation and exports. Government must create policy that assists innovators and entrepenuars and private equity will follow to accomplish this goal of economic restructuring and global value proposition. The USA must have a strong value proposition to the globe in agriculture, metals, technology and healthcare. The USA has abundant natural resources the world needs. We should learn the lessons of the Great Depression and NOT cut off trade but accelerate raw material exports in work off our debts to foreign nations.

2008 Sep 17 08:21 AM

[john s. gordon:]

yes more & wiser regulation is needed, but by now it may be too late to prevent financial catastrophe.
> jack

2008 Sep 17 08:27 AM

[Tom Armistead:]

As you note, the problem is chronic lack of regulation. A new administration should enforce existing laws and make new ones as needed to prevent a recurrance.

Meanwhile, regulators struggle with damage control.

2008 Sep 17 08:56 AM

[notsosmart:]

& mr.fuld gets an additional $22 mil. for the great job @ lehman.all this will never be resolved as long as this stuff continous.

2008 Sep 17 10:05 AM

[elated7:]

"iTHinkBig" you are thinking small, Not Big !!!

Get lost with your BUSH and Republican Scheme of Deregulation.

The paradigm of New Economy is Kaput !!!

You will never learn.

2008 Sep 17 12:48 PM