Bailouts: Misunderstanding the Moral Hazard 22 comments
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Various individuals (many of whom I respect greatly) have been sounding the call to stop talking about the "moral hazard" introduced into the markets by the recent round of bailouts, typically pointing towards the massive losses in shareholder equity as evidence that perhaps the moral hazard doesn't exist. The other argument is that there is no point in complaining about the moral hazard once the city is already burning - just do whatever you can to put out the fire.
While I don't completely disagree with these points, I think that those saying we should ignore the moral hazard have missed a key point:
The moral hazard isn't so much the bailout itself it's the way the bailout is being executed, more specifically it's the fact that Wall St. is being allowed to socialize their losses with minimal penalties, will benefit more from the bailout than the taxpayer and their executives are walking away with generous severance packages.
Now why is that a hazard? It’s a hazard because it creates a win/win by a lesser amount situation for corporate executives who get to walk away from shattered companies with severance packages that exceed the net worth of 99% of the population.
Obviously, no one wants the company they're managing to fail, and it's highly unlikely that the Executives of Freddie (FRE), Fannie (FNM), Bear, Lehman (LEH), et al, would have made many of the decisions they did if they knew what the future outcome would be.
However when you know you can walk away with your multi-million dollar severance, will be allowed to privatize your losses if the worst happens, the government will insure money market funds if "the buck is broken,” etc., etc., it leads one to make riskier choices than they would otherwise.
Which CEO is likely to manage risk more conservatively? Is it the one who knows that if the worst happens he/she will be forced to surrender the bulk of their assets, their company will be orderly liquidated and they may face civil penalties, or is it the one who knows that he/she can walk away with an eight figure severance payment like the former CEO of Freddie Mac?
The moral hazard doesn’t exist due to the mere existence of a bailout; it exists due to the way the bailout is conducted because it isn't about receiving a bailout; it's about receiving a bailout without suffering severe penalties. Yes, there are many who lost dearly as a result of their companies collapsing but there are many who didn't, and the fact that there are people involved with bailed out companies that didn't really lose anything is the essence of the moral hazard.
A case in point: The treasury's proposal for the bailout of the financial sector makes no mention of penalties, while at the same time insists that the best solution for everyone is to dump the financial sector's mistakes onto the balance sheet of the taxpayer. Where exactly is the penalty for the financial sector in this scenario, where the banks get to use the taxpayer as an Enron style SPE to dump their toxic assets on?
Another example is the financial writers (many of whom have former, or current ties to Wall Street) who have been crying for the government to save Wall Street firms for months, as if keeping their buddies employed is synonymous with the best interests of Joe Six-pack.
While I don't dispute the need for some sort of government intervention, the way the bailout is being proposed, the fact that the CEOs of Fannie and Freddie walked away with $23 MILLION in severance, the attitude of entitlement from certain individuals, et al, is the reason the current slate of bailouts constitute an extreme moral hazard.
No company receiving a red cent in assistance from the Federal Government should be allowed to continue to exist. The assistance should be provided in order to facilitate an orderly dismantling, liquidation, et al, of the core business in a manner similar to a bankruptcy or FDIC receivership. Executives in charge of these companies should be forced to surrender compensation going back to 2006, and all severance and retirement packages should be rescinded. They should also have to surrender the majority of their personal assets.
If the financial sector must be bailed out to protect the economy so be it, but make it as painful and difficult as possible for those receiving bailouts so that no one benefits from having run a company into the ground and endangering the economy.
Disclosure: At the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice. The author is also patiently waiting for his "student loan, housing and general expenses bailout," because he feels it would be better for the economy if he spent that money with local retailers instead of on his bills.
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This article has 22 comments:
If the FBI real does something (which I doubt because it is to far reaching and would be bigger than the Nuremburg trails after WWII) we will be reading about government, Private Equity, Wall Street and Corporate Executive involvement … I hope the FBI does do something and if so, these guys should really be treated as “War” criminals…
what's this BS??? if they have no choice but to 'participate' than what the f*ck is this argument??? if they're not forced to 'participate' they're either running a healthy business or are in the midst of a cover-up operation in which case there should be some investigation into top execs personal liability...
The plutocrats have calculated in a remote possibility of revolt and taken precautions:
www.youtube.com/watch?...
Besides in my view the situation should be handled like FDIC receivership: "Sorry but we're MAKING YOU do this, you will suffer greatly, get over it"
But maybe I'm just being an overly Calvinist bear again, it's happened before
-M
Since these methods already exist, what's the point of a bailout package under those conditions? Why not just let them go bankrupt and save the taxpayer hundreds of billions? If the only point is to "orderly liquidate" the bailout is only replicating what already exists.
No, the whole point of the bailout is to transfer wealth from the public to the bankers for the gambles they took that failed miserably. The financial con men are trying to avoid culpability for their past actions while simultaneously keeping the financial windfalls (pay, perks, bonuses, etc) they received for same.
It will end badly regardless, it's just a matter of whose wallet gets lighter.
Has anyone considered instead of handing a huge amount of money over to a bunch of people who created this mess, instead doing something that would benefit the people who are in the crisis with these failed mortgages, helping the small Main St. banks who are struggling, and instead of removing the possiblity of home ownership from all but the rich, by providing programs that will offer "realistic" mortgages to people with limited incomes, and credit scores below 740. The current mortgage programs and rates set these people up to fail. Many failed because these mortgage underwriters knew they were telling these people they had to borrow much more than they could afford at rates they could not afford.
I think it would be a HUGE MISTAKE to rush to authorize a bailout on these terms for this amount of money and expect the taxpayers to blindly comply. I just wonder, does modern politics remember the Boston Tea Party?
The proper course of action would have been to set aside this $700B as a Super Liquidity Fund which would ensure that all current debt needs are met, and that liquidity is ample.
Then, leadership should have bombarded the taxpayer with this message:
"America is safe. Your money is safe. FDIC insurance will be increased to $250,000. Any solvent company that needs liquidity will have it provided via this $700B fund. This fund will ensure that orderliness is swiftly restored to the credit markets and any viable, solvent company will have all the liquidity they need. There will be some turmoil in the short term as a lot of poorly managed companies, especially banks, cease to exist. Rest assured that this will pass, and that we will be the stronger for it. I say again, both America and your money are safe."
Boom. Problem solved.
PS - If the entire economy is about to collapse, why is it that I have yet to hear from any nonfinancial Fortune 500 CEO or CFO giving their unabashed support for this plan. I'm always skeptical when the only party advocating a solution is the sole benefactor. General Electric, Caterpillar, Wal Mart... these companies all have pretty smart guys as their CFO. If the demise of the economy were imminent, I would think these very CFOs would be just as active in advocating this bailout as the Wall Streeters. But the only people I hear crying wolf are the very people this package will benefit.
These financial guys are coming across as aggressive used car salesman. "Once in a lifetime!", "Act Now!!! It Won't Last Long!!!", and just like used car salesman what they really mean is: "please take this crap off our hands for more than its worth!"
Instead of funding the losses of incompetent or corrupt bankers why not let them go bankrupt? Creditor financial firms of a bankrupt financial firm would get repaid of what would be left after non-financial creditors have been repaid. Financial firms should know better than others where to put their funds. In the event non-financial creditors are not repaid for their full deposits after using all available guaranties, a federal fund would finance the difference through a long term loan. Surviving financial firms would also get help from this fund. The obese US financial system would be at long last trimmed to service, not itself, but the producers and the consumers.
ACORN. Thus, it caused all this delay and noises. They themselves are mostly crooks.
The problem with this "bailout" as proposed by Wall Street is that it looks like they are BAILing OUT on the rest of America, it appears they are saying see ya to the rest of this country who allowed them to be at the top of the food chain to ensure the financial security for all of America. The moral crisis now exists because for the last several years, a very large portion of the America has been experiencing a recession while Wall Street claims all is well, and in their view IF some parts of the country are in trouble, oh well, we are not socialists that's just the way capitalism works. Now the recession is knocking on their door, and all of a sudden, they want a socialist bailout. And to add fuel to fire Paulson arrogantly comes begging for a bailout, and then has the gaul to insist that if the bank execs. don't get the compensation they want, well then they just won't participate...RU kidding me??!!
It's bad enough for Wall Street to turn their backs on their America after initially profiting greatly from pushing their cocaine (ultra low starting interest rate mortgages) on credit addicted Americans, which created this crisis in the first place. But to turn their backs when America needs them to do there share and step up to the plate (by investing in America and not overseas in this time of crisis), and assume their share of the responsibility I find appalIing. I can hear the Wall Street types claiming that we are capitalists not socialists and as such, we can't be held responsible, that's just the markets. To that I say yes, we are a capitalist society, AND yes, by the moral bond of honor, decency, and of course mutual self preservation, have created a socialist safety net for ALL. If this is really a crisis that needs our immediate attention, I say united we stand, divided we fall! It's either that or take your greedy a*ses to another country, pull these same stunts over their, and we'll be watching CNN when they take your money and hang your a*ses in the middle of some town square. The rest of America will survive as we always do, maybe just barely, but survive just the same.