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Moral Hazard: The Real Culprit of the Financial Crisis

When economists, financial analysts and social scientists examine financial bubbles they look primarily at the agents’ incentives. Whether we’re talking about individual investors or institutions we’re always told to follow the money. Generally, we see empirical and anecdotal evidence in the bubble formation period of both groups making abnormally high risk-adjusted returns. (One may even argue that at this early stage there really is not a bubble because no bubble has even been created yet. It’s just investors making abnormally high risk-adjusted returns.) The post hoc analysis, however, never looks at the institutions who sat on the periphery and recognized three fundamental realities: (1) not participating may permit other institutions to continually make these high rates of returns; (2) these other institutions may take their profits and diversify in businesses like theirs; or (3) profits pouring into the coffers of our competitors may make us irrelevant.


So the periphery sitters have two choices, let the players build and grow their business (and make a lot of money) or get in the game (and take some of that business). It’s in the latter decision where the bubble gets created, logic is abandoned and a period unwarranted capital allocation proceeds. The periphery sitter doesn’t care if their involvement will create the bubble or if it will create a bubble, exacerbate a burgeoning bubble or if, in the long run, it will ultimately lead to capital destruction. No, the periphery sitter only looks at its own survival and concludes if I don’t get in the game, new wealth may get concentrated in the hands of players that may seek to diversify their lucre into my business.


It is precisely when the periphery sitters enter the game when the bubble potential is heightened and most vulnerable. (The size of the bubble will be a function of the added production capacity the periphery sitters add to the market when they join.) Few industries can, effectively, double or triple their capacity and get the same returns as the players were getting when the capacity was much smaller; yet that is exactly what we see in each bubble. (Because Wall Street has virtually unlimited access to capital, it’s easy to see how their movement from periphery sitter to primary player can dramatically change the capacity for any industry they decide to throw capital at. The 2000 telecom bubble had the same problem. Tons and tons of new capacity were brought on line by Wall Street’s unchecked easy money policies towards telecom carriers that lacked the requisite demand to absorb the new capacity.)


So why does Wall Street, in the most hackneyed of clichés, throw good money after bad? Is it because they don’t understand the risks? Is it because they don’t understand the industries they’re investing in?


It seems unlikely that Wall Street doesn’t understand the businesses they invest in. After all, they hire the best and brightest from inside the industries they look to invest in supported by the best financial minds their money can buy.


The problem is more fundamental than that. It’s fear, jealousy and the expectation that when reality catches up to fantasy, everyone will fail. Blame will be evenly distributed among all players. Depending on the size of the bubble some companies will fail and in the case of the most recent bubble, even some Wall Street firms will fail. But in the end, since everyone is to blame, no one is to blame.


The aftermath is ugly, but the gun is already reloading for the next bubble.