Tuesday, March 24, 2009

The selective abandonment of moral hazard

The Federal government announced plans yesterday to use our money to purchase so-called "toxic debts" from private banks in an attempt to free up credit markets.  The plan calls for using up to $100 billion of the bailout money and "giant federal loans" to encourage private investors to purchase securities backed by failing mortgages and mortgage-related investments, that have either no current value or no market.

The stock market soared over 500 points after the announcement.

It seems to me that what we have here is the complete abandonment of the concept of moral hazard, a phenomenon by which someone accepts risks they wouldn't otherwise accept because they are insured from harm. These so-called "toxic debts" began as investment vehicles that carried a higher interest rate than other products because they were risky investments.

The banks that purchased these instruments were (presumably) aware of the basic laws of economics and knew they were putting their money in a risky investment. They chose to do so because of the potential reward if the bet paid off.

As it turned out, those banks made the wrong choice and now, instead of living with the consequences, they are being handed a lifeline and we are being left to hold the bag. So, let me get this straight, we are socializing the loss but privatizing the gain. While shareholders in the banks will be rewarded for the incompetence shown by their executives, taxpayers will be left holding worthless assets. Seems like a good deal, huh?

And why are we abandoning the idea of moral hazard? Because the banks are "too big to fail," we must protect them from themselves. Where's the incentive to evaluate risk when making investments if los federales ride to the rescue when the so-called financial geniuses have a collective brain fart?

Think of moral hazard like this - parents give son the keys to a new car on his 16th birthday. Son drives like a maniac and totals the car. Parents immediately go out and buy him a new one and hand over the keys with no conditions attached. What do you think happens next?

So we bend over backwards to bail out the banks because they're "too big to fail," yet a prosecutor doesn't want to hear about how putting a father behind bars will devastate a family. Bank executives don't face the consequences of their decisions, yet a prosecutor insists that a father accept his. The moral hazard of bailing out the banking sector is dismissed with nary a sound, yet a prosecutor insists on imprisoning a father because of the message showing compassion for a family would send.

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