The End Of The Moral Hazard? Not Quite

Here is an interesting piece from the Financial Times discussing the “alleged” demise of the moral hazard:

From the FT:

The Decade of Moral Hazard has ended, as it began, with a weekend of intrigue on Wall Street.

Ten years ago, the New York Federal Reserve brought together the leaders of the biggest Wall Street banks to decide how to deal with the stricken hedge fund Long-Term Capital Management. It had come to grief in the wake of the Russian debt default. Credit markets were frozen.

The Wall Streeters agreed to club together to take over LTCM, the Federal Reserve followed up with cheaper interest rates, and life returned. The move was intensely criticised, not least by former Fed chairman Paul Volcker, who questioned why the weight of the government should be put behind a private investor.

The problem – according to Volcker and many others – was that the LTCM rescue increased “moral hazard”, or the risk that investors would enter into contracts in bad faith. Knowing that the government was there to help them, banks and other investors were free to make irresponsible commitments.

In the five years following LTCM, the S&P financials outperformed the rest of the S&P by a third. All of that outperformance has been wiped out in the past few weeks. Financials’ share of corporate profits rose from below 20 per cent to above 33 per cent (it had been below 5 per cent in the early 1980s). The financial industry’s share of the US gross domestic product rose sharply.

In hindsight, this behaviour 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.

With all due respect to Mr. Authers I’m not sure that the fact that Lehman (LEH) was allowed to fail constitutes the end of the Moral Hazard, because Lehman’s apples aren’t the same as the GSEs & Bear Stearns Oranges. Furthermore the impact of the Lehman Bankruptcy won’t be on the same scale as the damage that would’ve been inflicted if Bear Stearns had gone bankrupt, not to mention the fact that the government simply has far fewer resources to utilize to rescue failing institutions than it did in the past.

However I do agree that it will give the banking industry pause and remove the assumption that government assistance will always be there, now whether or not this truly causes significant changes in banking executive behavior remains to be seen.

Personally I think that it will take more than the Lehman bankruptcy to truly foster changes in the way banking executives behave because there will always be that attitude of: “that won’t happen to me”; what needs to happen is for the executives in charge of these malaise ridden enterprises to face some truly harsh consequences for their actions. If you want executives to truly change their stripes force them to confront a future where instead of walking way with a fat severance, they get their assets (including retirement) seized save enough to buy a used Hyundai and rent a modest apartment. Force them to front a future where all earnings (and capital gains) in excess of the median household level are garnished at 100%, and they have to retire off of social security.

I’m not saying that the Lehman bankruptcy won’t help, I’m saying that if you really want to change executive behavior you have to dismantle the current environment that allows them to behave like gamblers that can’t truly lose. The message from the government should be clear: “While we’re not going to punish business failures in general, executives in charge of companies that require government intervention (in order to protect the economy) may very well face harsh financial penalties as a result”

The FT has a video from John with more on the topic that you can view here.

Sources:

The Financial Times: “The Short View: Moral hazard” — John Authers, September 15, 2008

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.

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