Misunderstanding The Moral Hazard

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 the fire out.

While I don’t completely disagree with these points I think that a key point has been missed by those saying we should ignore the moral hazard:

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?

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 (LEHMQ.PK), et al, would have made many of the decisions they did if they know what the future outcome will be.

However when you know you can walk away with your multi-million dollar severance, will be allowed to privatize your losses if the worse 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: the one that knows that if the worse 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 the one that knows they can walk with a eight figure severance 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, the moral hazard 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 they’re 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.

Case in point: the Treasury’s proposal for the bailout of the financial sector makes no mention of penalties, whilst insisting 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 are the financial writers (many of whom with former or current ties to Wall St.) who have been crying for the government to save Wall St. firms for months, as if keeping their buddies employed is synonymous with the best interests of Joe sixpack.

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 ‘06, all severance and retirement packages should be rescinded and they should 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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