March 18, 2008
Richard Gwyn
In recent months, two phrases have entered the public debate. One is "financial crisis." The other is "recession."
A third phrase has just joined the conversation. It's "moral hazard," an odd saying that better describes the nature of what's now going on than either of the others.
"Moral hazard" means creating, even if unintentionally, an incentive for someone to commit a crime, or, at the very least, an anti-social act.
The classic example is an insurance company that allows a client to insure their house for far more than its real value. This company has created an incentive for the homeowner to burn it down and cash in the policy.
To deal with the financial crisis and so to head off a threatened recession, the U.S. Federal Reserve has just engaged in a massive exercise of moral hazard. This doesn't make the Fed an immoral institution. But it may have made it a most unwise one.
Being too indulgent to an individual insurance client is a pretty small matter. Doing the same to a major financial company on an issue at the very heart of the contemporary financial crisis risks magnifying the crisis itself because those who caused the crisis aren't being held accountable for it.
And if those responsible for financial incompetence, and greed, pay no price, then, pretty obviously, they, and others, will do the same again. And again.
The current example is, of course, Bear Stearns. This financial company went more deeply into the high-risk, subprime mortgage market than did any other. It was known in the industry for its highly "aggressive" style, a delicate way of saying it skirted to the very edge of the legal line.
This is the firm that the Fed has just chosen to wrap inside a protective bubble of moral hazard.
Effectively, the Fed has just nationalized Bear Stearns, although, since in the U.S. the word "nationalization" is synonymous with socialism, the Fed has got another financial company, JPMorgan, to take it over at a fire-sale price.
Nominally, JPMorgan has bought Bear Stearns for $2 a share. (A year ago, the shares were valued at $170). To cover this cost, the Fed has advanced JPMorgan a $30 billion loan and will itself take control of Bear Stearns' portfolio of financial assets.
None of these financial contortions alter the central fact: a company that was a substantive cause of the financial crisis is being rescued from its own ineptitude.
Moreover, the money to do this is coming from ordinary American taxpayers, many suffering the consequences of that financial crisis in the form of lost houses and jobs.
Here's the real rub. One response to the crisis would be to reach out a helping hand to its victims. This would involve the government getting into the heart of the mortgage mess by guaranteeing the mortgages of homeowners who can no longer keep up their payments.
On the weekend, President George W. Bush specifically rejected this approach.
The remaining alternative is the one the Fed has adopted, backed by U.S. Treasury Secretary Henry Paulson who said he was concerned a "chain reaction" might follow Bear Stearns' fall.
So the company is still standing.
But, as happens with any act of moral hazard, it itself will cause other falls. Word is, speculators are out to run down the share value of other troubled financial firms, counting on the Fed to step in.
The Fed has taken a huge gamble. If it loses, a lot of people are going to suffer for a long time. Very few of them, if any, will be executives of financial companies.
http://www.thestar.com/World/Columnist/article/347139
Richard Gwyn
In recent months, two phrases have entered the public debate. One is "financial crisis." The other is "recession."
A third phrase has just joined the conversation. It's "moral hazard," an odd saying that better describes the nature of what's now going on than either of the others.
"Moral hazard" means creating, even if unintentionally, an incentive for someone to commit a crime, or, at the very least, an anti-social act.
The classic example is an insurance company that allows a client to insure their house for far more than its real value. This company has created an incentive for the homeowner to burn it down and cash in the policy.
To deal with the financial crisis and so to head off a threatened recession, the U.S. Federal Reserve has just engaged in a massive exercise of moral hazard. This doesn't make the Fed an immoral institution. But it may have made it a most unwise one.
Being too indulgent to an individual insurance client is a pretty small matter. Doing the same to a major financial company on an issue at the very heart of the contemporary financial crisis risks magnifying the crisis itself because those who caused the crisis aren't being held accountable for it.
And if those responsible for financial incompetence, and greed, pay no price, then, pretty obviously, they, and others, will do the same again. And again.
The current example is, of course, Bear Stearns. This financial company went more deeply into the high-risk, subprime mortgage market than did any other. It was known in the industry for its highly "aggressive" style, a delicate way of saying it skirted to the very edge of the legal line.
This is the firm that the Fed has just chosen to wrap inside a protective bubble of moral hazard.
Effectively, the Fed has just nationalized Bear Stearns, although, since in the U.S. the word "nationalization" is synonymous with socialism, the Fed has got another financial company, JPMorgan, to take it over at a fire-sale price.
Nominally, JPMorgan has bought Bear Stearns for $2 a share. (A year ago, the shares were valued at $170). To cover this cost, the Fed has advanced JPMorgan a $30 billion loan and will itself take control of Bear Stearns' portfolio of financial assets.
None of these financial contortions alter the central fact: a company that was a substantive cause of the financial crisis is being rescued from its own ineptitude.
Moreover, the money to do this is coming from ordinary American taxpayers, many suffering the consequences of that financial crisis in the form of lost houses and jobs.
Here's the real rub. One response to the crisis would be to reach out a helping hand to its victims. This would involve the government getting into the heart of the mortgage mess by guaranteeing the mortgages of homeowners who can no longer keep up their payments.
On the weekend, President George W. Bush specifically rejected this approach.
The remaining alternative is the one the Fed has adopted, backed by U.S. Treasury Secretary Henry Paulson who said he was concerned a "chain reaction" might follow Bear Stearns' fall.
So the company is still standing.
But, as happens with any act of moral hazard, it itself will cause other falls. Word is, speculators are out to run down the share value of other troubled financial firms, counting on the Fed to step in.
The Fed has taken a huge gamble. If it loses, a lot of people are going to suffer for a long time. Very few of them, if any, will be executives of financial companies.
http://www.thestar.com/World/Columnist/article/347139
