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Grace from the U.S. Government: The Moral Hazard Problem
: : By Waldo T. Best

Waldo Best is a vice president and supervisory analyst in the global research division of a major global investment bank. In his 16-year Wall Street career at Barclays, Morgan Stanley, Credit Suisse, and HSBC, he has worked as a money market economist, bond strategist, senior metals equity analyst, and financial editor. He is a second-year Ph.D. student in the Organizational Leadership program at Regent University and can be reached for comment at waldbes@regent.edu.

In a period of weeks, the U.S. government has taken extraordinary steps to stabilize and reform the financial system. Beginning with the government takeover of troubled mortgage lenders Fannie Mae and Freddie Mac, followed by its takeover of the global insurance giant, AIG, and the proposed $700 billion (USD) plan to buy soured mortgages and mortgage-related securities from financial institutions, the price tag for the stabilization will eventually be in the trillions of U.S. dollars. The U.S. Federal Reserve has allowed the two remaining independent investment banks Morgan Stanley and Goldman Sachs to restructure themselves into bank holding companies, meaning that they will be able take deposits but will be able to take on far less risk. The two key questions now are: who will pay for these extraordinary financial actions and what would have happened if the government had not acted?

The U.S. financial markets are driven by access to credit and risk. Individuals and companies borrow money to buy things and conduct business based on their ability to repay. Banks lend money and charge fees and interest rates that compensate for the amount of risk of the loan. These loans are packaged together into debt securities that are then resold into the financial markets. Insurance companies, like AIG, get involved because they sell insurance policies related to the risk of these debt securities. The insurance policy, called a credit default swap, pays the holder if the debt goes bad.

What this extremely-simplified explanation represents is a series of transfers of risk. In the U.S., these risks tend to become concentrated in two types of institutions: investment banks like Morgan Stanley, Goldman Sachs, and Merrill Lynch, and global insurance companies like AIG. When the economy is strong, as it had been during the last expansion, these risks seem small; investment banks make outsized profits because they are compensated for risks that never turn down. The insurance companies collect premiums for default insurance that is never needed. These financial institutions have scores of complex financial models that are used to continuously balance these risks. The firms trade the risks back and forth among the players like a game of hot potato. 

The problem with this system is that risk, like matter, can never really be destroyed; it can be transferred or converted, but it is still there. When aggressive mortgage loan officers, eager to make large commissions, fudged critical details on mortgage applications to get people into homes they really could not afford–that created risk. The same thing happens when aggressive investment bankers arrange loans for companies that are stretched financially. These risks were then bundled into pools of other mortgages and loans, some of which were also risky, some of which were safer. This averages the risk lower, but does not eliminate it. Once the economy turned down, the models of the risk of default on these mortgage and loan debt securities did not work any more. All of a sudden, the investment banks who created and traded the securities were at risk for failure.  When they turned to the insurance companies for insurance against default, they found out that the insurance companies’ risk models did not work either.  The answer to the question of “who insures the insurer?” became clear when the U.S. government gave AIG an $85 billion (USD) secured loan that, in fact, gave the U.S. government an 80 percent ownership interest in AIG.

The cost of this massive bailout will be borne by the U.S. taxpayer in the form of higher taxes, but the more long-lasting impact will come in the form of higher inflation as the trillions of U.S. dollars pumped into the financial system and the reluctance of the U.S. government to allow the U.S. economy to experience a sharper recession to purge the inflationary pressure will result in continued high prices for energy and food. The restructuring of the investment banking industry removes an important source of risk disintermediation. It is unclear who or what will emerge to take their place.

Government bailouts of the financial sector, of course, are nothing new. In 1984, the FDIC (Federal Deposit Insurance Corporation) and the Federal Reserve Bank of Chicago rescued the failing Continental Illinois Bank.  In 1991, the Bank of New England failed after the Federal Reserve and U.S. Treasury lent the bank about $1 billion (USD) to stabilize it. Ultimately, the FDIC rescued the bank, guaranteeing all deposits and infusing $750 million (USD) in capital.¹ The question with all bailouts, whether in the financial sector or in other sectors is, what is the alternative? If the government did not act to takeover Fannie Mae and Freddie Mac, the U.S. mortgage market would have shut down, resulting in a collapse of home equity values causing a deep economic recession. If the government did not act to save AIG and allow Morgan Stanley and Goldman Sachs to restructure into bank holding companies, the entire U.S. financial system could have collapsed. The moral hazard question is whether the leaders of those institutions took on excessive risk, knowing that if things went bad, the government would have to rescue them because they were too big to fail.

Moral hazard impacts all parts of society, from the Texas residents who had to be rescued after failing to evacuate in the face of Hurricane Ike, to the highly-compensated leaders of large companies who fail to steer their companies toward profitability. While most stakeholders are risk-averse, the possibility of government bailouts can create inefficiencies in leader decisions, particularly in large corporations.² In financial institutions, in particular, there is a particular incentive based in moral hazard as the more highly compensated members of any firm are those who take on the most risk: the traders, the risk managers, and the underwriters. The upside/downside is biased towards taking on more risk, despite the huge costs, as the upside in the case of investment banking can be multi-million (USD) annual bonuses directly related to how much risk was taken on. The downside, if things go bad, is unemployment, and perhaps some negative press. Young bankers, tempted by the lure of the ability to become millionaires in their twenties, face huge moral decisions.

The Bible, in I Timothy 6: 6-11, warns against the temptations that can lead those who desire to be rich into “destruction and perdition.” Paul writing to Timothy says, “Greed is at the root of all kinds of evil," but in his letter, Paul was not aware of the special types of financial grace that can be available from the U.S. government if your firm is deemed to be too big to fail. At the end of the day, as I said earlier, risk cannot be destroyed; it can only be transferred or converted.  By putting the results of these bad loans onto the U.S. government’s balance sheet, the government and by extension, U.S. citizens, will now bear the costs of the sins of a relative few³. We will all need God’s grace now.