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Bailouts and the nasty consequence of 'moral hazard'

Bailouts and the nasty consequence of 'moral hazard'

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Published by: Manning Centre on Oct 20, 2009
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Bailouts and the nasty consequences of ‘moral hazard’

Gwyn Morgan, Globe and Mail – Aug 3, 2009

'As Wall Street institutions began collapsing under the weight of their own behaviour, the greatest moral hazard in economic history occurred'
From its origin in the 1600s, the term "moral hazard" has been used to express our revulsion toward protecting reckless risk-takers from downside consequences. Over time, it has also come to describe other situations, such as when successful enterprises are taxed while failing enterprises are subsidized. The current economic meltdown and its aftermath vividly demonstrate moral hazard. Government policies planted the seeds of the U.S. subprime mortgage debacle. For example, an affirmative action-style policy requiring lenders to report the demographic profiles of borrowers fostered mortgage loans to people with highly questionable creditworthiness. The upside for the borrower was gaining equity value as house prices rose. The moral hazard was that in contrast to Canada, U.S. mortgages bear no recourse to the borrower, allowing mortgagees to simply walk away when house prices collapsed. Moral hazard continued right through this disastrous chain. Mortgage brokers earned bonuses on the value of mortgages written with no downside in the event of default. Next, investment dealers earned billions in bonuses for slicing and dicing mortgage loans into packages called mortgage-backed securities, for sale to unsuspecting investors who relied on appallingly flawed analyses provided by supposedly independent credit-rating agencies. As Wall Street institutions began collapsing under the weight of their own behaviour, the greatest moral hazard in economic history occurred. Uncle Sam committed funds from taxpayers, whose own jobs and savings had been devastated by the economic meltdown, to bail out the very people who had not only caused the problem, but profited hugely from it. Fast forward to July and the announcement by Goldman Sachs of a $3.4billion (U.S.) quarterly profit, and plans to pay out half of its 2009 booty in bonuses that are expected to average some million dollars per worker. Goldman was given $10-billion from the Troubled Asset Relief Program (TARP), which the company has since repaid. Critics point out that one of the reasons for Goldman's resurgence is that the U.S. Treasury's massive bailout

of failing credit default insurer American International Group (AIG) rescued the brokerage from tens of billions in loss-exposure to AIG. Moral hazard on Wall Street certainly doesn't stop with Goldman. Citigroup and Bank of America, which received the biggest shares of the $340-billion in TARP funds paid out so far, notched up quarterly profits of $4.3-billion and $3.2-billion, respectively. Examination of these profit announcements reveals a highly ironic moral hazard. A substantial portion of Wall Street profits came from the trading of what Goldman calls "credit and interest rate products" - largely U.S. Treasury bills. So, why are the T-bill printing presses working overtime? You guessed it ... to finance the government's multitrillion-dollar deficit resulting from bank and auto bailouts, plus recession stimulus spending in the face of sharply lower tax revenues. And wasn't it the crazy culture of unaccountable Wall Street bonuses that ignited the financial meltdown and plummeted the global economy into this recession? This is moral hazard in its most disgraceful form. Profit by causing the problem, then profit again from government reaction to it. As the saying goes: "They gets us coming, and they gets us going." The Wall Street bailouts demonstrate the folly of privatizing profit while socializing risk. But the financial industry is by no means alone in the moral hazard of socializing risk. Bailout-eschewing Ford not only sees competitors GM and Chrysler relieved of their debt burdens, but must also face the prospect that governments will keep throwing in money, rather than face the political consequences of failure. Having become one of GM's new owners, Ontario Premier Dalton McGuinty travelled to a General Motors dealership recently to announce an electric-car subsidy package that includes $10,000 (Canadian) toward the purchase price, preferential purchase for his government's fleet, and special green licence plates allowing travel in transit system lanes. Despite the use of the term "green" at least a dozen times during his announcement, the fact is that the Chevrolet Volt will be powered by electricity partly generated by coal and other fossil fuels. Ignored by Mr. McGuinty's rhetoric are authoritative, full energy-chain analyses showing that hybrids such as the Ford Fusion, Honda Insight and

Toyota Prius are "greener" than the Volt, yet the subsidy doesn't apply to them. This prompted Stephen Beatty, managing director of Toyota Canada, which has just become Canada's top auto maker, to ask the question: "Is this a well-thought-out industry strategy, or is it sort of the next stage in advancing a particular product and helping a particular company?" Good question, Mr. Beatty. Finally, there is the money-printing frenzy to finance the U.S. deficit, setting the stage for an inevitable inflationary spiral. Inflation is a particularly insidious and unfair form of moral hazard, letting off the hook both governments and individuals who have imprudently piled up debt, while eroding the value of savings and pensions put away by those who acted responsibly. Whether it's in business, politics or family life, protecting people from the consequences of their actions leads to dysfunction. Societies whose governments condone or encourage moral hazard are societies sliding down the proverbial slippery slope. This should be the biggest lesson we take away from the financial meltdown and the reactions of governments to it.

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