Streetwise Professor

There is a debate going on in the blogsphere about whether the moral hazard model is helpful in understanding the financial crisis.  One view is that it is not.  For instance, Jeffrey Friedman argues that it does not:

First, the moral hazard of “too big to fail” (TBTF). Empirical problem: Before the bailouts, nothing of this scale had ever happened, so no bank could have been sure they would be bailed out. And if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett’s Fool’s Gold and William D. Cohan’s House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn’t think they were doing anything particularly risky (an ignorance-based human error), so they didn’t even consider the chances of being bailed out.

Second, the moral hazard of “corporate compensation systems,” i.e., bonuses.

Empirical problem #1: When this theory took hold, there was virtually no evidence for it (whereas now there is one study for it and one against it)–see Wladimir’s and my post on the topic (below).

Empirical problem #2: There was, and remains, the following overwhelming evidence against the theory: 93% of the banks’ mortgage-backed securities were either guaranteed by the U.S. government (i.e., Fannie and Freddie) or were rated AAA–the “safest” and *lowest-yielding* securities available. Triple-A bonds are the last thing revenue-seeking, bonus-hungry, risk-indifferent (i.e., risk-knowledgeable, rather than risk-ignorant) bankers would have bought.

Russ Roberts thinks otherwise:

I don’t think bankers planned on being bailed out. But I think it affected their decision-making. . . .

Hmmm. Not the best evidence. Do you really expect Jimmy Cayne, the CEO of Bear Stearns to tell a reporter that he threw away his firm’s money because he thought he’d get it back from taxpayers? But here’s what he does tell William Cohan:

The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?

And then there’s this moment from Andrew Haldane?, the Executive Director of Financial Stability of the Bank of England:

A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices.  The first meeting of that group sticks in my mind.  We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.  A quick survey suggested these were very modest stresses.  We asked why.  Perhaps disaster myopia – disappointing, but perhaps unsurprising?  Or network externalities – we understood how difficult these were to capture?

No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

All of the other assembled bankers began subjecting their shoes to intense scrutiny.  The unspoken words had been spoken.  The officials in the room were aghast.  Did banks not understand that the official sector would not underwrite banks mis-managing their risks?

Yet history now tells us that the unnamed banker was spot-on.  His was a brilliant articulation of the internal and external incentive problem within banks.  When the big one came, his bonus went and the government duly rode to the rescue.

I think that both Jeffrey and Russ might be looking for moral hazard in all the wrong places.  If lenders to big financial institutions figured they would get bailed out, they would be willing to extend cheaper credit to these institutions than would be the case in the absence of the expectation of a bailout.  It’s pretty clear that Fannie and Freddie were able to borrow at very attractive rates, and hence grow grotesquely large, because of the expectation that the government would not let them fail.  Similarly, lenders expecting that a Citi or BofA were too big to fail might also have expected that they would be bailed out with high probability, allowing these banks to borrow at rates that did not reflect the true risks.

The managers of these institutions would have faced distorted price signals: debt was cheaper than it should have been (due to the lenders’ expectation that a bailout was possible, or even likely), so the financial institutions became bigger and more leveraged than they should have been.  Importantly, this would have happened even if the bankers themselves had discounted the possibility of a bailout, or believed that a bailout would not save the equity holders (including them) or their bonuses.

Turning to today’s news, this source of moral hazard is exactly why the Euros are playing with fire if they actually do bail out Greece, not to mention Portugal or Spain if it comes to that (as it might).  Once this crisis passes, especially if it passes due to a bailout, lenders will feel quite safe in extending credit to profligate governments in the future, which will just lay the groundwork for another crisis.

There is a serious risk that the EU and the Euro cannot survive a bailout.  Germans in particular are dissatisfied with the Euro as it is; a bailout of the Greeks and whoever else comes knocking will only stoke that dissatisfaction.  Especially if it is not accompanied by credible institutional constraints that will prevent the problem from recurring: the credibility of the original constraints on member country budgets is already in tatters.

But it is not clear that the Euro (and the EU) can survive no bailout either.  The natural course for the affected countries is to go off the Euro and devalue, or default

That’s why it seems that the EU is playing a huge bluff.  There are important sounding announcements of hazy plans to support Greece in its hour of need, even though a bailout could well violate EU law. The Germans, French, etc., are hoping that the promise of a bailout will calm the markets, allowing the crisis to pass without the need for the bailout actually to take place.

Paulson tried that gambit with Fannie and Freddie.  We all know how well that worked out.  The credibility of the promise is so suspect, that it is highly likely that some big funds will bet against it, and call the bluff.  Hence the jeremiads against speculators:

In a joint press conference with Mrs Merkel, the French president, Nicolas Sarkozy. said euro-zone countries were offering “solidarity” in exchange for Greek promises of “rigour and transparency”. This would give Greece’s promises vital “credibility”, he said. Challenged on the lack of detail in the summit declaration, Mr Sarkozy said “speculators should understand” that Europe had agreed a strategy for defending the euro zone, and “we will come up with tactics as needed.”

That swipe at speculators probably offers a hint about the political tactics that Mrs Merkel and other leaders may employ to sell any Greek bail-out to voters. Already, politicians including José Luis Rodríguez Zapatero, the Spanish prime minister, have portrayed market pressure on their countries as part of a broader plot by murky market forces that want to destroy the euro and fight off tougher financial regulation within the EU. Expect to hear more about European political solidarity versus the speculators.

Knowing that his country is also on shaky ground, Spain’s Zapatero also launched a verbal strike against speculators, adding an element of conspiracy theory that would make a truther or a birther proud:

Mr Blanco told Cadena Ser radio that attacks on Spain were attacks on the euro, and were “rather dirty dealings” on the part of speculators, who:

“now that they see we are emerging from the crisis, do not want to see better regulation of their activities, [but] want to be free to carry on pursuing their own interests… None of what is happening, including editorials in some foreign media with their apocalyptic commentaries, is happening by chance, or innocently. It is the result of certain special interests.”

Here is Mr Zapatero:

“There is an attack underway by speculators against the euro, against tougher financial regulation of the financial system and of the markets”.

How dare those speculators say the emperor is naked!

The crisis, arguably born of moral hazard, is by no means over.  And “solving” the crisis may just ensure that moral hazard will survive, bigger and badder, in the future.  Just don’t ask the bankers or national leaders about it.  Ask the people who lend them money.