Monday, September 22, 2008

The Price of Moral Hazard

Moral Hazard:

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

See also: 1999-2008.

So what are we going to do about it? Who knows? The Treasury Secretary wants to administer a $700 billion bailout. The bidding on Capitol Hill has already begun. Partisans on both sides are blaming the other for causing the mess.

The only thing I am certain of this: the people who are taking steps to fix the problem aren't likely to fix anything, because they all had a hand in it. I sure did: I worked for Bank of America for 3 years during the height of the boom and B of A was involved in what's happened (and is bidding to benefit from the wreckage). B of A had better standards than a lot of lenders, but I was privy to financial information for our line of business and there were some bad loans in our portfolio, loans that would never have been made in a more normal time. We all knew it, deep down, but no one wanted the party to end.

You can't count on Congress to fix the problem -- Barney Frank, Christopher Dodd and yes, Barack Obama were wholly-owned subsidiaries of Fannie Mae and Freddie Mac. You can't count on the Fed: Alan Greenspan and Ben Bernake would occasionally make cryptic comments about things, but they didn't stand up to say that madness was afoot. And the Bush administration didn't bother, either.

We all own this. It won't do to pretend otherwise.

1 comment:

Right Hook said...

What is really maddening is that clowns like Barney Frank are spinning the situation as a failure of capitalism and a lack of government regulation and the lamestream media is dutifully reporting it that way. Nothing could be further from the truth. Does anyone really believe that the financial sector, with all of the money involved, is under regulated? The problem is not lack of regulation, but rather who is doing the regulation and how it is done.

This problem was caused by the government distorting the marketplace and introducing the moral hazard. Going back to the Carter Administration policies were inacted using the force of government to induce lenders to give mortgages to people who would never otherwise get loans based on their financial status and credit worthiness. The Clinton Administration really accelerated the problem by turning the Reno Justice Department (talk about an oxymoron!) loose to make not-so-veiled threats that "red lining" would not be tolerated and lenders who didn't play ball would be persecuted and prosecuted by the government, presumedly under authority of disparate impact statutes that spun off of so-called civil rights litigation. Essentially lenders were regulated to force them to make bad loans.

When lenders pointed out that they could very well go out of business the government "fixed" the situation by instituting GSE's like Freddie and Fannie - essentially saying "quit your whining and make the loans because we've got you covered". This is the introduction of the said moral hazard. Taking the risk out of an investment is tantamount to playing with the house's money. The problem further snowballed when clever financial people saw the opportunity to create derivative, CDOs,and other financial "instruments" based on bundling, brokering, and trading "can't lose" propositions. When the housing market, which was severely inflated due to the nearly "free money" caused by these financial fiats hit a down cycle (as any economic trend always will) the bottom dropped out and the "guarantee" is being called.

To his credit, it was reported on SRN Radio news this morning that the Bush Administration had questioned government regulators no less than 17 times in the last eight years as to the viability of Freddie and Fannie but was ignored. McCain also brought it up in 2005. Perhaps Bush and McCain did not try hard enough, but the fact is that this problem was seen on the horizon and was ignored by the congress and the regulators.

Yes, we unfortunately own this problem and can't count on congress to fix it. As in the case of the relatives of a murder victim not being able to bring the victim back, the best we can do is to take as many steps as possible to avoid future repeats. This starts by voting liberals out of office at all levels of government.