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 $3.4-

billion (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.