Rescuing Wall Street — What about Moral Hazard?

by

Invoking moral hazard instead of rigorously regulating the financial industry has resulted in the worst financial crisis since the early 1930s.  To prevent a recurrence of the problems that led to this financial crisis, the United States and indeed the entire world need a new vigorously enforced regulatory structure for the financial services industry.

Citigroup Bailout

On Monday, the Bush Administration announced the terms of the Citigroup bailout.  Over the weekend, Citigroup identified a pool of U.S. residential and commercial mortgage loans, leveraged business loans and other related assets with a nominal value of $308 billion; the U.S. government agreed to provide insurance.  For that asset pool, Citigroup agreed to be responsible for the first $29 billion in losses, and 10% of the remaining losses, with the U.S. government picking up the rest.  The government risk was assigned among agencies as follows:  The Treasury will take the first $5 billion in government losses, and the Federal Deposit Insurance Corp. will absorb the next $10 billion in losses. If the asset pool losses exceed those triggers, the Federal Reserve will grant a loan for the remaining losses.  In exchange for that insurance, Citigroup sold $27 billion in preferred stock to the U.S. Treasury for $20 billion.  The preferred stock will have a dividend rate of 8%.[i] 

Conditions of the rescue included an agreement that Citigroup will not pay quarterly dividends of more than 1 cent a common share for three years unless the company obtains consent from the three federal agencies, as well as restrictions on executive compensation, including bonuses. Commentators said the deal raised the issue of moral hazard in dealing with large financial institutions.[ii]

Definition of Moral Hazard

According to Wikipedia, “Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions…  [In finance], a moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.”[iii]

Role of the Concept of Moral Hazard in Paulson Actions

Treasury Secretary Hank Paulson has worried publicly about moral hazard while dealing with the current financial crisis, which began in the Spring of 2007 when more than the expected percentage of subprime mortgages started defaulting.  Two Bear Stearns hedge funds, which used high leverage to buy subprime mortgage-backed securities and also bought credit default swaps to reduce risk, collapsed and were liquidated in July 2007.  For the rest of 2007, the damage seemed to be contained, but during the week of March 10, 2008, rumors and short sellers brought down Bear Stearns.  On March 16, 2008, under the leadership of Hank Paulson and Ben Bernanke (chairman of the Federal Reserve), the government encouraged J.P. Morgan Chase (Jamie Dimon, CEO) to acquire Bear Stearns at a low stock price – originally $2 but a week later raised to $10 per share.  To facilitate the deal, the Federal Reserve Bank of New York gave a loan of $29 billion, to be repaid from the sale of Bear Stearns assets valued at $30 billion in a mark-to-market exercise on March 14, 2008.[iv]   Mr. Paulson argued that the large decline in Bear Stearns stock price in the week before the acquisition (and a $133 per share 52-week high) negated the moral hazard concern.

To try to avert a recession, Congress authorized and the U.S. Treasury sent economic stimulus checks to almost everyone in the country.  The Bush Administration hoped that an economic downturn had been averted.  However, oil and gasoline prices went up during the summer of 2008, housing prices continued to decline, and mortgage delinquencies continued to rise.  A few people started to worry about derivatives such as credit default swaps.  Home foreclosures started to set records.

Fannie Mae and Freddie Mac

As concern mounted about the solvency of Fannie Mae and Freddie Mac, Treasury Secretary Paulson requested from Congress the authority to bail them out if necessary.  The Housing and Economic Recovery Act of 2008-passed by the United States Congress on July 24, 2008 and signed into law by President George W. Bush on July 30, 2008-expanded regulatory authority over Fannie Mae and Freddie Mac by the newly established Federal Housing Finance Agency (FHFA), and gave the U.S. Treasury the authority to advance funds for the purpose of stabilizing Fannie Mae, or Freddie Mac, limited only by federal debt limits, which were increased.

On September 7, 2008, James Lockhart, director of the FHFA, announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA.  He cited their combined losses of $14.9 billion and their difficulty in raising sufficient fresh capital to continue to perform their mission as mortgage defaults continued to climb.  Treasury Secretary Paulson and Federal Reserve Chairman Bernanke sat next to Lockhart as he told the CEOs of Fannie and Freddie that they were losing their jobs as part of the takeover.  The takeover was described as one of the most sweeping government interventions in private financial markets in decades, but Congress had created these Government-Sponsored Enterprises (GSE) to provide liquidity in the home mortgage market, and most investors had assumed all along that Fannie Mae and Freddie Mac bonds would be backed by the U.S. Government if any difficulty arose.  The Treasury committed to invest as much as $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating.  To assert moral peril, the common stockholders lost their entire investment, and preferred stock dividends were suspended.

In suspending Fanny and Freddie’s preferred dividends, the Treasury and the Fed underestimated the impact on ordinary Main Street banks, which were only allowed to own preferred stock.  According to the Financial Times, “Nearly a third of US banks hold preferred stock issued by the two mortgage financiers that were taken into conservatorship…, according to an industry survey conducted by the ABA. The average bank exposure to such securities relative to core equity capital was 11 per cent.”[v]  The preferred dividend suspension wiped out $36 billion in capital that U.S. banks had to write down, at the same time the Treasury and the Fed were trying to improve the capital position of banks, both large and small.  Thus another mess was created in the name of minimizing moral hazard.

Lehman Brothers Bankruptcy

Allowing Lehman Brothers go bankrupt on September 15, 2008, in an attempt to minimize future moral hazard, turned out to be a huge mistake. In addition to many thousands of creditors holding its bonds, Lehman had made derivatives deals with 8000 firms, and other firms held credit default swaps with notional value of hundreds of billions that were triggered by the Lehman bankruptcy. Lehman was reported to be involved in as much as $1 trillion in outstanding derivative transactions.  The entangling counterparty risk was enormous, affecting financial institutions as well as individuals all over the world.  Scores of hedge funds that had hundreds of millions in cash and other securities parked with Lehman’s prime brokerage operation in London had their accounts frozen.[vi] Law suits abounded, asking for the return of frozen collateral.  Wind farm operators were left to scramble for alternate sources of funding, because Lehman Brothers had had a big green energy program.

Before the election, and long before Barack Obama started assembling his economic policy team, Ezra Klein reported that Tim Geithner had argued in favor of rescuing Lehman Brothers, it could not be allowed to file for bankruptcy, because the entangling counterparty risk was too great for the markets to handle.[vii]  Hank Paulson said Congress wanted to send a signal that bad risk management would not be rewarded.  Lehman fell.  The result was a catastrophe.  Despite the government rescue of AIG the following day, financial institutions lost all trust to lend to each other, and the credit crisis reached disaster proportions.  Swap sellers sold equities to raise cash to pay swap buyers, driving down global stock markets.  In the two months following the Lehman Brothers bankruptcy, the U.S. stock market alone declined approximately $5 trillion in addition to the approximately $3 trillion decline from its peak to the last trading day before the Lehman bankruptcy.  That is quite a price to pay to minimize moral hazard.

How did we get into this mess?

The primary cause of the current financial crisis was the deregulation of the financial services industry, not moral hazard.  The precursor was the Savings and Loan Crisis.  S&Ls had previously been restricted to investing depositor funds in home loans and community development projects.  During the Reagan Administration, S&L deposit insurance was raised from $20,000 to $100,000 per account, and S&Ls were allowed to invest in any real estate project they wanted – shopping malls, out-of-state hotels, even casinos. Risk-taking S&L executives lost money on poor investments.  The Federal Savings and Loan Insurance Corporation was overwhelmed by the losses, and the federal government was forced to close many S&Ls, refund depositors’ money and take over foreclosed properties. 

Remembering the lessons learned from the S&L crisis, Congress passed the Home Ownershi and Equity Protection Act (HOEPA) in 1994, giving the Federal Reserve the power and duty to regulate the mortgage lending industry, to require adequate disclosure and prevent predatory lending.  However, Federal Reserve Chairman Alan Greenspan, a lifelong Republican, was reluctant to regulate mortgage lending.  Dr. Greenspan publicly encouraged people to make use of adjustable rate mortgages, which he said would lower the cost of home ownership.

When, in July 1998, the Commodity Futures Trading Commission proposed to regulate OTC financial derivatives such as swaps, SEC Chairman Arthur Levitt objected.  Less than two months later, we almost had a world-wide financial crisis when highly-leveraged LTCM collapsed but was saved by several commercial and investment banks at the instigation of the Treasury and the Federal Reserve.  

Unfortunately, our government leaders learned nothing from the LTCM near-disaster in 1998.  Alan Greenspan (with support from Treasury Secretary Robert Rubin) persuaded Congress to pass legislation removing from the CFTC the power to regulate financial derivatives.  The OTC derivatives market remained unregulated, providing a means for banks and other financial institutions to skirt capital requirements and increase their leverage.

In 1999, a Republican Congress repealed the Glass-Steagall Act, a cornerstone of New Deal regulation.  The Glass-Steagall Act of 1933 created the Federal Deposit Insurance Corporation (FDIC) and separated investment banks from commercial banks.  Commercial banks were part of the banking system. They created credit. They were regulated, supervised, usually enjoyed FDIC insurance, and had access to advances from the Fed in emergencies. Investment banks were allowed to take more risks in their investments, but any losses on those investments would have to be borne by their shareholders, not the government.[viii]

However, during the Reagan Administration in the 1980s, regulators who didn’t believe in regulation either allowed explicit waivers of some aspects of Glass-Steagall or looked the other way as commercial banks and investment banks became more alike. In 1998, Travelers CEO Sandy Weill created the world’s largest financial supermarket Citigroup, with $700 billion in assets, via a $140 billion merger of the consumer and commercial banking giant Citicorp with the financial services conglomerate Travelers Group, whose businesses covered credit card services, consumer finance, retail brokerage, bond trading, investment banking and insurance.[ix]  The deal would enable Travelers to market mutual funds and insurance to Citicorp’s retail customers while giving the banking divisions access to an expanded client base of investors and insurance buyers.  This merger was a gross violation of the Glass-Steagall Act.  The basic premise of Glass Steagall had been to prohibit retail banks from selling common stocks to unsophisticated depositors, and to segregate insured banks from the risk-taking culture of investment banks.   This merger was not the first violation of the Glass Steagall Act, just the most flagrant.  Weill predicted at the time of the merger that legislation would obviate the need to divest prohibited assets.  Under the leadership of Senator Phil Gramm (R, Texas), and supported by Treasury Secretary Larry Summers, Glass-Steagall was officially repealed in November 1999 by Gramm-Leach-Bliley Act.[x]

In 2000, the Federal Reserve established an advisory committee chaired by Walter Shipley, former CEO of Chase Manhattan Bank.  The Shipley panel recommended specific changes in regulatory oversight to improve risk management and to require better disclosures for all financial institutions.  However, Fed Chairman Greenspan chose to ignore the recommendations of the Shipley committee, as he had ignored HOEPA.  Last month, Alan Greenspan admitted to a hostile Congressional Oversight Committee that his deregulatory philosophy had a flaw.  Thanks a lot, Mr. Greenspan.  Ten years too late!

Deregulation ideology continued to prevail in this decade. In 2003, the Federal Government preempted authority from the states when several state Attorneys General tried to investigate and rein in deceptive and fraudulent peddling of subprime mortgages.  In 2004, the SEC held a basement hearing with only representatives of five major investment banks, including Goldman Sachs – led by Hank Paulson, now Treasury Secretary – in attendance, and agreed to relax capital requirements on those banks, and allow them to operate at higher leverage.  Meanwhile, the unregulated credit default swap market grew from $900 billion in 2000 to $62 trillion in 2007, or four times U.S. GDP, threatening the entire global capitalist system.[xi]

Treasury Secretary Hank Paulson has been consistently behind the curve in dealing with this financial crisis.  Nationalizing Fannie Mae and Freddie Mac in the waning days of summer (September 7, 2008) was the right thing to do.  However, allowing Lehman Brothers go bankrupt on September 15, 2008 turned out to be a huge mistake. In addition to many thousands of creditors holding its bonds, Lehman had made derivatives deals with 8000 firms, and other firms held credit default swaps with notional value of hundreds of billions that were triggered by the Lehman bankruptcy.  The entangling counterparty risk was enormous, affecting financial institutions as well as individuals all over the world.  Financial institution lost all trust to lend to each other, and the credit crisis reached disaster proportions.  Swap sellers sold equities to raise cash to pay swap buyers, driving down global stock markets.  In the two months following the Lehman Brothers bankruptcy, the U.S. stock market alone declined approximately $5 trillion in addition to the approximately $3 trillion decline from its peak to the last trading day before the Lehman bankruptcy.  Millions of people will lose their jobs as the recession deepens.  Millions of hard-working people with limited financial acumen have seen their savings destroyed and their retirement dreams deferred.

Where does financial services policy go from here? 

The federal government needs to regulate all aspects of the financial services industry.  As Barack Obama said in his speech on March 27, 2008, “We need to regulate financial institutions for what they do, not what they are.”[xii] The basic principles should be based on asking what role the financial institution plays in the economy.  If it is accepting and keeping retail and commercial deposits, with FDIC insurance, it should be regulated as a commercial bank.  If it invests the shareholder capital in risky assets, using leverage to increase its returns, it should be regulated as an investment bank.  Some 21st Century version of Glass-Steagall is necessary to protect taxpayers from the need to bail out investment banks.

Leverage needs to be controlled for all financial institutions, whether they are called banks or insurance companies or hedge funds or commodity futures trading companies.  No company should be allowed to operate with so much leverage that its failure could threaten the entire global financial system, a situation in which we have found ourselves during the past two years.  To be more specific, leverage of 30:1 is outrageously too high.  Fines are not a sufficient deterrent to the greed of some people who will use high leverage whenever they think they have a chance to make a large fortune risking other people’s money.  Legislation needs to specify significant prison time for people who violate the rules of the new financial system. 

Now that we have mentioned hedge funds, the question is whether they have any redeeming social value.  Banks keep depositors money safe and put money to work by lending to households and businesses based on the lender’s assessment of their ability to pay the loans back.  Insurance companies spread risk among large groups of customers, sparing the focus of hardship on the unlucky few.  Financial advisers help people and businesses save and invest wisely.  Venture capitalists raise funds for entrepreneurs who create innovative products and services.  Hedge funds should not be allowed to exist just to gamble on giant returns by using greater leverage than is allowed of regulated financial institutions.  As a minimum, hedge funds should be regulated with regard to leverage and the transparency of their operations.  If hedge funds cannot find a contributing role in the real economy, they should be shut down.

The new financial order must ensure the independence of the financial rating companies.  We need to separate the funding of financial rating companies (like Moodys, Standard & Poors, and Fitch) from the financial engineers who came to them for ratings.  We have suffered from a system under which bond issuers paid the ratings companies to rate their bonds, and the ratings companies sold consulting services to tell the issuers how to tweak the composition of their Collateralized Debt Obligations to get AAA ratings. The federal government needs to police conflicts of interest like that. [xii] 

Transparency is a key issue.  New Deal legislation sought to increase transparency in the interstate offering and sale of securities.  The Securities Act of 1933 requires every U.S. public company to register new securities (with the SEC after 1934) and to offer (interstate) securities only through a truthful prospectus giving basic financial information as well as stating the risk involved in investing in the offered securities.  Corporations were also required to issue audited annual reports on the status of the business.  The Securities Exchange Act of 1934 focused on the sale of securities in secondary markets, creating the Securities and Exchange Commission (SEC) to monitor and enforce corporate reporting, ensure conformance with regulations, as well as to detect and punish accounting fraud, false information distribution, insider trading or other violations of the securities law.[xiii]  Unfortunately, despite additional legislation (e.g., the Investment Company Act of 1940, the Investment Advisors Act of 1940, and the Sarbanes-Oxley of 2002), federal laws have not kept up with the pace of financial chicanery (described in the industry as innovation).

There needs to be more transparency of all kinds of financial instruments, including the kind of mortgage-backed securities, collateralized debt obligations and credit default swaps that have created the multi-trillion dollar financial meltdown we have experienced over the past eighteen months.  For example, standardized credit default swaps should be traded through a CDS clearinghouse (something that Tim Geithner has been encouraging in recent months). Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[xiv]

Size is also an issue.  No financial institution should be allowed to grow into a company that it is too big to fail.  Sandy Weill was right when he predicted the repeal of the Glass-Steagall Act after he created Citigroup, but he was also right in what he implied, which was that he had created an institution that had an inherent advantage over its rivals because it was too big to fail.  Citigroup must be broken up.  If the Citigroup management does not spin off parts of its business voluntarily, then antitrust litigation should be used to break up the company.  Furthermore, we need to reverse the trend during the Paulson era of turning to the biggest banks to absorb other big banks that get into trouble.  We must ensure that there are no more Citigroups in the future.

We hope and trust that the new Economic Recovery Advisory Board to be chaired by Paul Volker will address these issues and recommend a new financial system regulatory framework.

Summary

Invoking moral hazard instead of vigorously regulating the financial industry has resulted in the worst financial crisis since the early 1930s.  This site is not alone in saying proper vigorous regulation of the financial industry must replace the concept of minimizing moral hazard as the means for preventing financial crises such as we have been experiencing for the last year and a half.[xv] 

In September 2008, with the worldwide economy teetering on the brink of calamity, Treasury Secretary Hank Paulson decided to reduce moral hazard by standing back, demanding that the financial industry heal itself, and allowing Lehman Brothers to go bankrupt when Barclays Bank could not accept the risks of a takeover.  The result:  Credit markets froze and stock markets crashed all over the world.  In the two months following the Lehman Brothers bankruptcy, the U.S. stock market alone declined approximately $5 trillion in addition to the approximately $3 trillion decline from its peak to the last trading day before the Lehman bankruptcy.  Citigroup tottered on the brink, and needed a federal bailout.  Millions of people will lose their jobs as the recession deepens.  Millions of hard-working people with limited financial acumen have seen their retirement savings deferred or destroyed.

The ad hoc Bush Administration response to the unfolding financial crisis has been guided by its failed laissez faire free market ideology.  Unable to break away from a flawed [Alan Greenspan’s term] ideology, Treasury Secretary Paulson has zigged and zagged from one approach to another as he sought a temporary solution to contain a conflagration that he did not understand. 

Finding a buyer for Bear Stearns was the right thing to do.  Although the terms could have been formulated better, nationalizing Fannie Mae and Freddie Mac was the right thing to do.   Injecting capital into banks was the right thing to do.  Rescuing Citicorp was the right thing to do.  But none of these rescues fix the underlying cause.

To prevent a recurrence of the problems that led to this financial crisis, the United States and indeed the entire world need a new rigorously enforced regulatory structure for the financial services industry.  In the United States, Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[xvi] 


 

[i] http://www.smartmoney.com/breaking-news/smw/?story=20081124075535

[ii] http://www.pbs.org/newshour/bb/business/july-dec08/citirescue_11-24.html

[iii] http://en.wikipedia.org/wiki/Moral_hazard

[iv] http://www.newyorkfed.org/newsevents/news/markets/2008/rp080324b.html

[v]http://www.nakedcapitalism.com/2008/09/banks-take-bigger-than-estimated-hit-on.html 

[vi] http://www.businessweek.com/investing/insights/blog/

archives/2008/10/lehman_bankrupt.html

[vii]http://www.prospect.org/csnc/blogs/ezraklein_archive?month=09&year=2008&base_name=pointing_fingers

[viii] http://en.wikipedia.org/wiki/Glass-Steagall_Act

[ix] http://en.wikipedia.org/wiki/Citigroup

[x]http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms

[xi] https://westonpolicy.wordpress.com

[xii]http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms

[xiii] http://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Commission

[xiv] https://westonpolicy.wordpress.com

[xv] http://seekingalpha.com/article/95858-moral-hazard-the-demise-of-lehman-brothers

[xvi] https://westonpolicy.wordpress.com

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