Moral hazard in financial transactions

It is bailout time again. Every time Wall Street sees the writing on the wall, the hitherto hallowed principles of free market are consigned to the dust heap and the clamour for tax payer sponsored bailouts starts. It happened with the Argentinian Tequila crisis and the LTCM collapse in the 1990s, with the likes of WorldCom and Enron at the turn of the Century, and is getting re-enacted with the sub-prime mortgage lenders. The entire Wall Street cast led by the major Investment Banks, hedge funds, private equity firms, commercial banks, real estate developers, mortgage lenders, rating agencies, accountants etc are now busy making a case for the "B" word.

John Paul Getty famously said, "If you borrow $100 from a Bank, you have a problem. But if you borrow, $1 million from a Bank, then the Bank has a problem"! This captures the essence of one of the most important concepts in modern finance, Moral Hazard. If the Banks have a problem, Wall Street is not far behind. This means that the likes of Alan Greenspan, Ben Bernanke and Hank Paulson, have to surely step in. (Remember the "Greenspan put", the very epitome of "moral hazard" at work) Translation: taxpayers' money has to be rolled out to bail out the irresponsible and greedy lenders, or else we risk endangering our entire economy, or so the wise men say.

Moral Hazard refers to the phenomenon wherein the re-distribution of risk through a transaction, adversely affects the incentives of economic agents involved in the transaction. It arises when parties to this transaction have assymmetric access to information, which is crucial to the success or otherwise of the transaction. The world of finance is rife with numerous examples of moral hazard problems like insurance, lending and securitization, investment decisions etc. The most classic moral hazard issue arises when greedy lenders throw out due diligence standards and pour money at anybody willing to borrow, in the firm belief that the system will not, or cannot afford to, let them fail. The recent decision by the Federal Reserve to cut the discount rate by 50 basis points to 5.75% is only the latest instance of confirmation of this belief. The sub-prime mortgage lending debacle is an example of moral hazard caused by a firm conviction among all the agents, that the Government will step in if thngs go bad!

The enormity of this moral hazard scandal is staggering. First, the mortgage lending agencies like Fannie Mae and Freddie Mac, threw caution into the wind by lending massively to individuals and institutions with very dubious credit histories. With interest rates at historic lows, the Wall Street Banks lent heavily to corporate sector and private equity firms and hedge funds, to finance their megalomaniacal share buybacks, M&As and LBOs. The Investment Banks, Private Equity Firms, and Hedge Funds, flush with funds from high net worth individuals looking for high yields in a low return market, floated high risk, high return investment funds, which bought mortgage-backed, structured credit derivatives and other exotic financial instruments.

The crime does not stop with Wall Street's big Investment Banks. As Paul Krugman observed, "Rating agencies like Moody's Investors Service, which get paid a lot of money for rating mortgage-backed securities, seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the 1990s, the accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest -quality, AAA assets."

If you have not got a feel of the sheer madness of the situation, try this out. Assume MyBank lends $100 to a A, B, C, D, E and F, with credit histories in the descending order. In fact, though E and F are known defaulters, MyBank is not concerned because they get a markup of atleast 300 basis points on such lending. MyBank in turn takes this loan off its balance sheet, by selling it off to Nobody's Bank. It in turn dices the loan and packages them into structured Collateralized Debt Obligations (CDOs), with different payment tranches, and sells it off to Everybody's Bank and investors like P,Q, and R, who have invested through the hedge fund floated by Everybody's Bank. (In fact, with the liberalization of restrictions on mutual funds and pension funds, many of them, who deal with investments of small investors, have taken substantial stakes in such hedge funds and private equity funds)

The risk has therefore been transmitted across the entire system, from MyBank to NoBody's Bank to Everybody's Bank, and finally to P, Q, and R. Now if E and F defaults, as they invariably should, the Ponzi scheme collapses. P,Q, and R ends up paying for the greed and irresponsibility of MyBank. Meanwhile seeing the success of MyBank in getting away with this roulette, more bankers enter the picture. This draws out more defaulters like E and F. The bubble grows. As is evident, in any such financial transaction, there is a need to put in place safeguards and undertake due diligence at every level, to minimize the moral hazard and disincentivize agents.

Government investments are a less discussed example of moral hazard. Such decisions are more likely to be flawed for a number of reasons. Such decisions are invariably taken based on incomplete information and on extraneous political or other considerations. But the most critical moral hazard danger comes from the fact that nobody owns the investment capital. The investment capital is somebody else's (tax payer's) money, and the bureaucrats making the investment decision have no incentive nor disincentive in making informed and optimal choices.