ED VS. COGNITIVE BIASES, PART 4: MORAL HAZARD

Like an episode of Law & Order, this entry could be described as "ripped from the headlines." The current state of our nation's financial system is shaping up to be an exercise in moral hazard.

The concept is simple: people (and organizations) act differently when they believe they will be protected from the consequences of their actions. But there are rarely explicit guarantees to that effect; this amounts to an information asymmetry in which I know that you'll let me off the hook even if you think you won't.

A common example is found in the world of international aid. Rich Western Country gives Poor Dirty Country a giant check and a set of instructions: "Spend this on A, B, and C or else." Now, the kleptocrat in charge of PDC knows damn well that this is an idle threat. So he buys a gold-plated 737. RWC says "You failed to do A, B, or C. No more checks." But the checks come anyway for any number of reasons: guilt, concerns that PDC will buddy up with a country hostile to western interests, or emotional appeals about starvation and poverty and AIDS and sadness. "Benchmarks" are never met. The flow of money never stops. The money never gets spent on anything productive. Under the circumstances, how could we expect otherwise? Mr. Kleptocrat is reacting as all humans do to an environment in which the risks are manipulated in his favor.

Of course a good portion of our current financial turmoil is based on a moral hazard. For every stern-faced lecture from The Fed or Chimpy about how There Will Be No Bailout, there is always a bailout. It is difficult to convincingly threaten Fannie Mae and Freddie Mac just a few months after Uncle Fed served up a quarter-trillion dollar bailout for Bear Stearns. Remember that? Everyone on Wall Street sure does.

While the government is not above making examples out of smaller financial entities like IndyMac (a large bank, but far from an integral component of the world of finance), investment banks, underwriters, and large mortgage guarantors – Freddie and Fannie – are happy to play fast and loose with Other People's Money. Maybe they sweat a little more when they see FDIC take over a bank, but they know goddamn well that their time will never come. Congress and the President will saber-rattle, talk big, and lecture like a humorless hall monitor but they will be there with the bailout when things go to hell.

The Fed already created a situation ripe for abuse when they agreed to let mortgage lenders trade shitty, insolvent subprime paper for cold hard cash. That's a pretty sweet deal, eh? The Fed (i.e., the public) takes on worthless past-due mortgages and the lenders take on billions in cash. As usual, and as we'll shortly see again with Freddie and Fannie, the profits belong solely to the stockholders but the risk (i.e., the losses) belongs to all of us. It's socialism for Wall Street and hard-knocks capitalism for the rest of us. Fannie's executives earn $10-$13 million per year to risk someone else's money with full confidence that we will pay the tab when they fail.

And people wonder without a hint of irony why we ended up in this mess.

Oh, not everything is rosy from the investors' perspective. Bear Stearns stockholders certainly felt the pain of an 18-month free-fall from $170 to $2. Fannie and Freddie investors are walking funny these days as well. But in the long-term (which is, in my humble view, the only rational way to look at stocks) they will be just fine. If anything, they will benefit from an extended opportunity to buy cheap stock in companies that Uncle Sam will not allow to fail.

In a normal country, the government would insist on a restrictive set of regulations and caveats to go along with the bailout checks or dispense with the charade of private ownership altogether and simply nationalize Freddie, Fannie, and the other insolvent big-shots. But the financial sector doesn't believe in big government's rules, just it's cash. If the situation rights itself – as it did after the massive S&L bailout in the 1980s – you can guarantee that we'll be repeating it endlessly in the future. It's like being sent into a casino with someone else's money and two simple rules: win, and the money's yours. Lose, and the debts are on the house. Gee, what could go wrong?

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