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Saturday, September 13, 2008

The Destructive Culture of Bailouts

In the last year, The Federal Reserve has bailed out Bear Stearns. The Congress has bailed out sub prime borrowers. The Department of the Treasury has stepped in to bail out Fannie Mae and Freddie Mac. Now, the Federal Reserve is about to do something similar with Lehman Brothers.

The financial world held its collective breath today as the U.S. government scrambled to help devise a rescue for Lehman Brothers and restore confidence in Wall Street and the American banking system.

Deliberations resumed Saturday as top officials and executives from government and Wall Street tried to find a buyer or financing for the nation's No. 4 investment bank and to stop the crisis of confidence spreading to other U.S. banks, brokerages, insurance companies and thrifts.

Failure could prompt skittish investors to unload shares of financial companies, a contagion that might affect stock markets at home and abroad when they reopen Monday.Options include selling Lehman outright or unloading it piecemeal. A sale could be helped along if major financial firms would join forces to inject new money into Lehman. Government officials are opposed to using any taxpayer money to help Lehman

An official from the Federal Reserve Bank of New York said Saturday's participants included Treasury Secretary Henry Paulson, Timothy Geithner, president of the Federal Reserve Bank of New York, and Securities and Exchange Commission Chairman Christopher Cox. The New York Fed official asked not to be named due to the sensitivity of the talks.

What the Federal Government, and Federal Reserve specifically, has created is the culture of bailouts. There are several troubling things with all of these bailouts. Whether you are a mortgage giant, investment bank, or some poor borrower, if you get yourself in financial trouble you can count on the Federal government to bail you out.

1) The Weakening Dollar

The first problem is that the government is not an endless pit of money. The government is already running a deficit to the tune of about $400 billion as of the last tally. The Government can't simply print money with no consequences. By running bigger and bigger deficits, the Federal government weakens the Dollar.

2) Privatizing Profits and Socializing Losses: The Moral Hazard

The reason each and every one of these entities is in trouble is because they engaged in risky behavior. Bear Stearns, Fannie/Freddie, and Lehman each bought up far too many risky loans. Those loans became far too large a portion of their portfolio. When those risky loans blew up, these entities were in financial dire straits. Borrowers took on loans that were far too risky or expensive for their income and risk profile. Then, those payments became too large for them to afford. In each case, these persons or entities took on risky behavior and that risky behavior put them into financial dire straits. Risky behavior must have consequences or more will occur. Instead of facing a real financial punishment for all of this risky behavior, the government has stepped in and saved each of these groups from financial peril. That is called a moral hazard.

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. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or
incentive to behave inappropriately from the perspective of the party with less information.

By creating this moral behavior for everyone from the powerhouse financial services company to the average borrower, all the government really is doing is encouraging more of this behavior.

3) Culture of Dependence

Our economy is supposed to be a Capitalistic one. That means that private business is supposed to lead the way and the government's main role is to stay out of the way as much as possible. Instead, all of these bailouts create the exact opposite effect. Instead of having private industry lead while the government stays out of the way, the market now counts on the Federal Reserve and the Federal government to fix every problem that private industry creates. Capitalistic markets don't demand that private industry function perfectly at all times. Markets allow for the mistakes that all humans will make. These markets also require that the players learn from their mistakes. Bailouts become the equivalent of a parent stepping in to solve the problem of their irresponsible children. Now, instead of having private industry lead and function on its own, the market expects that the federal government will bailout private industry every time they screw up.

All of these bailouts certainly seem like the right thing to do in a crisis situation. They are even political viable, however their long term effect is corrosive. These three real side effects will have a devastating long term effect on our economy. At some point, we will have one too many bailouts and I just hope we haven't gotten there yet.

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