Warning! Moral hazard alert

AMID the scramble of US politicians debating the historic $US700 billion ($A840 billion) financial rescue plan, and against a seemingly ever darkening background of urgent economic warnings, actor Michael Douglas was asked at a press conference this week whether "greed is not good".

The reporters who asked probably wanted to put the questions to Gordon Gekko, the rapacious tycoon whom Douglas portrayed more than two decades ago.

But Gekko, being fictional, was not available for comment.

Imagine. If Gordon Gekko were around today, as a hedge fund manager or a board member of a major investment bank, would he admit that greed had stumbled, apologise for what Wall Street had done to the world, and resolve to invest more responsibly in the future? Or would he be lobbying behind the scenes, trying to carve out some of that $US700billion for his own balance sheet? And, once the storm had passed, would he carry on as before, safe in the knowledge that any future failure would again be fixed with billions and billions of taxpayers' dollars?

Wall Street is limping after the collapse of Lehman Brothers and the near-deaths of Merrill Lynch, Bear Stearns and American International Group. Globally sharemarkets have lost trillions, and global money markets are frozen.

Wall Street's fate, and that of the US and global economies, rests with a contentious $US700 billion rescue package that involves the US Government taking on the bad debts of financial institutions. The stalled progress of this plan through the US Congress has gripped investors around the world this week, as US regulators, business leaders and even President George Bush urged haste in the face of what they painted as certain financial anarchy.

Large sections of the US public angrily opposed the plan on moral grounds, asking why the apparent architects of the crisis were being saved from their own mistakes. And the phrases in use didn't help. "Bail-out" somehow implied that taxpayers were paying to get criminally negligent institutions out of a kind of corporate jail, and "Wall Street bail-out" ignored the fact that it included financial institutions, big and small, around the US.

And free-market exponents, especially Republicans in Congress, agonised over the plan in ideological terms, arguing that Government intervention would distort the market further.

"It's financial socialism and it's un-American," one said this week. In a tactic some suggested had more to do with politics than ideology, coming against the back of a knife-edge presidential (and congressional) election, some Republicans have dug in their heels.

Economists, however, warned of a still greater threat - the risk of a "moral hazard" that bailing out the financial giants could lead to an even greater crisis down the track by encouraging those institutions to take even bigger risks in future confident of certain rescue should they fail.

"Moral hazard" recognises that a person may act less responsibly knowing they will be compensated for any losses - they are less likely to double-check that the iron is off if they have comprehensive house insurance.

The concept becomes crucial in the world of finance, where risk equals return. Does bailing out a fing bank, one that took risks that did not pay off, encourage it to do the same again, knowing it will be saved? And does it encourage that bank's peers and competitors to do the same?

"There are huge moral hazard implications in this," says John Roskam, executive director of Australian free-market think tank the Institute of Public Affairs. "In an ideal world the government would not intervene because of the moral hazard. In an ideal world, you would let people bear the outcomes of their own failures, especially if these people have made millions of dollars from those failures."

Renowned US economist Peter Bernstein labelled the moral hazard inherent in the initial bail-out plan this week as "awesome". "For as long as I can remember, every government or Fed bail-out has elicited cries of alarm about moral hazard," he told subscribers to his newsletter. "Up to this point, I have always argued that moral hazard is a valid but secondary concern, because saving the system must have the highest priority.

"The Government is now indulging in moral hazard in extreme orders of magnitude. How do we control the consequences?"

Capitalism requires risk takers to pay for their mistakes. US regulators know this, and allowed Lehman to collapse rather than step in to save it. Even the Federal Reserve's acquisition of Bear Stearns caused pain for investors, given the $US2 a share JPMorgan Chase paid was a fraction of the price Bear executives were initially willing to sell out for.

But capitalistic principle was abandoned in the case of giant insurer American International Group US regulators judged that the costs of letting something that big fail outweighed the moral hazard concerns (many disagreed).

Such questions have always surrounded bail-outs, rescues, or corporate salvage operations of any kind. And, looking back, it is always hard to say for certain whether a moral hazard resulted.

Australia has had its share of bail-out conundrums, most notably Ansett in 2001. In that instance the Federal Government walked away, despite being under intense pressure to rescue the failing airline. But if it had "saved" Ansett, would a more efficient (and cheaper) player like Virgin Blue have been able to launch and expand?

Melbourne University corporate law expert Professor Ian Ramsay remembers heated debate about moral hazard during the savings and loan crisis of the 1980s, which cost the US taxpayer $US124.6 billion. Some have even suggested that the moral hazard created by Alan Greenspan's rescue of the LTCM hedge fund in 1998 helped create the subprime crisis, in partnership with Greenspan's move to keep US interest rates low.

In truth, this week's attempted "bail-out" is merely the latest and most spectacular example of US Government intervention in the wake of the subprime crisis. In August 2007 the Fed cut the interest it charges on loans to banks and Fed chairman Ben Bernanke pledged to act "as needed" to keep markets liquid and orderly.

Clearly, Bernanke had no idea what slippery slope lay in his future. Further, broader rate cuts followed, and the Bear Stearns sale was brokered with financial support from the Fed. Fannie Mae and Freddie Mac were placed in conservatorship, and AIG was helped out with cheap loans worth $US100 billion.

The risk of moral hazard probably existed from the first rate cut, only growing when AIG was judged "too big to fail". The central question now, according to Ramsay, is whether the moral hazard implicit in the original bail-out plan can be reduced by adding conditions to the bail-out.

As negotiations continued during the week, it seemed likely that executive salaries would be scrutinised and perhaps capped. Taxpayers may become shareholders in some of the institutions seeking help - efforts designed to placate both the moral outrage of the public and the moral hazard concerns of economists.

Ramsay suggests that having the Government as a partial owner may mitigate moral hazard, making such a company subject to greater scrutiny, with the result that it would probably take on less risk. US taxpayers got a 79.9% stake in AIG in return for saving it - surely a powerful guard against moral hazard.

And regulatory reforms are likely a development that may combat moral hazard by simply banning the practices that led to subprime. Fed chief Ben Bernanke himself suggested this year that the best way of tackling moral hazard was by "prudential supervision and regulation", ensuring that financial institutions managed risks in the good times in preparation for the bad times.

At present, the US financial system is regulated by a hotchpotch of bodies -

the US Treasury itself has acknowledged that the regime is outdated and inadequate.

Banking, insurance, securities and futures are all regulated separately, and overlaps and gaps exist between state and federal jurisdictions. Some of the biggest subprime lenders were subject to almost no oversight, Treasury admitted in March.

The US has no equivalent to the Australian Securities and Investments Commission or the Australian Prudential Regulation Authority. The establishment of an all-powerful corporate enforcer like ASIC might mitigate moral hazard with a few high-profile scalps.

But this still may not be enough. "There has to be some obvious downside for failure,

to show that the Government can't be there as a guarantor for your failure," Ramsay says. "In that respect, it seems to me the Government does have the right to set certain terms and conditions for those who want to draw upon that amount of money."

If the bail-out is approved, it will almost certainly look much different to how it went in. According to the IPA's Roskam, what's important is that it does get through. The IPA is a proponent of small government, holding "economic and political freedom" dear above all else. Almost.

"It may be that in some cases pragmatism outweighs principle," Roskam says. "If the US financial system and with that the rest of the Western developed world was to, if not tumble then crumble slowly down, in some circumstances there would be justification for bail-outs of these sorts."

This week, ANZ chief executive Mike Smith warned that the health of the world's banking system depended on the rescue plan proceeding. Reflecting on the causes of the boom, Smith said it was "too simplistic" to blame the boom conditions of recent years on moral hazard from the LTCM rescue and Greenspan's low interest rates.

"I think there has been a culture of greediness to it," he said. "I'd also say its a mechanism of the market - there has just been too much money available and a focus on short-term results."

But while he remained aware of the risk of moral hazard, Smith remained certain that "the system itself is the thing that matters - because without that you have anarchy".

When confidence is gone, there is no credit - no one will lend money, and corporations, businesses and consumers cannot borrow to finance their needs. The global economic engine stalls.

"The financial markets are in quite fragile condition and without action they will surely get worse," Bernanke warned this week.

"In wild periods of alarm, one failure makes many," noted 19th-century business journalist W Bagehot, a favourite of Bernanke's. Bagehot, who described a financial panic as "a species of neuralgia", advised central banks to lend money, and lend it freely, to calm a crisis such as this. "They must lend it to merchants, to minor bankers, to 'this man and that man'," he wrote.

By the end of the week, it seemed likely that, in this case, moral hazard principle would eventually be abandoned for financial stability. "What we are always chasing is the lessor of two evils," Roskam says. "Out of two bad choices, the least worse option is maintaining some sort of functioning credit system."

It was not Wall Street investment banks that sold mortgages to people who could not afford them. And it was not the investment banks who gave the securities linked to these products triple-A ratings that could not be justified.

It was the financial institutions that created those incomprehensible securities, that marketed and sold the securities, who sank their own money into them, and those of their clients. Who played with risk and got burned. And it was bank executives who made hundreds of millions of dollars overseeing this process.

"A lot of blame (belongs) with big financial institutions that engaged in this irresponsible lending," Treasury Secretary Henry Paulson acknowledged this week.

And if ever-fatter executive pay packets had not already created an image problem for financial institutions, this week the FBI revealed it was probing institutions irrevocably linked to the subprime crisis: Fannie Mae, Freddie Mac, Lehman and AIG, among others.

No wonder memories of Gordon Gekko returned this week. Corporate law expert and author Harry Glasbeek, from Melbourne but based in Canada's York University, rejects suggestions the bail-out will increase the risk of moral hazard. "It is true that the purchasing of AIG and bailing-out of Bear Sterns smacks of social welfare for the rich in a country that prides itself on self-reliance and free-market promotion," he says. "My view is the moral hazard is not greatly increased by any proposed bail-out, regardless of its size. We are talking about a class of actors who always have shifted risks onto others, that is, always have been a moral hazard."