Ah, September: Moral Hazard Month

Ah, September: Moral Hazard Month
September 19, 2008
 
 
“Moral hazard” is the term economists use to describe the fact that insurance can change the behavior of the person being insured . . . The savings-and-loan crisis of the nineteen-eighties was created, in large part, by the fact that the federal government insured savings deposits of up to a hundred thousand dollars, and so the newly deregulated S. & L’.s made far riskier investments than they would have otherwise. .
The Moral Hazard Myth
Malcolm Gladwell
New Yorker Magazine
8/29/05
 
 
Dear Friends,
 
September is “Back to School Month,” and this one offers a teachable moment for Americans of all ages about a concept known as “moral hazard,” which is a slippery little devil, as we shall see.
 
It’s taken me a long time to get the gist of it, and the truth is every time I hear the term used by a commentator or policy wonk, I have to reexplain it to myself.
 
Initially, I thought it described a powerful temptation that tested one’s moral mettle -- e.g., finding a bag full of cash in your office building elevator on the day your job was eliminated; playing a round of golf and filling out your scorecard a la Bill Clinton; or being a comparatively new state officeholder and getting a call from someone you’d met once asking if you’d be his vice presidential running mate.
 
Things you know you shouldn’t do, but which are tempting -- and -- difficult to account for -- morally, that is.
 
The dictionary wasn’t helpful because every reference was about insurance -- “the loss to an insurance company resulting from possible lack of prudence or honesty on the part of policyholder.” Not to put too fine a point on it, but I’ve never used “moral” and “insurance” in the same sentence or conversation, so I was still confused.
 
But after consulting a couple friends in the think tank world, I learned that the term is used in the world of politics and public policy to characterize public policy decisions that may encourage future risky and costly private behavior for which taxpayers could be responsible.
 
Or in slightly more cynical terms, situations in which enormous and costly errors are made by the wealthy and powerful and for which little folks are on the hook.
 
Okay.
 
Take September, for example.
 
Fannie Mae and Freddie Mac; AIG, Lehman Brothers, and Merrill Lynch; and just yesterday, news that the powers-that-be are considering putting together the largest financial bailout in American history.
 
And the month isn’t over.
 
Five financial giants at the heart of America’s capital markets, all headed for extinction. Wall Street reeling, stock exchanges around the globe experiencing huge losses, investors small and large wondering whether the country is in freefall, and a President with virtually no political capital and personal credibility to help soothe the country’s jangled nerves.
 
So it has fallen to Treasury Secretary, Hank Paulson and Federal Reserve Chairman, Ben Bernanke to take the lead on a scenario that even Hollywood wouldn’t have conjured up.
 
Lehman Brothers’ CEO, Richard Fuld, had good reason to believe that the government might come to his firm’s rescue, given its bailout of Fannie Mae, Freddie Mac, and the salvage operation of Long Term Capital Management, which was organized by the New York Federal Reserve Bank a decade ago.
 
Turns out he guessed wrong. Who knew?
 
Had he known with certainty that the federal government would not be the court of last resort for a large failing financial institution, his firm (and others) might not have engaged in certain kinds of high risk investment instruments and practices. And having chosen not to do that, they might not be in Chapter 11 today.
 
Maybe, maybe not.
 
The same could be said about Merrill Lynch, but thanks to the good judgment of a new CEO who saw that gravity was rapidly evacuating Merrill’s market value, and who understood that his endgame options were evaporating precipitously, the firm stayed in the private sector, even if in the belly of the whale.
 
And I’m told that if you understand the finer details of credit default swaps (CDO’s) --- and, no, I don’t -- you’ll appreciate even more how Merrill CEO John Thain may have pulled off the most artful and legal legerdemain since Tom Sawyer got Ben to paint the fence.
 
Fannie and Freddie you know about -- sort of. Taken over by the government, which means that taxpayers are ultimately responsible for any losses that might be incurred. Counterbalancing that is the reality that if the government hadn’t stepped in, markets will still be falling, and current and future homeowners would be in a world of hurt.
 
Capping it all was this week’s AIG mega-deal, the details of which are still unfolding, but which demonstrate two verities:
 
First, size matters. If you’re going to fail be v-e-r-y big, bigger than Lehman Bros., apparently.
 
Second, that capitalism (in its slightly modified September 2008 configuration) and morality are strange bedfellows.
 
So if you’re confused about how the experts can rationalize the AIG deal and the Lehman non-deal, and which meets the moral hazard test and which does not, you’re not alone.
 
This doesn’t mean you’re right and they’re wrong. It means that when push comes to shove, the moral hazard standard gets v-e-r-y fuzzy, and then disappears from sight.
 
If you’ll pardon the leap from AIG to Abraham Lincoln, you’ll recall that when Lincoln ordered the suspension of writs of habeas corpus during the Civil War -- for which he took unmitigated political heat -- he said: "[A]re all the laws, but one, to go unexecuted and the government itself go to pieces, lest that one be violated?"
 
Now, one week in advance of the first presidential debate, we might ask ourselves about moral hazard and the McCain–Palin ticket.
 
If one believes that the CEO’s of Fannie and Freddie, Lehman, Bear Stearns, Merrill, Countrywide and other financial institutions were brazen, careless, or negligent in their management decisions -- at great cost to stockholder value and the impact on the American and global economy -- consider Senator John McCain’s selection of Sarah Palin.
 
Even if you admire Palin, find her story compelling, and believe that she’s a quick study, it’s a very long, cold ride on one of those throbbing snow machines to equate that with her being qualified to be vice president of the United States. And, using McCain’s financial advisor Carly Fiorina’s logic, she’s also unqualified to be vice president of Hewlett-Packard.
 
Yet, there she is, chosen because John McCain needed to change the dynamic in his faltering presidential run. A number of qualified candidates from which to choose, but only one who offered three things he needed most: first, red meat -- caribou presumably -- to excite the Republican base of social conservatives; second, strengthening the ticket’s appeal to women, and particularly to disaffected Hillary supporters; and third, buzz -- driving Democrats to distraction and sending the political press into overdrive to vet her in a way that McCain had clearly not done.
 
And if there’s one thing the Republican base hates more than Democrats, it’s the press.
 
But her selection by McCain is a political decision purely in his self-interest with enormously risky implications for the national interest, as this month’s historic financial meltdown and this week’s bombing of the U. S. embassy in Yemen remind us.
 
Just imagine Sarah Palin at the helm.
 
Much of the hoopla about McCain’s stunningly impetuous choice has been spun to fit the persona of that young Navy pilot who survived the horror of the Hanoi Hilton and came home to run for office, and who has built a reputation of bucking his party on key political and public policy issues. It’s a narrative of independence, courage, and audacity. It’s a modern day “Mr. Smith Goes to Washington.”
 
Fine, but this isn’t a movie.
 
And the point is that John McCain didn’t just bet his ranch, he mortgaged ours -- and with a subprime, no less.
 
And we best understand that now.
 
McCain is a big risk taker, a frequent risk taker, and a man for whom risk has been a way of life. That’s admirable in some instances and select vocations, even in the Senate, but it isn’t what we’re looking for in #44.
 
We have seen what bold and risky, strong and wrong, and our way or the highway looks like at 1600 Pennsylvania Avenue, and we have had enough.
 
After twenty-two years in the United States Navy and twenty-six in the United States Congress, one would think John McCain would understand the implications of moral hazard.
 
But apparently not.
 
While he expresses outrage at the greed and selfishness on Wall Street and pontificates on the platinum parachutes that those failed financial CEO’s are bailing out with while their stockholders and employees are left with pennies on the dollar, he ought to take a good, long, hard look in the mirror.
 
That’s if he’s still got the courage.