Of Risk and Bailouts

A week ago today, I got to hear an Italian economist (whose name I can't remember) speak at the St. Louis Fed about the current financial mess. During the Q&A I asked him if he was worried that bailing out Bear Stearns would cause moral hazard problems down the road. He balked at me calling it a bailout and dismissed the moral hazard problem because $2 a share "isn't much." I believe the price has moved up to $10 a share now, but that still isn't much, or at least I think he would say that.

He seemed to be working with a different concept of bailout than me. To me, a bailout occurs when the government (Fed or otherwise) intervenes in some way to prevent someone from bearing the full consequences of a financial collapse. In this case, the Fed lent JP Morgan the money it needed to buy out Bear Stearns. Had the Fed not been there to offer a nice loan, JP Morgan probably wouldn't have been willing to spend as much money on the buyout, if at all. It wasn't a direct bailout, sure, but the bottom line is that the shareholders of Bear Stearns lost less than if the Fed hadn't intervened.

Which brings me to the moral hazard problem. For some reason the aforementioned economist at the Fed wasn't thinking at the margin. At the margin, shareholders at Bear Stearns were shielded from loss. At the margin, this encourages risky behavior. So, at the margin, we have a moral hazard problem. The size of the bailout may be small in the end, but by signalling willingness to orchestrate such a bailout at all, the Fed may create the moral hazard problem anyway.

Or am I completely wrong?

Russ Roberts agrees and Arnold Kling disagrees.


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It's worse than that

From the WSJ

To induce J.P. Morgan to do the deal, the Fed agreed to take losses or gains, if any, on up to $29 billion of securities in Bear Stearns's portfolio. The outcome will influence the sum the Fed turns over to the Treasury, so this is taxpayer money; that's why the Fed sought Treasury Secretary Henry Paulson's OK.

It's pure and simple bailout and the only reason the guy didn't acknowledge it was PCness.

moral hazard to counterparties

One source of moral hazard which not many people seem to notice is the elimination of counterparty risk on derivatives. One reason stated for the bailout was to prevent systemic threats to the financial systems. One such threat was if Bear Sterns went bankrupt, then anyone who was a counterparty to a derivative trade with them could suddenly lose a ton of money. Which could cause systemic ripples.
W/o the bailout, banks would be discouraged from trading this derivatives, and encouraged to closely monitor the health of their counterparties. W/ the bailout, they can just not worry about it. Which means an ibank can do stupid things with derivatives and take on huge risk, b/c their counterparties aren't watching closely. Hence, moral hazard.

Important nitpicking: this

Important nitpicking: this is true for OTC derivative, exchange traded derivatives (your vanilla put and call equity options for example) are actually insured by the exchange. Of course if a player with huge position goes down, the exchange could be in trouble as well, but they generally do a good job monitoring credit and collaterals.