Feb 19, 2009

Jeff Tucker on bailouts, moral hazard, and LTCM

The idea is simple. If you are continually willing to protect people from the consequences of their own errors, your benevolence will be factored into the future decisions of the persons rescued. In the long run, they will make even more errors. The principle exists at all levels. The teacher who changes grades when students plead hardship isn't helping in the long run. The teacher is rewarding and thereby encouraging poor study habits. He is creating moral hazard.

So it is in banking and finance. How was it that the hedge fund Long-Term Capital Management, bailed out on pressure from the Fed, believed they could be leveraged 50-100 to 1 in some of the riskiest financial instruments in the world? True, the fund employed people who were said to be the smartest guys on Wall Street, plus two winners of the Nobel Prize in economics, and that gave the firm credibility the town-fair magician can't get. True, also, that returns of 40 percent in 1995 and 1996 reinforced the appearance of superhuman intelligence.

More fundamentally, however, moral hazard was there from the very beginning. Credit has been generally loose in the mid and late nineties. The firm's money was being loaned by banks backed by deposit insurance and an implicit too-big-to-fail doctrine on the Fed. The firm's preferred investment targets (like Russian bonds) were backed by a bailout promise as well. The risk spiraled onwards and upwards until one day it unraveled, and the fund itself was bailed out.

~ Jeffrey Tucker, "Mr. Moral Hazard," The Free Market, December 1998

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