Moral hazard in the Bear market

Megan McArdle worries a little about the moral hazard problem that JP Morgan and the Fed’s ‘rescue’ of Bear Stearns creates (although her major point is that we should be relieved that it was rescued from default). knzn’s take on the issue puts the problem in perspective:

[Hypothetical future investor]: I own a major stake in an investment bank, and I’m getting concerned about their risk management. Should I bring this up at the shareholders’ meeting?

[Hypothetical friend]: I don’t see why. What’s the worst that can happen? The bank will go sour, the Fed will arrange a bailout, and you’ll only lose 95 percent of the money you invested, 96 tops. What’s the big deal?

  • “The bank will go sour, the Fed will arrange a bailout, and you’ll only lose 95 percent of the money you invested, 96 tops. What’s the big deal?”

    I can smell his sarcasm, but I think it is important to remember that exactly what the Fed is doing is uncertain at the moment. People don’t know what the extent of the bailout will be, or whether this is just a front to allow J P Morgan to take over the operations of Bear Stearns easily (http://bigpicture.typepad.com/comments/2008/03/two-dollars.html).

    Remember, no matter how small the bail out is, it will make other firms feel that they have some of their downside risk covered, leading to riskier behaviour. If we do not believe that there is any social benefits from this riskier behaviour, it is inefficient. The size of the bailout simply changes the size of this effect.

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