Prior moral hazard and the credit crisis

Were inextricably linked.  A quote that illustrates this to me strongly came from a Bloomberg article today.  The ECB decided to tell the countries that have high soverign debts to go to hell, and now that they aren’t going to take on the risk themselves private investors aren’t willing to and are selling.

This makes sense, previously people purchased the junk on the basis that someone else would pay for it – high return low risk!  Now that they have to face the real risk profile they are like “f**k that”.  However, Bloomberg (or at least David Kovacs) stated:

The reason the market is horrified now is Trichet said it’s not even being discussed. Smart investors are basically selling risk(y) assets

No s**t.  An asset appeared low risk, and now it is high risk, and the expected return is (at most) unchanged – so the risk adjusted return is lower.  No wonder they want to sell.

Now we are in a crisis, and if there is a run on good quality debt because of concerns we have to do strange things – sure.  But we need to come up with a system that rips this moral hazard out of the system.  It is the moral hazard that helps to drive crisis after crisis ultimately.

  • Miguel Sanchez

    Agreed on the need to remove moral hazard, but any thoughts on how to do it? I get frustrated hearing people say that governments need to make a firm commitment to no bailouts, when the problem in the first place was that “no bailouts” is not a credible threat.

    It’s not like people haven’t tried to come up with an alternative. For instance, Anne Krueger at the IMF spent years promoting a Sovereign Debt Restructuring Mechanism – a clear set of instructions for dealing with sovereign defaults. The member countries dragged their feet, and eventually canned it, because they didn’t want to agree to a set of rules that they themselves might be held to in the future… hmm, what were the odds of that? Sure the SDRM was far from perfect, but it seems like the debate has gone backwards since then.

  • WH

    are you going all Austrian on us?

    Miguel has a point that a collective voluntary system is not likely to work – see game theory. But what we could do is utilise game theory to establish a system that provides for rewards/punishments to address systemic failure (not individual agent failure). I don’t think insurance per se would work, as in the event of a systemic run the insurance sector is not going to provide the liquidity needed (due to insurance funds being heavily invested in the securities that are being dumped).

    don’t have the answer off the top of my head – but will come back with come considered thought. Also Basel rules need redressing while we are at it, there should not be preferences for particular security classes such as mortgages that count towards banks capital adequacy (especially not in NZ where combined with tax you create a slightly preferred security/asset, and we now that slight preferences can have big medium term consequences courtesy of Schilling)

  • @Miguel Sanchez

    Agreed.

    Ultimately, a system that prevents a bank run but ensures that the long-term liability falls on the actual owner of the asset is the best way we can go. We should accept that there will be some moral hazard issue, and I accept that the Fed was right to intervene given contagion across to otherwise good assets.

    However, in the current case we know the sovereign debt of these countries is rubbish. The ECB bailing them out would be equivalent to a transfer to these countries and the owners of their debt – which doesn’t seem fair and ingrains a strong moral hazard issue. They are right that they have to take a hard line to actually get these countries to get their book in order – I reckon kick Greece and maybe the others out of the Euro tbh

  • @WH

    I do not disagree with your points – I’m just annoyed that the author in the Bloomberg article was trying to say that the current choice not to fund sovereign debt was equivalent to the choice the Fed had to make to prevent a run on otherwise good assets.

    I actually think the way the Fed did things was quite good – and making people pay back with a market rate of interest in the future ensured that, when normal conditions returned, repayment would be made. This implies that we are able to actually separate “good” and “bad” asset classes, which in itself gets rid of the fundamental issue of a “bank run” type situation. This was a huge improvement over the savings and loans crisis.

    “Also Basel rules need redressing while we are at it, there should not be preferences for particular security classes such as mortgages that count towards banks capital adequacy (especially not in NZ where combined with tax you create a slightly preferred security/asset, and we now that slight preferences can have big medium term consequences courtesy of Schilling)”

    The reason there is a preference towards certain asset classes is because of the implied volatility of their value, no? I agree that all our regulation regarding credit markets needs to be cleared up – ultimately we want to balance the trade-off between the efficiency of receiving the market price and the information problems in the market that can lead to sub-optimal outcomes.

    I agree that banks tend to have a strong preference towards lending on housing (specifically this can be viewed more broadly as lending to consumers with a relatively amount of physical asset backing), but I don’t really see the problem with this. There is a physical asset that they feel they can regain much of the value of the loan off AND consumer income is less volatile than business income – so they would show a preference.

  • Miguel Sanchez

    WH, I was actually saying that something like the SDRM would work – it’s not really about a collective voluntary system, it’s just about making sure that everyone knows the rules in advance. At the moment we have a non-credible threat that markets can see right through, and no rules about what to do when the government’s hand is inevitably forced.

    Oh, and the stuff about Basel capital rules is a sideshow. If capital requirements were the driving force in lending decisions then banks would plough all of their cash into government bonds, which carry a zero capital requirement. Gareth Morgan is wrong anyway; NZ’s mix of tax and bank capital rules is not unique, it’s quite standard.

  • Kimble

    If government wasn’t big enough to bail out the TBTF’s, moral hazard would disappear instantly.

  • Miguel Sanchez

    To paraphrase Voltaire: if a government large enough to bail out banks did not exist, it would be necessary to invent one.

  • the stuff about Basel capital rules is a sideshow. If capital requirements were the driving force in lending decisions then banks would plough all of their cash into government bonds,

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