July 14, 2008
Moral hazard misconception
by Ricardo Caballero
Here we go again. Two pillars of the US and world financial system, Fannie Mae and Freddie Mac, have become embroiled in the current financial turmoil. To be sure, nobody in their right mind expects these institutions to stop operating; the issue instead is whether, how and when a government intervention takes place.
Treasury secretary Henry Paulson has just announced a first package of all out support that involves contingent credit and possibly equity. The terms of the latter are yet unclear but they harbor hope that Treasury has realized how dangerous its previous anti-stockholders strategy had become. Only last Friday the rumor had it that Secretary Paulson was insisting that any potential government rescue plan would not benefit the companies’ shareholders. In fact, if he were to continue with the modus operandi he adopted during the recent Bear Stearns intervention, not only shareholders would not benefit, but they would be “exemplarily” punished.
The standard rationale for such strategy is that doing otherwise would invite “moral hazard.” That is, it would encourage excessive risk taking by equity holders as they can count with government insurance for their errors and mishaps. A slightly more cynical interpretation is that a bailout carries a political cost by giving the appearance of favoring the rich over the working families struggling with foreclosures.
Unfortunately, while either of these motivations is a sound one during normal times, Secretary Paulson’s anti-“moral hazard” strategy has been extremely counterproductive in the current economic environment of systemic distress and recurrent flight-to-quality episodes. This policy simultaneously hampers the private sector’s ability to solve the crisis and exacerbates the likelihood of further panics. There are two reasons for this backfiring.
First, a private sector solution to the current crisis requires fresh capital injections into financial institutions. However, in an environment of widespread uncertainty where the instinctive reaction is to run away from risk-taking, private capital is likely to remain on the side for much too long. Thus, the optimal policy response is to encourage and leverage private risk-taking, not to discourage it with a pending threat of exemplary punishment were a fragile situation turn worse, regardless of cause. Economic policy risk is compounding the private sector’s reluctance to capitalize financial institutions.
Financial institutions and leveraged institutions more generally, are subject to coordination failures whereby a sudden loss of confidence can cause the demise of an otherwise sound institution. Granted, better managed and capitalized institutions are less likely to encounter a run - it is not a surprise that it was Bear and Stearns rather than JP Morgan that went under a few weeks back - but no institution is immune to panics, as long as it is providing its socially useful liquidity transformation and intermediation role. It has always been understood that it is good economic policy to help financial institutions ride crises of this kind, and that a central role of policymakers in such events is to stabilize expectations with the hope that once the panic is gone, it is private rather than public funds that foster the recovery. In fact, it is this perspective that led both the FED and the Treasury to support Bear Stearns on the days preceding the weekend’s forced fire sale. By punishing equity holders, the Treasury chose to hurt those that it had invited to stabilize the situation just a few hours earlier. In doing so, it may have damaged its ability to leverage its policies with private capital support, a key aspect of policy success in dealing with a coordination failure problem.
Second, during periods of high uncertainty and the potential for runs, large or coordinated shortsellers are more likely to succeed in triggering socially inefficient panic-selling. Rumor-mongering and persistent selling pressure eventually weaken wary investors and depositors. Unfortunately, by choosing to punish shareholders, Secretary Paulson has rewarded shortsellers and raised their ammunition to cause further financial instability. Again, while shortselling plays a very useful role during normal times, it can turn into a source of instability during periods of high uncertainty.
In summary, given the extreme fragility of the current economic scenario, there is no doubt that it is better to err on the side of inducing “moral hazard” than to risk discouraging private capital markets initiatives and eliciting speculative attacks and wasteful predatory behavior. Failing to assess the relative risks correctly and obsessing over “moral hazard” at this time, carries the great danger that the financial system may succumb to a much more serious flight-to-quality problem.
Charles Wyplosz: Ricardo Caballero is obviously quite right that the authorities must finely balance the need to stabilize markets and the risk of creating yet more moral hazard. This is an extraordinarily difficult task and no one is ever sure to have found the right balance. It is not obvious, to me at least, that the US authorities have it wrong and that Caballero’s plea to deal gently with shareholders is correct.
When stock markets crash, shareholders take a loss, cleansing has been done and it is all the way up thereafter. A recession may come, which hurts millions of innocent bystanders, but at least we know where we are. This time we have a banking crisis. A year after it started, the cleansing is far from complete. Banks want to protect their shareholders, which is understandable but not a compelling argument for using taxpayers’ money. Caballero suggests that these shareholders should be treated differently because they are needed to be part of the solution. But their protection is part of the problem, a key reason why the crisis lingers. Besides, we do not really need to pamper them, there are other potential bank shareholders. All that is needed is to offer them the right price. We are really talking about what is the right price, not about fund availability.
From early 2000 to mid 2006, according to the Case-Shiller Composite 20 index, US housing prices have more than doubled. Since then they have declined by 20%. Do we know that they are now back to equilibrium? This is very unlikely, and much can be said about many share prices, especially bank shares. Wisdom starts by recognizing that the crisis will not end until prices are down to equilibrium. Anything that slows down this unavoidable process will merely delay crisis resolution. Surely, this will hurt the economy and the authorities should protect the bystanders. Sending checks to taxpayers makes a lot of sense, but not sending them to bank shareholders.
Posted by: Charles Wyplosz | July 14th, 2008 at 4:12 pm | Report this commentRicardo Caballero: I’m fully sold to the idea that the process of creative-destruction is a fundamental engine of economic growth. I also believe that Japan paid dearly for failing to deal with its on-performing loans faster than it did. (See my cv for multiple references on both topics).
However, good ideas, when taken to an extreme or when applied in the wrong context, can backfire. This is what my article is about.
The “liquidationist” school, personified by Secretary Mellon but supported by many prominent academics of the time, already tried the one-size-fits-all approach during the onset of the Great Depression. Let’s not try it again.
Posted by: Ricardo Caballero | July 16th, 2008 at 9:58 am | Report this commentMartin Wolf: If I understand Ricardo correctly, his view is that at times of high uncertainty, such as the present, the ultimate risk taker should not be the shareholder, but the taxpayer. This is capitalism? How do you persuade the public at large of the equity of such a system? Shareholders share in the upside and are protected on the downside, so long as they have succeeded in making a big enough mess of things.
I understand the argument for counter-cyclical monetary policy. I understand the case for aggressive liquidity provision by central banks in illiquid markets. I even understand the case for rescuing creditors in times of panic. If these things had been done in the 1930s, the great depression would not have happened. But if we are talking about government rescues of shareholders in insolvent institutions (and surely that is what we are talking about here), we are not talking about capitalism at all. After all, these are already limited liability companies whose shareholders are, or should be, highly diversified. If they can’t lose their investment in the biggest housing bear market in US history, I really don’t understand what sort of economic systems we are discussing. But whatever it is it is not a market economy.
It would be better for the shareholders to be wiped out, the institutions to be taken over by the government and then for them to be reprivatised in better times. This was done during the Scandinavian banking crisis. It worked very well.
Posted by: Martin Wolf | July 18th, 2008 at 5:37 pm | Report this comment[…] Caballero’s argument in his Financial Times column of July 14, Moral hazard misconception about moral hazard, is essentially that doing the right thing to minimize moral hazard would be too […]
Posted by: FT.com | Willem Buiter’s Maverecon | There is never a right time to tackle moral hazard… | July 19th, 2008 at 6:05 pm | Report this commentWillem Buiter: I find myself in profound disagreement with Ricardo on this subject. My disagreement is explained at (no doubt excessive) length in my blog at http://blogs.ft.com/maverecon/2008/07/there-is-never-a-right-time-to-tackle-moral-hazard/
Posted by: Willem Buiter | July 19th, 2008 at 6:08 pm | Report this commentI commend Willem Buiter’s devastating blog on Ricardo’s idea. He has convinced me that these institutions cannot be reprivatised in their existing form. They should either be run as nationalised entities or wound down. When the market has recovered, the latter can be done by selling off the entire loan book. There is no case for this massive subsidisation of mortgage lending. There is certainly no case for allowing private entities to borrow with de facto government guarantees, particularly on this insane scale. Now Ricardo suggests that the government guarantee should apply even to shareholders. Words fail me. As I remarked in my previous post, this is not just a case of moral hazard on an enormous scale: it has nothing to do with any kind of market economy.
Willem’s post is here: http://blogs.ft.com/maverecon/2008/07/there-is-never-a-right-time-to-tackle-moral-hazard/#comment-2987
Posted by: Martin Wolf | July 19th, 2008 at 6:42 pm | Report this commentRicardo Caballero: Contrary to what it may appear, Charles, Martin and I share the view that the ultimate concern of policymakers ought to be the welfare of households and taxpayers, rather than that of shareholders and management. However the issue is what is the best way of protecting these households and taxpayers during a financial crisis. I believe that the cost for them of providing free partial insurance to some key financial institutions is simply an order of magnitude smaller than the cost of letting the financial crisis run its course.
It seems to me that the main reason behind the differences between both Charles and Martin conclusions and mine, is that they assume that all the ongoing crises and failures are unavoidable given past investments and decisions, while I do not. Moreover, I believe private capital markets can do most of the job, as long as they are adequately supported.
But for private capital markets to do the heavy lifting, we need (at least) two related set of measures: those that encourage new capital to come into struggling but promising businesses before a full blown and socially wasteful crisis takes place, and those that buy time for these investments to happen by slowing down socially inefficient predatory behavior by shortsellers and rumor mongers.
Ideally, supporting new capital should come without supporting old capital, but in practice these two capitals are difficult to separate if one is to prevent a crisis altogether. When the Fed and the Treasury make an effort to calm markets, they are implicitly encouraging capital to come to the rescue or at least not to withdraw. The investments that respond to their call are a key part of new capital, even though it is not capital that comes after a liquidation.
Moreover, Martin’s claim that supporting shareholders would undermine capitalism by removing (negative) risk from equity investment is not tenable in the current context. Many of the old-capital shareholders have lost over 90 percent of their initial investments, and hence have already experienced risk at its worst. In any event, the real concern is that new capital is facing too much real or perceived risk and uncertainty, and hence is reluctant to come to the rescue. Absent new capital’s participation, it is hard to see light at the end of the tunnel. Scandinavian type solutions are ultimately more interventionists and riskier in the context of the much more complex and larger US financial markets.
Posted by: Ricardo Caballero | July 19th, 2008 at 7:31 pm | Report this commentMany new EU member states resolved similar banking sector crises as Finland and Sweden towards the end of their economic transition. The typical solution was to bail out private shareholders of the three to five largest banks (that were all insolvent).
Posted by: Zdenek Kudrna, PhD student, Central European University | July 23rd, 2008 at 11:46 am | Report this commentThe Czech case is particularly interesting. All four largest banks were bailed out, but shareholders of only three of them were allowed to retain their shares. The shareholders of the forth bank were wiped out, when the government took over and sold the bank over the weekend to one of its domestic competitors (in a transaction closely resembling Bear Stearns sale).
The largest among failed bank’s investors - Japanese investment bank - invoked an arbitration against the Czech Republic on the basis of the bilateral investment protection treaty. It claimed that their investment was damaged by the fact that its three direct competitors received state aid, whereas their bank did not. At the end, the Czech government had to pay considerable damages.
The moral of the story is that if shareholders of some failed US bank were bailed out, the (foreign) shareholders of Bear Stearns could sue US regulators for damaging their investment by helping their competitors more than to Bear Stearns. The implications for the moral hazard of foreign shareholders (such as sovereign funds) are obvious.
Martin Wolf: I hesitate to return to these issues. But they seem so important that I feel there is no alternative.
In his response above, Ricardo states that “the main reason behind the differences between both Charles and Martin conclusions and mine, is that they assume that all the ongoing crises and failures are unavoidable given past investments and decisions, while I do not. Moreover, I believe private capital markets can do most of the job, as long as they are adequately supported.”
This is a good and useful pair of sentences. So how do I respond?
First, yes, I agree with Ricardo’s description of my position. The ongoing crises and failures are indeed unavoidable, given past investments and decisions. If we look at the house price bubble, its unavoidable subsequent deflation, the quality of lending against overpriced housing, and the behaviour of the originators, raters, packagers, distributors and ultimate buyers of these loans, I am astonished by how little mayhem there has been in the financial sector and by how little impact such mayhem has had on the real economy, so far.
So, no, I think the consequences we have seen are in no way extraordinary. On the contrary, they are a welcome, salutary and necessary reminder that the equity risk premium is indeed a risk premium, that lending to people with no assets, income or credit history is stupid and that packaging loans in such a way that nobody knows what they are worth, what they contain and how they are to be renegotiated is irresponsible.
Second, in deciding how to rescue institutions, one needs to ask what Ricardo means above by “private capital markets”. I see no reason to rescue Fannie Mae and Freddie Mac as the private entities they self-evidently are not. It is apparent that the liabilities of these institutions are fully guaranteed by the federal government. No financial institution with such a guarantee can be plausibly viewed as private. The consequences of allowing institutions with such guarantees to operate as if they were private are lethal. So Fannie and Freddie ought to be renationalised.
I see no reason, therefore, why one should wish to attract private capital into these institutions or save their shareholders. If they are to be kept private, the government should at least charge shareholders an appropriate insurance premium for the risk taxpayers are bearing. I cannot believe these institutions would then survive in private hands.
Third, where institutions that should be in the private sector are concerned, the situation is different. My own view is that the lender-of-last-resort function of the central banks remains the right way to deal with the co-ordination problems Ricardo describes.
It is not the job of the government to recapitalise private institutions. If an institution is decapitalised by its losses, regulators might give it time to achieve the needed recapitalisation. In the meantime, of course, dividends should be suspended. If the government regards continued operation by a deeply decapitalised institution to be both necessary and dangerous, it can purchase equity itself, at a suitably discounted price. Provided the institution is plausibly solvent, that discount need not wipe out the existing shareholders altogether. If the institution is insolvent, it needs to go through a standard bankruptcy procedure, unless the government believes it must be kept in being. That means nationalization, with shareholders losing everything.
Posted by: Martin Wolf | July 24th, 2008 at 4:12 pm | Report this commentMartin Wolf: I commend Joseph Stiglitz’s article in the FT today (July 24th). I do not always agree with him, but I do entirely agree with him in this case. There is a strong tendency among what I would call the “pseudo-free-market-right” to believe in the free market, except when things go wrong, whereupon, suddenly, it is the job of the taxpayer to come to the rescue, for “systemic reasons”. This is socialism for the rich. If one is going to be a socialist, at least one should be an egalitarian one, rather than an inegalitarian one. So, in this case, let the government rescue the poorer borrowers, rather than the lenders, if it has to rescue anybody.
Posted by: Martin Wolf | July 25th, 2008 at 2:11 pm | Report this commentRicardo Caballero: Martin and I seem to be converging…
In particular, in his concluding paragraph he states: “It is not the job of the government to recapitalise private institutions. If an institution is decapitalised by its losses, regulators might give it time to achieve the needed recapitalisation. In the meantime, of course, dividends should be suspended. If the government regards continued operation by a deeply decapitalised institution to be both necessary and dangerous, it can purchase equity itself, at a suitably discounted price. Provided the institution is plausibly solvent, that discount need not wipe out the existing shareholders altogether. If the institution is insolvent, it needs to go through a standard bankruptcy procedure, unless the government believes it must be kept in being. That means nationalization, with shareholders losing everything.” I agree with every single sentence in this paragraph, and there is nothing in my original article that suggests otherwise.
I also agree with his: “If they are to be kept private, the government should at least charge shareholders an appropriate insurance premium for the risk taxpayers are bearing.” And in the specific case of the GSEs he goes on to claim that “I cannot believe these institutions would then survive in private hands.” If he is right (we don’t know this at this stage – liquidity creation is a good business in general), so be it, and renationalisation may well be the way to go. By the way, my article is not about the GSEs in particular, but about the general principle that there are times when moral-hazard type arguments can be taken too far, and I believe that the intervention of Bear Stearns is one such case. I wrote the article right before the weekend’s GSEs package (there is always a publication lag) out of concern that Moral Hazard considerations would again take a disproportionate (given the current context) role.
However, I do not agree with Martin’s idea that conventional lender of last resort can solve the current problem. We are past that point for many key and solvent institutions.
Moreover, as I said earlier, many shareholder have already lost over 90% of the value of their original positions in some of the key financial institutions, so the idea that they will not understand that there is risk in financial investment absent a total collapse of the system is untenable. To me, Martin’s claim that “…the consequences… are a welcome, salutary and necessary reminder that the equity risk premium is indeed a risk premium, that lending to people with no assets, income or credit history is stupid and that packaging loans in such a way that nobody knows what they are worth, what they contain and how they are to be renegotiated is irresponsible…” seems more of a debating than a substantive point.
Finally, recall that right before the forced sale of Bear Stearns, there were private parties considering paying around $20 dollars a share to recapitalize it, which already represented a huge loss for existing shareholders. However, it is common knowledge that Secretary Paulson was adamantly opposed to double digit figures for the share price. It seems to me that the strategy outlined for solvent institutions in Martin’s last paragraph would have been a much better way to deal with that problem and, by avoiding the policy uncertainty created by random punishments, it could have prevented the further equity market panics we have seen since then.
Posted by: Ricardo Caballero | July 25th, 2008 at 5:25 pm | Report this commentMartin Wolf: I think we have largely converged and appreciate Ricardo’s courteous and complete responses. Let me add just one point.
It is true that shareholders in many institutions have lost 90 per cent of their initial investment. But this correct observation needs to be qualified in two important respects. One is that, as a result of excessive risk-taking in the context of implicit public insurance of liabilities, shareholders of many institutions, including, I assume, Fannie Mae and Freddie Mac, have enjoyed supernormal returns for years. Losing their investment now may not mean much. The other is that public sector subsidies may now rescue these businesses and restore shareholder value, at the taxpayers’ expense. For both of these reasons, implicit and explicit government subsidies may have encouraged excessive risk-taking and may now do so again. This is why moral hazard does, indeed, matter even now.
I think I will pass for now on whether and how far the lender-of-last resort function would deal with the current situation for allegedly solvent institutions. I think it depends on how one defines this classic function.
Posted by: Martin Wolf | July 27th, 2008 at 3:57 pm | Report this commentCharles Wyplosz: So we seem to be back to old Bagehot’s rule: lend freely at punitive rate and make sure that management is out, possibly without any golden handshake. If this is what Ricardo means to say, there is no disagreement.
But Ricardo still writes that “however, I do not agree with Martin’s idea that conventional lender of last resort can solve the current problem. We are past that point for many key and solvent institutions. We are past that point for many key and solvent institutions”. What does that mean? That they are insolvent? If so, being “nice” to shareholders that, in effect, do not hold anything any more, is wrongheaded. If these are “key” - meaning systemic - institutions, they cannot be left to bankruptcy but they have to be either nationalized or given for free, possibly with a subsidy to make up for negative net worth, to institutions willing to take over. This is more or less what happened to Bear Stearns. So I still fail to understand why Ricardo is upset about Bear Stearns. That Secretary Paulson wanted a harsh treatment can be read either as politicization or combating moral hazard. Well, spending 30 billion of taxpayer’s money is political, whether we like it not, and I certainly don’t.
As for moral hazard, Ricardo is ambiguous when he writes: “The issue is what is the best way of protecting these households and taxpayers during a financial crisis. I believe that the cost for them of providing free partial insurance to some key financial institutions is simply an order of magnitude smaller than the cost of letting the financial crisis run its course.” Sure, a big dollop of taxpayer’s money will help getting out of the current crisis but it will also ensure future crises, for free insurance encourages risky behavior.
Posted by: Charles Wyplosz | July 27th, 2008 at 9:41 pm | Report this commentTim Young: Ricardo made an important point in his original article which seems to have been overlooked in the discussion. The US authorities would be well advised not to wipe out new shareholders that have been encouraged to buy equity in an ailing financial business in a bid to provide enough capital to stave off bankruptcy. In particular, sovereign wealth fund investments in US financial institutions have been welcomed as “stabilising”, while investments in technology firms have been blocked. Regardless of the economic principles, wiping out such an investment shortly after it has been made would raise serious political problems.
Posted by: Tim Young | July 28th, 2008 at 11:15 pm | Report this commentMartin Wolf: I agree with Tim Young that the US authorities should not deliberately wipe out shareholders in a solvent business. But this does not mean they should bail out shareholders who have made mistaken investments in what turned out to be insolvent ones. Like other shareholders, sovereign wealth funds bear the risks of losing everything.
The idea that the US government should bail out foreign government shareholders, but not private shareholders, is unconscionable. It would also be far more politically unacceptable than allowing the sovereign funds to lose their investments.
Investments in technology firms have been blocked for quite different and perfectly understandable reasons. Foreign governments cannot expect to be allowed to buy control of strategically important companies in other jurisdictions.
Posted by: Martin Wolf | July 29th, 2008 at 9:12 pm | Report this commentRicardo Caballero: I believe my answers to Charles’ comments are contained in my previous postings. I think at this stage we should simply agree to disagree.
I do concur with Tim Young’s sense that somehow in our exchange we got driven into the standard black and white, elementary, time-consistency/moral hazard arguments, and lost track of the more subtle and novel points. It is comforting to know that not everybody lost sight of the real issues.
But more importantly, the recent measures by the SEC and Treasury supporting key financial institutions and their equity, do suggest that they are on the right track. This is a great relief.
Posted by: Ricardo Caballero | July 30th, 2008 at 2:20 am | Report this comment