Larry Summers: Beware Moral Hazard Fundamentalists

Larry Summers says the moralists have it wrong:

Beware moral hazard fundamentalists, by Larry Summers, Commentary, Financial Times (free): Central to every policy discussion in response to a financial crisis ... is the concept of moral hazard. Unfortunately, there is great confusion ... about ... when moral hazard is, and is not, a problem. ...

The term “moral hazard” originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire...

In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future “bail-outs”. ...

Moral hazard fundamentalists misunderstand the insurance analogy... As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability. They are wrong in three crucial respects.

First, ... the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is “contagion” as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened. In the presence of contagion there is every reason to expect that individual institutions will under-insure because they will not feel obliged to take account of the benefits their insurance will have for others.

Second, the insurance analogy fails to take account of ... a key aspect of the financial context – moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent... But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion.

More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive but illiquid projects and reduces the risk of contagion.

Third, in the insurance template used in thinking about moral hazard, the insurer pays more out because of the behavioural changes induced by insurance... Something parallel happens when the government guarantees a financial institution’s liabilities.

But much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. In the much criticised LTCM case no taxpayer money ... was spent. A competent lender of last resort ... actually turns a profit, as the IMF did in its response to the financial crises of the 1990s. Monetary policies that prevent deflation of the kind that cost Japan a decade of growth in the 1990s are another example of how a policy can respond to stress without imposing costs on taxpayers or the economy.

Where does all of this leave policy? ...[T]hese considerations suggest that prudent central banks will make judgments during financial crises not on the basis of “avoiding moral hazard” but rather by asking themselves three questions.

First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.

Comments

[gordon]

There is a fourth question: How do we avoid this happening again?

[moral-hazard-fundamentalist]

But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough.

On one side is people who refuse to buy bubble-priced assets, and on the other side is speculators who cannot carry the costs of borrowing.

Why should the speculators be supported? They gambled and lost. Why are the prudent being plundered by devaluation of their savings?

Let us be specific - should Countrywide fail or not?

There is enough people with cash - it's assets will always be find buyers at prices on a DCF basis

But current prices are far above the DCF. So prices need to fall. If they fall, CFC goes insolvent. So slowly devalue the debt, so that CFC does not become insolvent. How can the debt be relieved? By inflating, by devaluing the currency.

Cheap credit has driven all asset prices higher, and yields have dropped. Now yields do not even support the costs of borrowing. So can anyone explain how liquidity will make the asset suddenly produce more returns? Isn't this a code word for inflation?

Ditto for all investments. Aren't all the asset prices depending on devaluation of the currency?

Isn't that what Summers is obfuscating here? That a bubble, bail-out and mop-up devaluation cycle will outrightly transfer wealth TO those who got into the asset first, FROM those who got in later and those who did not get in? An outright plunder, that transfers and concentrates wealth upwards?

More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive but illiquid projects and reduces the risk of contagion.

What utter bullshit! Can Mark Thoma list what productive investment has happened in this country after the Greenspan pumping of 1%? All that credit ended up in overpriced McMansions which do not even generate enough rents.

The Fed has zero, - ZERO - control over what credit gets used for.

As soon as the Fed lowered, IB's lend out to hedge funds, and they all jumped on oil and commodities. Is that the "encourages investment in productive but illiquid projects" this shill is taking about?

The "moral hazard fundamentalist" is a straw man. People who make this strawman argument are shilling for their paymasters or self-benefit.

The bigger lie is that they pretend that a bail-out is a FREE LUNCH.

These shills are hiding the facts
(1) that there are people who benefit it from bail-outs
(2) the people who benefit are the same people who actively encouraged and denied the original reckless lending, and profited by fees and commissions during the mania.
(3) The people who lose are the same people who invested prudently, who warned that this would end badly, and who were ridiculed as chicken heads.

Let the bankers and hedge funds who said nothing was wrong during the mania bail out their brethren. Do a repeat of LTCM.

But that's not what these shills want, isn't it? They want those who did not participate in the bubble to bear the costs. They want a bail-out via the public's debt, the people's money, the Fed.

If Summers (or anyone) wants to make an honest argument, let him describe who bears the cost of a bail-out and who loses in a bail-out.

[calmo]

Hiya morally,
So Summers missed his chance to borrow from the expression "islamofascist" and invent "moralhazardofascist"?
I'm savoring the heat of your post [put the toaster away, people, morally's furnace is on] and unlike Decartes, think it must be real and honest and veritable...and steamy!
Let me put a fire hose on this bit you quote from Summers: :More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive [roasted so well by morally] but illiquid projects and reduces the risk of contagion. [no contagion thingies during booms tho]

What utter bullshit! Can Mark Thoma list what productive investment has happened in this country after the Greenspan pumping of 1%? All that credit ended up in overpriced McMansions which do not even generate enough rents. Tis Summer's bull and transcriber, Mark, is only looking for our response...and man, do you supply it!
Ok, such a small squirt back on your blazin post.
Additional dribble: are there innocents (non-speculators) who might be hurt if the speculators are not bailed-out? Should we exercise that principle 'First Do No Harm' by ensuring that we identify them and provide some net?

says...

Greenspan on Daily Show, with Jon Stewart:

Stewart: When you lower the interest rate and drive money to the stocks, that lowers the return people get on savings in a bank.

Greenspan: Yes, indeed. Yes, indeed.

Stewart: So they've made a choice -- we would like to favor those who invest in the stock market and not those who invest in the bank; that helps us.

Greenspan: That's the way it comes out but that's not the way to think about it.

Stewart: It seems to me that we favor investment but we don't favor work. The vast majority of people work and they pay payroll taxes and they use banks. And then there's this whole other world of hedge funds and short betting and...it seems like craps. And they keep saying, "No no no, don't worry about it, it's free market, that's why we live in much bigger houses. But it really isn't, it's the fed, or some other thing, no?"

[paine]

moral hase :

you i suspect are taking a rentier viewpoint
widows and orphans no doubt

and the poor soul looking
to make a belated enter
into home ownership
not ....NOT ...the house lot ELVIS PLATE /TULIP fandango

well there is a way to let house lots slowly subside
without forcing folks with existing oversized mortgages
to stop buying anything discretionary or go broke

give relief by lower arm hikes thru lower interest rates

AND simultaneously

reduce the mortgage amount
any given income stream qualifies for
ie
reduce the credit flowing into the house market

this will not facilitate
over mortgaged folks (what percent are they ??) ca
if they want
to bail out of their mortgage
by a sale and a downsize
use no rising lot values
----u fear any simple easy credit regime will re ignite -- it will however

sink lot values for any entry thresholders
roughly as fast as
the higher standard of income
qualifying for a given mortgage amount
shrinks ability to afford a home and meanwhile
those upside down will face lower carrying costs

i agree no reason worth a majority vote
of even existing homeowners
lies sleeping inside
dreams of any fed /treasury policy induced
return to the unit sales rates for existing homes
of the last few "salad bar " years
of alan le grease's lot bubble macro -slump- fix it

want to get the construction going again ??

build some low income public housing

[calmo]

That might B it: pay for the deconstruction of the McMansions under some land reclamation act and make them Parks repleat with placards (legislation would need to explicitly state the modest dimensions of these items) identifying the donors. The Greens would go for this, no?
But the low income public housing?
Ok, maybe prison expansion first, so that everybody understands...

[paine]

the fuddyduddy -correctional complex
has a long post 68 secular boom underway already cal

here's a tasty slogan

mcgulags si mcmansions no

[paine]

haze

"The Fed has zero, - ZERO - control over what credit gets used for.'

that is completely non truthy

between the fed and the treasury uncle sam
can make credit flow where and in whatever quantity chosen

obviously uncle has a modesty about proclaiming this ability
when its funded spec shit
and knowingly begotten irrational ponzification

no need to be secretive however
just don't trumpet it all

sure the policy is run
for the benefit of "the wised up"

call it typical open door
no secrets necessary "conspiracy of unequals "

the wised up flow like a gulf stream
thru the ignorant ocean of us idiots

[moral-hazard-fundamentalist]

Over on Calculated Risk they are discussing this.
http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

The Subprime Crisis & Ratings: PRMIA Meeting Notes
September 24, 2007

The meeting began with remarks by Thomas Day of SunGard, who formerly worked in the bank supervision function of the Board of Governors of the Federal Reserve System and now is responsible for product development at SunGard's Bancware unit. Day related his recent experience with a home purchase several years ago, where his transaction was not even subject to an appraisal and the myriad of structuring options which were available made the former safety and soundness examiner wonder if the marketplace had not grown overly complex.

"There's a regulation called 12CFR 34 which requires lenders to get appraisals," Day noted. "I'm not sure exactly how this worked, but we didn't get an appraisal. It was an AVM model, an automated valuation model, that was applied to the particular property I was buying... When they first told me how much I could borrow, I remember thinking to myself 'I'm rich.' And then it sunk in that no, I'm not. I'm not making any more money, got four kids and all of that. We eventually did a 7-1 piggyback."

Day then reflected on how, when he was still working at the Fed's board of governors three years ago, it was apparent to bank supervision personnel that "innovations" by mortgage lenders were creating the circumstances for serious credit quality problems. "Two and a half or three years ago, when I was still at the Fed, we were already talking about when it was going to happen. Looking at the type of lending going on inside the banks, we knew that this was going to hurt at some point. Everyone in the banking industry knew that risk was not priced rationally... How did this problem occur is a great question, but I think that everyone would agree that the leverage which was available when rates had declined 550 basis points is the key factor... "

So much for Greenspans protestations about his innocence. The Fed knew and abetted this bubble.

[calmo]

Ah paine, those lower ARM hikes, here: well there is a way to let house lots slowly subside
without forcing folks with existing oversized mortgages
to stop buying anything discretionary or go broke

give relief by lower arm hikes thru lower interest rates

AND simultaneously

reduce the mortgage amount
any given income stream qualifies for
ie
reduce the credit flowing into the house market and are we wishing on a star that those rates will plummet with those Fed moves...or is that august body beyond embarrassment and plowing for 1% nomatterwhat?
Seemed a bit unhinged on the way up. I can't think of anything that has rehinged it (esp those LIBOR rates), but that might B me wearing the dark shades and not giving interventionist legislation its due...the lobby bein what it is.

[JS]

Nicely put, moral-hazard-fundamentalist. Summers' case is somewhat of a straw-man itself since Summers is a Wall St. shill and argues as one would expect. In a contest between a Wall St. shill, I'll call them reckless greed Nanny statists, and a moral hazard fundamentalist, I think I'll take the moral hazard.

[knzn]

moral-hazard-fundamentalist:

The people who lose are the same people who invested prudently, who warned that this would end badly, and who were ridiculed as chicken heads.

What? What people are you talking about? Surely you don't think that people who bought long-term treasury bonds at 4% were investing prudently! The people who refused to diversify out of the dollar at a time when the US was running a record trade deficit, surely these people were not investing prudently!

The ones "who warned that this would end badly", if they put their money where their mouths were, have been holding their assets in German treasury bills or something like that. The way to reward them would be to conduct a gargantuan bailout, sink the dollar for good, and make the yield curve as steep as it has ever been in this country's history, giving them the chance to take their foreign exchange profits and reinvest them in long-term treasuries in the US at attractive yields.

[moral-hazard-fundamentalist]

The people who refused to diversify out of the dollar at a time when the US was running a record trade deficit, surely these people were not investing prudently!

Ah, the vowel-less economics Pavlov is back. How would the sheeple react if I turn this knob? What if I push that lever? You, I know, don't care for individual aspirations. Your all about the system. All hail the system! You'd make Mengele proud.

Right. We should all have bought the stock market and houses at these ridiculous prices and watch it get devalued in real terms. The people who got in first, get rich in real terms, and everyone else either stays in place or gets screwed.

Refusing to invest is also a prudent decision sometimes. Didn't you read this above

Stewart: When you lower the interest rate and drive money to the stocks..

That's a Fed forced bailout of imprudent investments, the cost being borne by people who refused to buy at ridiculous prices.

The people who bought at ridiculous prices cant bear the carrying costs, and are collapsing. Hence the need for a bailout.

How can people who refuse to buy at ridiculous prices be forced to buy and bailout these reckless people? Devalue the currency at a faster rate than the assets.

Who made money in real terms in this racket? The bankers, hedge funds, and rich guys who got into these assets first, who had access to credit first. The sheeple with their 401Ks and pensions are last.

On Sep 18th, the Fed cut, the Banks fed a binge of borrowing by hedgies, who started buying up oil. Oil prices shot up so much that CEOs of oil firms publicly state that the price is not justified.

I'm sure that the sheeple will be manipulated by levers and knobs to buy that oil investments out of their hands down the line. The system has to be saved, you know.

With the likes of you all shilling for the system, even if murder and war and looting are incited internally, as long as the system runs, it is utopia.

[Robert Edele]

"What? What people are you talking about? Surely you don't think that people who bought long-term treasury bonds at 4% were investing prudently! The people who refused to diversify out of the dollar at a time when the US was running a record trade deficit, surely these people were not investing prudently!" Perhaps those people were being patriotic and didn't want to cause harm to our country by sending money overseas. Perhaps they don't want to encourage the extremely environmentally destructive process of precious metal mining. PS: Those that invested in short term notes have done little better either - short term rates have been near or below inflation since 2000.

[paine]

calmo
indeed market long rates resisted still resist
the upside
short rate policy correction
and taking em back down may face
a market head wind

but a determined fed ....will prevail
motto de jour

recall the volcker dammerung

as to the numbers
as in from here at todays rates
down to x marks the sweat spot
bring out the fast and powerful computers
i never do calcs anymore
strictly into qualitative quality products

up down yes no

with maybe a few
"way way downs "( or "ups ")
but never any " just a smidge up " calls
i save the close in number hacking
for the whiz kids
sum up :

a repeat .... motto de jour
recall the volcker dammerung

[moral-hazard-fundamentalist]

The discount window con game described. It's all for saving the system, of course. Don't listen to moral hazard cranks.

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

"Rosner closed by commenting on the rating methods used by the major agencies for looking at mortgage conduits: "I was looking at a conduit the other day that is a multi-seller sponsored conduits, sponsored by nine of the largest financial institutions in the world. And when you look at the actual rating of the conduit, the ratings are not tied to the underlying collateral. The rating agency graded based upon the financial strength of the sponsor. And so the assets which have been sold into this conduit this year, 80% or those assets are unrated or sub-investment grade, but the conduit actually has an investment grade rating. And this raises the question: is this part of the reason why there is not a liquidity crisis, but a crisis in confidence because we really don't know what is in these assets... There is no disclosure, no transparency, and in fact it gets even a little bit uglier. By contributing unrated assets to this conduit, the issuer is turning toxic waste into gold, because the CP issued by the conduit carries an investment grade rating. If one of the sponsors buys the CP, they can get 95 percent of face value from the Fed discount window."

[Back to the Real World]

"Surely you don't think that people who bought long-term treasury bonds at 4% were investing prudently!"

Get serious. Very few people are sophisticated enough to do something like buying German treasuries, nor should they need to be to avoid getting screwed.

[moral-hazard-fundamentalist]

Here is how it played out across the pond. Martin Wolf talking about the bailout of Northern Rock.

The Bank loses a game of chicken

By Martin Wolf

Published: September 20 2007 20:16 | Last updated: September 20 2007 20:16

"I regard Mervyn King, governor of the Bank of England, as a friend. I also admire him as an economist, as a man of principle and as a public servant. Over the last one-and-a-half decades he has played a central role in the emergence in the UK of a modern monetary framework under the control of an independent central bank of the highest quality.

More recently, I agreed with the tough line Mr King has taken on the provision of liquidity to the markets during the current turmoil. But I recognise that he has been gravely damaged by the last week’s events. This is not so much over the handling of the crisis at Northern Rock, for which blame is shared, as it is over the volte-face on the terms on which the Bank lends to the markets. Mr King is playing a game of chicken with the world’s most irresponsible industry. Sadly, he is losing.

.....

Albeit welcoming what it called “the more flexible approach” – that is, the defeat – of the Bank, the British Bankers’ Association demanded unconditional surrender, noting “concerns about the 100 basis point penalty paid by users of the standing facility”. In short, it wants the Bank to provide limitless liquidity against questionable security, without penalty. Will the Bank resist this pressure? I hope so, but doubt it.

In a game of chicken, the loser is the player who swerves first out of the way of the other driver’s car. Since the Bank is concerned about the health of the economy, while the banks are concerned only about their survival, the former is at a huge disadvantage. Apparently, the banks told the authorities they would not lend to their weaker brethren until the Bank opened its wallet. The threat was credible and the Bank swerved.

Am I unfair, then, in blaming these events on the irresponsibility of the banks? Consider that, even though the world economy has enjoyed years of good growth and the US housing market, epicenter of the crisis, has weakened but a little, credit markets are frozen. Consider, too, that the banks both created the radioactive securitised obligations and set up the special investment vehicles (off-balance-sheet banks) that they must now rescue at the expense of lending to everybody else. Consider, not least, that banks exposed themselves to the risk of illiquidity from which they expect a public rescue, at no charge.

Yet the banks are winning, not only because they are a formidable lobby, but because they can inflict such damage. Today, as a result, the government has guaranteed deposit liabilities and the Bank has taken a big step towards rescuing them from self-inflicted illiquidity. So Mr King is losing his gamble on toughness. Let us at least understand why. Our sophisticated financial system suffered a typical collapse in self-discipline. Now the authorities are under huge pressure to rescue it from its folly. Mr King’s “mistake” – what critics call his “inflexibility” – was the view that banks should no more enjoy a rescue than other businesses. Fortunately, the Bank’s provision of liquidity is not yet free. Let Mr King stick to his guns on the penalty. If not, still more dangerous crises will come."
(end)

Compare and contrast to Mr Summers and cronies.

Still believe that this whole bail-out is not a racket?

[moral-hazard-fundamentalist]

Wait, the fun does not stop there.

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2525410.ece

September 25, 2007
MPs call on Northern Rock to scrap £60m dividend payout
Northern Rock Bank in Kingston-upon-Thames

Patrick Hosking and Christine Seib

MPs on the Treasury Select Committee called on Northern Rock to abandon plans to pay out £60 million to shareholders only weeks after seeking emergency assistance from the Government.
....
A spokesman for the bank confirmed yesterday that, although the bank was not legally obliged to pay the 14.2p per share dividend that it announced in July, its decision on September 14 to go ahead with the payment had not changed.
...

No, no moral hazard at all, nary a bit.

[btgraff]

Stewart: So they've made a choice -- we would like to favor those who invest in the stock market and not those who invest in the bank; that helps us.

Stewart would be the first to admit he knows little about this stuff, but an interest rate cut also favours those that need to borrow money (small business, homebuyers, etc.) over those that already have it and can lend the money. sounds to me like a rate cut favours the less well off

do many people still put money in savings banks?