Moral hazards on the road to economic recovery
In the wake of the financial crisis, with more than $85 billion in government assistance to AIG, economists and financial experts are trying to figure out the future implications of the extensive government intervention during the fall of 2008.
As the economy continues to climb out of the recession, experts in economics and banking finance are looking at the precedent government intervention efforts might set for future situations – and experts on both sides see a potential pitfall filled with moral hazard and a lack of market discipline.
Societe Generale received $16.5 billion in these payments, while Goldman Sachs received $14 billion, according to a report by the Special Investigator General for the Troubled Asset Relief Program; the 16 counterparties received a total of $62.1 billion.
Dean Baker, the co-director of the Center for Economic and Policy Research, said much of the precedent for future crisis would be determined by people’s perceptions of government actions.
He said the “too big to fail” story – that the government will protect the biggest companies most involved in the financial system – has become more explicit.
“The lesson of this crisis is that if there is a systemic crisis the government will bail them out,” Baker said. He added the Troubled Asset Relief Program might have averted economic disaster, but it also concentrated the problem by encouraging banks to consolidate into even larger entities.
“The problems are worse today than they are at the beginning of the crisis.”
Baker said this story is exemplified by government intervention efforts with AIG. He added that the government payment to AIG counterparties – organizations that had purchased much of the risk for bad assets – set up a serious problem with moral hazard.
“Everything about AIG, including the payments to counterparties, was a bad story, and one hopes it does not provide a precedent for the future,” Baker said.
He said with companies that handle risk – companies such as AIG – there would be no market discipline if the government is expected to come in and make all parties financially whole.
In a report to Congress, the SIGTARP said “there is no question that the effect of the FRBNY’s decisions – indeed, the very design of the federal assistance to AIG – was that tens of billions of dollars of government money was funneled inexorably and directly to AIG’s counterparties.”
The report, released on Nov. 17, called the government to put an emphasis on transparency on any future actions and in its current work within the financial system.
In a hearing before the House Committee on Government Oversight and Reform, Neil Barofsky, special investigator for the TARP program, said there was not a lot of effort to negotiate with the counterparties, even though one of those –UBS – was open to accepting less than what was eventually paid.
“These negotiations could have been conducted in a different way, a more forceful way,” Barosky said. “We will never know what the result might have been, but it may have resulted in saving the taxpayers billions if not tens of billions of dollars.”
Peter Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, said the idea of moral hazard is not hypothetical, but a real question rooted in the future actions of creditors.
“The bailout of AIG has created a large amount of moral hazard,” Wallison said. He said the competitive nature of large companies means that their affect on the system is larger, and they benefit from issues of “too big to fail.”
He said that, while the government might be averse to bailing out companies right now, there is no legal obstacle if the government has to do so again.
Despite the unpopular nature of the AIG bailout right now, the government could do it again in a few years if it had to.
“You watch what the government does, not what the government says,” Wallison said. He added people should not have been surprised the AIG payments to counterparties would be 100 percent of what they paid for them.
“That’s what bailout meant, it meant the creditors or the counterparties would not suffer any losses," he said. "We are going to pay of 100 percent of the company’s obligations.”
He said by giving AIG this money and making the counterparties whole again the government is setting down precedent for how it might act in the future. Right now, he said, there needs to be a greater obstacle for a bailout than just the actions of the Federal Reserve chairman or the president.
Wallison suggested a congressional resolution as one possible solution. But if nothing changes to make the idea of a bailout more difficult to achieve, it’s only a matter of time before it happens again.
“The next time we have disruption we’re going to have a bailout,” Wallison said.
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