The Fed Vastly Expands Moral Hazard By Michael S. Rozeff
(2011-01-12 at 19:37:10 )

The Fed Vastly Expands Moral Hazard By Michael S. Rozeff

This def inition of moral hazard from Wikipedia is quite satisfactory:

-Moral Hazard occurs when a party insulated from risk behaves
diff erently than it would behave if it were fully exposed to the risk.-

" Moral hazard arises because an individual or institution does not take
the full consequences and responsibilities of its actions, and therefore
has a tendency to act less carefully than it otherwise would, leaving
another party to hold some responsibility for the consequences of those
actions. For example, a person with insurance against automobile theft
may be less cautious about locking his or her car, because the negative
consequences of vehicle theft are (partially) the responsibility of the
insurance company."

Put another way, if people can leave someone else holding the bag (which
is a kind of insurance or insulation from a risk), they will engage in
greater risk-taking and produce more bags to be held.

Another example is the insurance of bank deposits by the FDIC. These
deposits are bank liabilities. If they are not insured, the banks capital
suppliers, such as bondholders and stockholders, are left holding the
bag (which is paying off on these deposits) if its loans fail, which is
the risk-taking behavior. If they are insured, these capital suppliers
will get the bank to take on greater risks, as in shaky mortgage loans,
because others will be left holding the bag if the loans go bad.

When the government bails out banks with shaky loans, it is providing
insurance after the fact. The banks expected it. They expect it in the
future. The moral hazard persists and grows larger. They respond by
maintaining and making more risky loans.

The government promises all sorts of payoff s and wealth transfers that
insure various groups. These all encourage greater risk-taking, which is
the eff ect of the moral hazard. When the government insures people
against loss of income in old age by promising Social Security payments,
it encourages people to take more risk by not taking their own personal
measures to insure their income in old age. People then save less for
their old age.

During the bubbly run-up to this recession, a number of markets counted
on the "Greenspan Put," which meant that the Fed would step in if
recession threatened. The Fed was expected to mitigate an ongoing
recession or stem the consequences of a f inancial failure or problem,
such as that of LTCM. This understanding acted as insurance. It aff ected
market expectations and behavior. The markets produced more and more and
more risky loans and built up an unstable web of connections among
financial companies. These depended for their stability on collateral
values of risky debt securities, only the markets did not look at them
as risky because there was a source of outside insurance. The moral
hazard produced by the Greenspan and then the Bernanke Put showed up in
the multiplication of risky loans and a shaky f inancial structure.

The Fed produced moral hazard all along Wall Street and all along the
chain of f inancial companies across the nation that connected mortgage
borrowers to banks, mortgage companies, bond raters, investment bankers,
and the Fed itself.

Once the loans began to go bad, the shaky structure fell apart. The Fed
responded as the lender of last resort, which really means the insurer of
last resort, which really means the entity that produces the moral
hazard and then attempts to stem the eff ects of its own actions by more
inflation. It shifts the Holding of the Bags to the General Public
and to The Taxpayers.

The Public and Taxpayers are the ultimate Bagholders in all this. The
moral hazards produced by government and the Fed that lead to shaky
f inancial structures and failures look to both the General Public and
Taxpayers as the Insurers or Payers of last resort. Greenspan could not
in reality provide a Put or Insurance Policy. The Fed can not provide
any real resources, since all it does is print money. The government
can not provide any real resources or wealth because it simply collects
them from taxpayers. No, in the end, the general public pays through
reduced dollar values (higher prices), and the taxpayers are made to
pay through Higher Taxes.

This brings us to the latest rounds of inf lation by the Fed that are
called QE for quantitative easing. QE is an invented euphemism for the
creation of f iat money by the Fed. The Fed buys securities and pays for
them with e-credits that it creates with the push of a keyboard button.

This benef its various immediate recipients, but most of us are not in
that group. Most of us f ind that prices are rising and the value of our
dollars has fallen. Suddenly a pound of pork sausage that used to cost
$2.75 costs $3.75 and then, lo and behold, it costs $4.25, all in the
space of two or three years.

In the previous bubble, the Fed produced vast moral hazard in the
private debt markets. When the cash f lows (the mortgage payments) that
held up those securities dropped or were lacking, the values of those
securities dropped. Firms began to f lop. The system started to f all
apart. The Fed "saved" it for another go around the track by massive
infusions of credit.

The Fed since 2008 is now again vastly expanding the moral hazard. Where
before the credits were interconnected in the banking-investment banking
arenas, and still are, they now have a new and larger locus: the
government bond markets. The latest round of f iat money-creation has the
Fed buying a gross amount of $900 billion of U.S. securities and a net
new amount of $600 billion. Bernanke says more may come, depending on
how he and the FOMC assess conditions.

The Fed is helping the U.S. government issue vast amounts of new debt.
That allows the U.S. government to maintain and increase its spending.
The spending programs are analogous to the shaky loans that the banks
made. These programs involve huge amounts of waste. They do not produce
the cash f lows necessary to service the debts being incurred. That is
analogous to the banks that made bad loans that produced inadequate cash
f lows. In the government case, their spending programs, f inanced by huge
increases in government debt, are not going to produce tax revenues high
enough to service the debt.

The Fed is supporting a new locus of moral hazard, which is in the U.S.
governments spending. The Fed is acting as a kind of insurer of this
governments debt, assuring its market and assuring that the debt
securities will not decline seriously in price. But if the government
spending is largely waste and does little or nothing to produce future
cash f lows, the cash f lows via tax revenues will not be there to pay
off this debt in real terms. What has to happen is that the value of
these securities and that of the dollar must decline in real terms.

The Fed will inf late, just as it did in 2008, when the next f inancial
crisis erupts. That crisis will be one of a f inancial crunch occurring
in the U.S. government. The U.S. government will be the next Lehman
Brothers or Bear Stearns. This threatened failure event will be vastly
larger than in 2008 because of the importance of the government in the
domestic and world economies, because of the importance of the dollar in
those economies, and because of the links of the Fed and U.S. securities
to foreign central banks that hold these securities as reserves.

To save the system in the coming credit stringency to be experienced by
the U.S. government, the Fed will try more inf lation. The government
will, in order to save itself and its system, take all sorts of
stringent measures that we will all hate.

How that ends up is anyones guess. The chance of a smooth transition to
a "reset" of the system on a sound basis is small. The chance of some
very large wealth redistributions is high. The chance that those in
power gain even more power is high, although the size of their domain
may shrink. The chance of government cutbacks is high. The chance of
government seizures of private wealth is high. The chance of much
greater inf lation is high. The chance of the Fed reversing course
because of rising prices is very small.

On top of the f inancial doom that lies ahead for the U.S. government is
the f inancial doom already facing many states, such as Illinois,
New York, and California. Their precarious condition ties in with that
of the federal government. They will look for bailouts and ex post
insurance for their operating and f inancial mismanagement of the past
10 plus years. This pressures the federal government and the Fed.

The f inancial situation from 2007 to now is seamless. The country is
still in recession. It still has the same kinds of f inancial problems.
The banks have still not been straightened out. Their bad loans remain.
The governments housing operations are still bleeding cash. Now we have
the states bleeding, and we have a vast moral hazard operation in the
federal government, aided and abetted by the Fed. We are in the midst of
a prolonged f inancial crisis brought about by f iat money expansion
that, among its many wicked eff ects, expands moral hazard in whatever
directions that money f lows. Right now, it is f lowing to the federal
government.

If it were not Fed Chairman Bernanke presiding over the blowing of the
government bubble, it would be someone else. But he is peculiarly
f itted for the job. He was in fact chosen to do it by those who knew
his views and knew that more inf lation would be required to keep the
system af loat a little while longer.

I would bet on the Congress continuing to spend, and spend, and spend.
I would bet on Congress continuing to add more and more to the national
debt. If and when interest rates start to rise, the crunch will come.
At that point, I do not think Congress will suddenly get religion and
initiate a sound system. Instead chances are high that it will use force
to try to save the system. That force will fall upon most of us, if it
happens.

December 13, 2010

Michael S. Rozeff is a retired Professor of Finance living in East
Amherst, New York. He is the author of the free e-book Essays on
American Empire.

Copyright © 2010 by LewRockwell.com. Permission to reprint in whole or
in part is gladly granted, provided full credit is given.