SKARBECK: Are bailouts creating a 'moral hazard'?

June 1, 2009

Moral hazard is an expression that has worked its way into the public dialogue. Originally an insurance term, it refers to the scenario where, when one is no longer fully exposed to the risk of a loss, the potential for riskier behavior rises.

Considering the various bailouts and backstops that have prevented some of the large financial institutions from suffering more severe losses or bankruptcy, there is concern that a moral hazard is being established. In essence, the question becomes, will individuals and institutions take excessive risks in the future, operating on the belief that the government will step in to rescue them if they encounter problems?

Last fall, the government stepped in quickly to stem an economic tsunami. Admittedly, some mistakes were made, but this could be expected with a "shoot now ask questions later" approach. As time has passed, some of the earlier programs (TARP/TALF) have morphed into new programs (PPIP), all geared toward healing an overleveraged and illiquid financial system bogged down with "toxic" assets.

We don't know what would have happened if a hands-off approach had been taken. It likely would have been an even more frightening ride if the government had not intervened. For example, Warren Buffett has said we were on the verge of a financial meltdown and that to do nothing would have been crazy.

At the very least, the government bailouts bring up points for philosophical debate—for example, should not those who chose to act irresponsibly suffer the full consequences of their actions? But the bailouts raise critical economic issues, too. For example, by preventing the economic and financial system from clearing on its own, do we set ourselves up for something like Japan's "lost decade" of the 1990s?

Of course, the answers to these questions are not clear-cut. Some of the players in the leveraged subprime lending fiasco who acted irresponsibly have felt the brunt of their actions, while others have sailed through without a scrape. Also, since 1999, the U.S. stock market has logged a 10-year annualized return of negative 2.5 percent, though the prior-decade results tell us nothing about investment returns or economic growth going forward.

One sure bet in the future is a major overhaul of the financial regulatory system. Lawmakers must carefully balance changes so new regulation doesn't quash the entrepreneurial spirit that drives our economy. One probable result will be financial institutions that operate with less leverage in their capital base, which in turn should lower systemic risk. It also may mean slower economic growth and more muted investment returns.

Today, though, we find the government involved in all corners of our financial system, and now the trick will be to extricate it from the private sector as soon as possible. We can only hope that government's presence in this ordeal has not created a moral hazard in our economic system where profit is privatized and risk is socialized. Taking calculated risks, with the counterbalancing threat of loss, is a big part of what makes the capitalist system thrive.

One thing that can't be legislated away is the occasional outbreaks of fear and greed among the investing public. Prepared investors can act to their advantage on the mispricing of securities that occur during these periods.

Skarbeck is managing partner of Indianapolisbased Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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