The federal government has poured hundreds of billions of dollars into the banking system, and most experts seem to agree that the financial crisis is closer to its end than its beginning. But as attention shifts from fire fighting to rebuilding, many are worrying about the “moral hazard” that may remain, with an apparent government safety net encouraging a new round of foolish risk taking.
Not everyone thinks the problem of moral hazard has grown, underscoring the continuing debate about what exactly caused the crisis and how key players will behave in a financial world that is still taking shape. But several Wharton faculty members interviewed say the government response to the crisis could lead to new problems down the road.
“We have created huge moral hazard by, in most instances, sparing all creditors from the consequences of their choices,” says Wharton finance professor Richard J. Herring, noting that bond owners and others who lent vast sums to financial institutions have not been forced to take the kind of devastating losses suffered by stockholders.
“With the exception of Lehman Brothers and Washington Mutual, the government has simply caved when faced with the prospect of imposing losses on creditors,” he adds. Investment bank Lehman Brothers and super-lender Washington Mutual both collapsed last September, causing devastating losses to creditors as well as shareholders. Many experts believe the Lehman collapse provoked the financial market downturn that followed. Afterward, the government stepped in to avert similar catastrophes.
“They are rewarding failure,” Wharton finance professor Franklin Allen says of the government’s response to the crisis. “Going forward, these companies will know that if the management takes risks and things go bad, as long as they are a big enough company, the government is going to come along and bail them out.” A better government response, he says, would have been to temporarily nationalize some of the big failing institutions, clearing out the devalued assets, ensuring that debtors and shareholders were wiped out and allowing the firms to emerge healthy.
But Wharton finance professor Jeremy J. Siegel believes the crisis caused enough suffering among corporate executives, shareholders and others to deter overly hazardous financial practices. “The shock of what has happened is going to last many, many years,” Siegel says. “I’m not saying that 10, 20, 30 years from now something else may come up and they may take excessive risk, but it’s going to be a long time … probably decades.”
Many products and practices that contributed to the crisis have passed from the scene. The subprime mortgage market has dried up. And with credit terribly tight, financial institutions have curtailed the binge of investing with borrowed money that contributed to the crisis. The market for hard-to-understand securities based on mortgages and other kinds of debt has shriveled. Top executives at some firms closely linked to the mess have lost their jobs, as well as the fortunes they had amassed in company stock and options.
In fact, the main problem today is not excess risk taking but insufficient risk taking. Businesses and individuals have a tough time getting loans even if they have legitimate reasons to borrow and good prospects of keeping up with payments. The two chief sources of capital to fund business growth are bond holders and stockholders. Both groups, says Siegel, will now be more careful about where they put their money, demanding safeguards against excessive risk that can cause stocks and bonds to plummet. “Obviously, the shareholders are going to demand much better risk management,” he says.
Ghosts of Bubbles Past
Given these changes, it’s possible to argue that the markets have corrected themselves, and that the big players have learned their lesson. But many economists and financial experts are nagged by memories of previous bubbles, the latest of which was the dot.com collapse in 2000. Again and again, financial players have shown a great facility for forgetting the lessons of the past.
Part of the reason, says Wharton finance professor Marshall E. Blume, is that many of the people who lead the market into a bubble walk away rich despite the havoc that ensues. Also, the people who create one bubble are often gone by the time conditions arise for the next one. So long as there is a human desire to get rich quick, there will be people willing to bet everything on short-term gains. “Management is always interested in pursuing its own gain,” Blume observes. “That hasn’t changed. Now, maybe the calculus of risk taking … has changed, but certainly the underlying goal of managers is to make money for themselves.”
In addition to arguing that the pain was severe enough this time to stay lodged in long-term memory, Siegel says the current crisis was not really caused by moral hazard, which involves people taking big risks knowingly. In this case, he says, the problem was they didn’t realize how shaky their holdings were. Many players, including the people who issued new types of mortgages, those who invested in the securities based on them, and the agencies that gave those securities top ratings, simply thought the market was pretty safe. In part, that was due to a mistaken faith in valuation models that had too little track record. But beyond that, many experts believed — again mistakenly — that a nationwide collapse in home prices was virtually impossible, since it had not happened before. When it did come, that collapse triggered the huge losses in mortgage-backed securities.
If moral hazard was not a chief factor in the current crisis, it is not the main thing to worry about going forward, Siegel says. “The moral hazard question was not at all central to why this crisis happened. I think that’s the bottom line.” This contrasts with the savings and loan crisis of the 1980s and 1990s, which was driven by bankers’ expectations of government bailouts — or, as Siegel says, “Heads I win, tails the government loses.”
That doesn’t mean the big players are blameless in the current mess, he adds. “I do fault management for not recognizing the risks of these securities, and for taking false comfort in the triple-A ratings that Moody’s, Standard & Poor’s and Fitch gave them.” Others argue that by rescuing companies that otherwise would collapse, the government inevitably encourages risk. The government has shored up companies like AIG, Citigroup, Fannie Mae and Freddie Mac, and it has pumped hundreds of billions of dollars into the nation’s banks through the Troubled Asset Relief Program.
Big banks now believe they will be rescued from trouble, even though the government has left unclear exactly which institutions it considers too big to fail, says Wharton finance professor Richard Marston. “But we did find out … that managements, for the most part, are left in place and that bond holders end up whole, that only equity holders lose,” he says, adding: “As a result, tossing the dice isn’t such a disaster for the banks, just for their shareholders.”
Promise in New Rules
In June, the Obama administration issued 89 pages of proposals for improving the financial system. They include provisions for better monitoring risks that build up in banks big enough to threaten the financial system, as well as a re-examination of capital-reserve requirements to make sure financial institutions have enough resources to make good on obligations. The proposals also would give the government new powers to take over and dismantle large institutions that fail. And the administration would order regulators to issue new executive compensation guidelines to ensure that companies don’t encourage short-term risk taking at the expense of long-term health.
“Under the proposals, as I understand them, Lehman would have been liquidated in a very orderly way without disturbing the market,” Blume says. “That would have been good.” Still, he worries that the proposals’ focus on averting problems with big institutions creates an implicit safety net. “That could encourage additional risk taking on the part of management,” he notes. “It may provide a competitive advantage to some of the big firms at the expense of the little firms, and that’s not good.”
Herring, too, is concerned that the Obama proposals enshrine the concept that some financial institutions are too big to be allowed to fail. “Financial institutions that are too big to fail are simply too big,” he says. “Financial institutions that are too complicated to fail are simply too complicated. Financial institutions that are too interconnected to fail are simply too interconnected.”
Until the Obama proposals are fleshed out, it will not be clear whether regulatory oversight will be strong enough to prevent excessive risk taking, Marston says. “Let’s see how it is turned into legislation. But big banks are too innovative to be corralled very long.”
Among the governmental responses to the crisis, the Securities and Exchange Commission has proposed strengthening shareholders’ hands in dealing with management. Blume is not keen on one proposal, to give shareholders a non-binding “say on pay” for top executives, believing not many shareholders are knowledgeable enough. But he supports the SEC’s proposal to make it easier for shareholders, mainly large ones, to field their own candidates for boards of directors. Many shareholder advocates think a key factor in the crisis was directors’ failure to properly oversee managers with whom board members were too cozy. “To the extent that you can facilitate the ability of these larger stockholders to exercise their rights, I think that’s good,” Blume says.
The government has made various stabs at relieving banks of the “toxic assets” polluting their books — things like mortgage-backed securities now trading at a fraction of their face value — to free the banks from worries that inhibit new lending. None of these efforts has had much success, including the latest, a plan to use government loans and guarantees to encourage private investors, such as hedge funds, to buy the assets.
Allen argues the time for such measures has passed, as the banks now prefer to keep the assets in hopes that prices will rise rather than book losses at today’s fire-sale prices. “They are better off hanging onto them and valuing them at prices that don’t reflect what they are trading for.”
“If I am a bank with illiquid assets that I hope will be worth more later, why should I take a low price today?” Marston asks. That doesn’t mean banks are out of the woods, he adds, suggesting that, despite government help, they still face problems that could inhibit lending. “With the economy still deteriorating and lots of consumer and business loans going bad, some big banks are still facing great difficulty. And, of course, there are some rotten little banks that will fail, but that always happens in a recession. It will happen more often in this one because real estate continues to be such a mess.”
Still, Marston and others argue that conditions are improving. “Though problems remain, you should realize how much less dangerous a situation we are in now than last fall,” he says. “The short-term financial markets are functioning again. The Fed is actually slowly shrinking its commercial paper and bank loan positions. We will have serious lingering effects from this crisis, and we don’t know how to prevent another one. But the economy is bottoming out, so banks have a chance to mend themselves.”