The Greenspan, er, Bernanke Put

"The list is long, but distinguished."
--Goose (Top Gun)

Following up on yesterday's post, market participants coined the term 'Greenspan put' during the former Fed chief's tenure. The term represented the fact that, whenever markets went into tailspins, the Federal Reserve under Greenspan's watch was constantly there to bail investors out. The '87 crash, the peso crisis, Asian Contagion, Long Term Capital, the dot com bust...

It didn't take long for market participants to realize that the Fed was granting them free put options. Whenever markets got into trouble, participants could 'put' their problems on the Fed, just as any insurance claimant would.

The moral hazard implications of this arrangement should be obvious. "Hey, we can take more risk," market participants reason, "because the Fed has our backs in case our hoped for gains turn into big losses."

A pile of empirical research supports the notion that government intervention in financial markets encourages additional risk taking (e.g., Miller, Weller, & Zhang, 2002; Lee & Shin, 2008). A related stream of research, incidently, finds similar tendencies among consumer behavior when bank deposits are backstopped by government insurance programs such as FDIC (e.g., Grossman, 1992; Hooks & Robinson, 2002; Neir & Baumann, 2006)

Greenspan's retirement in 2006 proved that the put was not peculiar to his tenure. In fact, his successor, Ben Bernanke, has been even more aggressive in the bail out seat. During the past two years, Bernanke has thrown $trillions at the credit market meltdown and recently announced intentions to do more.

The Fed's recent signal that a big batch of money printing via QE2 has markets exuberant once again. Global rallies in nearly all risk markets reflect correlated confidence in the Fed and other central banks to revive economic activity with more money printing.

And if QE2 doesn't 'work'? "No worries," snort market participants, "if prices reverse and go lower central banks will bail us out like they always have."

After observing so many market participants jumping aboard the QE2 train lately, I wonder how close we are to pricing in the entire impact of this Fed money printing scheme in its best case scenario. I am confident that we haven't priced in the impact of downside scenarios.

There's another minor item that those banking on exercising another Greenspan Bernanke put may want to take into account. Insurers that are not adequately capitalized in times of  crisis go bust, rendering related insurance policies worthless.

position in SH

References

Miller, M., Weller, P., & Zhang, L. 2002. Moral hazard and the US stock market: Analysing the ‘Greenspan Put.’ Economic Journal, 112: C171-C186.

Neir, E. & Baumann, U. 2006. Market discipline, disclosure, and moral hazard in banking. Journal of Financial Intermediation, 15: 332-361.

Grossman, R.S. 1992. Deposit insurance, regulation, and moral hazard in the thrift industry: Evidence from the 1930s. American Economic Review, 82: 800-821.

Hooks, L.M. & Robinson, K.J. 2002. Deposit insurance and moral hazard: Evidence from Texas banking in the 1920s. Journal of Economic History, 62: 833-853.

Lee, J. & Shin, K. 2008. IMF bailouts and moral hazard. Journal of International Money & Finance, 27: 816-830.