Escalating Moral Hazard

"The mother of all evils is speculation - leveraged debt."
--Gordon Gekko (Wall Street: Money Never Sleeps)

One of the best scenes in Wall Street 2 is the meeting at the NY Fed meant to reflect the Fall 2008 situation. Prices are plummeting in all asset classes (especially mortgage-backed securities and associated derivatives), and all big banks face insolvency. The bank CEOs have gathered round the table with government officials with hats in hand. They need a bailout or they are history.

The Hank Paulson look alike Treasury Secretary berates the group for taking too much risk. Chief antagonist Bretton James, who had ironically only months before successfully led an argument in the same room against bailing out a Bear Stearns-like firm for taking excessive risk, now leads the other side of the argument. The fact that the banks took much risk didn't matter, he argued. If the government didn't bail out the firms, there would be no financial system tomorrow.

We know what happened.

So here we are a few years and bailouts later facing yet another 'fiscal cliff.' The argument goes that if government does not intervene with another round of interventions, then the economy goes over the cliff.

It doesn't matter how we got here, politicians argue. We need to save the system so that there will still be a tomorrow.

Every time that we buy into this line of thought, we lever up the system  some more. People see the bailouts, so they take more risk.

We have trapped ourselves in our own moral hazard.