Home > Government & Politics > Moral Hazard of Financial Reform

Moral Hazard of Financial Reform

At 5:39am this morning, conferees between the US House and Senate agreed to a compromise to the sweeping Financial Reform bill that will make the largest changes to the US banking system since the Great Depression.  It still needs to pass both the House and Senate and then be sent to President Obama for his signature, all which are expected to happen before July 4th.

The legislation is intended to address many problems and issues.  One of the primary purposes of the bill was to eliminate the “moral hazard” of the “too big to fail” justification for the unprecedented government intervention in the financial markets in the fall of 2008. 

Part of the impetus for the creation of the $700 billion TARP  was to prevent certain financial institutions from failing.  Government and industry leaders were concerned that the US financial system (and potentially the global system) would collapse if these large institutions went under.  Their influence had grown so large that they were too big to fail.

Democrats, Republicans, Independents, liberals and conservatives all had concerns with a perceived bailout of Wall Street bankers.  Liberals were reluctant to use taxpayer dollars to save billion-dollar firms with a reputation for paying out multi-million dollar bonuses to employees.  Conservatives were opposed to government intrusion into the free market system.  

Most people were concerned with the “moral hazards” of the bailout.  Rescuing the firms was viewed as rewarding bad behavior by shielding the companies from the consequences of their poor business decisions.  Furthermore, once you are protected from the results of risky or bad choices, what’s to stop you from engaging in similar behavior down the road?

There were multiple players and many factors that contributed to the financial meltdown in 2008.  Two of those players were Fannie Mae and Freddie Mac (Fannie and Freddie).  They may not be primarily at fault, but they share in the culpability.  These institutions effectively allowed banks and mortgage companies to issue subprime and other high-risk mortgages.

You can blame traders and investment bankers for gambling with things such as credit default swaps.   However you must also look to the underlying assets they were betting on… home mortgages packaged into mortgage backed securities guaranteed by Fannie and Freddie.  The rise in mortgage defaults caused the mortgage backed securities to implode in value, which resulted in the banks coughing up billions of dollars to cover their losses from derivatives trading. Are Fannie and Freddie solely at fault?  Absolutely not.  However, they did have a role, yet they are noticeably absent from the Financial Reform legislation.

The legislation is supposed to kill the notion that any institution is too big to fail and address the moral hazard issue.  Time will tell if it’s successful.  However, there is one moral hazard from this crisis that has yet to be addressed – Fannie Mae and Freddie Mac.

I believe that Fannie and Freddie also possess a moral hazard.  It’s doubtful that banks would have written many subprime loans if they had to hold those loans on their books.  It would have been too risky.  Fannie and Freddie’s willingness to buy these loans and guarantee payment gave the mortgage originators an incentive to write more of the loans.

In September 2008, the US Government put Fannie and Freddie under conservatorship.  Although still a publicly held company, the US taxpayers own 80% of each enterprise.  To date, we’ve put over $140 billion into them to keep them afloat.  Earlier this year, President Obama lifted the $400 billion cap to the government guarantee, which basically ensures that any security backed by Fannie and Freddie will be fully paid by the US government.  Therein lies the same moral hazard as with the Wall Street banks.  If the government  the losses at Fannie and Freddie, what’s to stop them from taking on the next wave of high-risk mortgages, with the intent of increasing home ownership or stimulating the residential real estate sector?

Congressional leaders have said they will address Fannie and Freddie at a later date.  Excuse my skepticism, but I don’t see it happening any time soon.  It took over a year to get this legislation passed.  I doubt that Congress wants to immediately jump back in the fray on this issue, plus they have many other priorities and issues to contend with, including an election in four months.

With all the publicity of TARP and Wall Street bailouts, Fannie and Freddie may be the granddaddy of all bailouts.  The government has already pumped $140 billion into these companies, and there doesn’t appear to be an end in sight.  These companies have loaned or guaranteed about half of the $12 trillion in US mortgages.  With an estimate of 15-20% of all homes in the US currently worth less than their mortgage and a steadily climbing foreclosure rate, it’s scary to think of how big this could get.  There was probably a reason that President Obama lifted the $400 billion cap.

A lot of this may seem political and irrelevant to you, but remember that’s your tax dollars at stake.  I also think the moral hazard principle applies to Wall Street bankers, government entities and individuals.  If you don’t have to pay the price for your actions, what’s to keep you from making stupid mistakes or engaging in risky behavior?  Positive encouragement can be a great incentive to changing behavior, but the pain of failure can be the greatest incentive to change.

This applies to all areas of life, including finances.  Unless you have someone funding your lifestyle, you may not have a moral hazard with your own money.  You are not too big to fail and will pay the price of any poor decisions you make.  However, the principle of the “moral hazard” applies anytime you make a financial decision without regard to the consequences because someone else is picking up the tab.  You may not be paying, but in the end, it will cost someone.

  1. October 3, 2011 at 11:19 AM

    The phasing out of Fannie Mae and Freddie Mac will bring back private capital and banks to the real estate market and the playing field will be level for private capital investment. Borrowers will also be required to put down a larger down payment.

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

<span>%d</span> bloggers like this: