MORAL HAZARD & CONFLICTS OF INTEREST

The Underlying Causes of the Credit Crunch

FUTURECASTS online magazine
www.futurecasts.com
Vol. 11, No. 7, 7/1/09

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 Moral hazard and conflicts of interest:

  The mortgage madness that preceded the Credit Crunch financial crisis is a story of moral hazard and conflicts of interest.  See, Tavakoli, "Dear Mr. Buffett."
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The interests of agents are never perfectly aligned with those of their principals, creating a persistent challenge to ethical standards.

 

Government has added the moral hazard ingredient that made it possible for the mortgage madness bubbles to grow big enough to threaten the financial stability of the entire world.

 

Regulatory oversight is an inherently weak reed, and business cycle contractions generally arrive on the scene only after much damage has been done.

  This is nothing new. Adam Smith warned us, over two centuries ago, that the interests of agents are never perfectly aligned with those of their principals, creating a persistent challenge to ethical standards. For this reason, he was highly skeptical of the corporate form of economic organization and thought that it would be the partnership form that would predominate. See, Adam Smith, "The Wealth of Nations," Part II, "Economic Policy," at segments on "Mercantile trading companies" and "Regulatory companies." Smith would thus not be surprised at periodic corporate scandals. Instead, he would be amazed at how well the vast bulk of business corporations are actually run.
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   Conflicts of interest have indeed been ubiquitous and widely acknowledged since the days of Adam Smith, but government has added the moral hazard ingredient that made it possible for the mortgage madness bubbles to grow big enough to threaten the financial stability of the entire world.  Government stabilization efforts and industrial policy have introduced moral hazard and undermined the disciplinary functions of the markets. This is why FUTURECASTS repeatedly emphasizes that the right to fail is as important as the right to succeed for the proper functioning of capitalist market systems. Without market disciplines - admittedly imperfect as they may be - only regulatory oversight and business cycle contractions impose essential discipline. Regulatory oversight is an inherently weak reed, and business cycle contractions generally arrive on the scene only after much damage has been done.
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   Moral hazard is routinely mentioned during any discussion of government stabilization efforts, and then just as routinely dismissed as a serious objection. Stabilization is always considered too important  an objective to be limited by inchoate fears of moral hazard. Unfortunately, economic stabilization is a will-o-the-wisp, persistently promised and sought after but impossible to provide. The business cycle is not only an inevitable part of a prosperous capitalist system, it is absolutely essential. Moreover, the more that ordinary market disciplines are weakened by government stabilization efforts, the less stable the economy and the more vital the business cycle become.
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There are always unintended consequences to government administered alternatives to market mechanisms.

 

Fear is in fact essential to balance greed so that the investment markets can produce prudent investing decisions. Caution must balance ambition.  

  A host of overextended and fraudulent houses of cards were brought down by the Credit Crunch as is usual during business cycle contractions. The regulators missed them all, even when knowledgeable financial experts were shouting the alarm. How much would the damage have been diminished if the business cycle contraction had come two years earlier? How much would the damage have been increased if the business cycle contraction had come two years later? The sums involved were increasing exponentially, and the regulators were determinedly deaf, dumb and blind to the problems. As late as the spring of 2007, despite numerous warnings in the financial press, regulators like the N.Y. Fed and Britain's Financial Services Authority were still spreading sunny confidence. Thank god for the business cycle!
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  Fear is in fact essential to balance greed so that the investment markets can produce prudent investing decisions. Caution must balance ambition, pessimism must balance optimism. Government guarantees - both explicit and implicit - and regulatory agencies are designed to support investor confidence to facilitate and reduce the cost of raising capital. Unfortunately, there are always unintended consequences to government administered alternatives to market mechanisms. Conflicts of interest and moral hazard are among the factors that undermine all of the government's stabilization alternatives.
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Accounting is one of the most nebulous of practical arts and there are always some who succumb to temptation and engage in the arts of creative accounting.

  Federal securities regulation is based on disclosure. It is a truly elegant and valuable regulatory approach. However, it all depends on the reports issued by management and generated by accountants. The vast majority of these professionals do their difficult jobs with diligence and amazing skill, but the conflicts of interest raise powerful temptations at every level. Accounting is one of the most nebulous of practical arts and there are always some who succumb to temptation and engage in the arts of creative accounting.
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  To deal with this, the government requires the auditing of books and records. This difficult task, too, is generally performed with diligence and amazing skill by independent auditors. However, they too face powerful  conflicts of interest. If auditors are too strict, they may lose lucrative auditing and consulting accounts. When one of the Big Five auditing firms succumbed too blatantly to such temptations, the government prosecuted - and now there are only a Big Four that are too important to the regulatory scheme to bring down. Prosecution of the major auditors is not being contemplated despite the obvious auditing failures prior to the Credit Crunch.
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  As an additional safeguard, the government makes use of the ratings agencies to limit the investment choices of many regulated financial entities, especially those that benefit from explicit and implicit government guarantees. It is also common for many private contractual arrangements to limit investment choices in this way. Unfortunately, the ratings agencies, too, can - and have - succumbed to conflicts of interest. If they are too strict in awarding investment grade ratings, fewer securities will be submitted to them for rating and they will earn fewer fees. Despite the carnage among investment grade mortgage backed securities, there is no hint as yet of prosecution of the ratings agencies. There are only three major ratings agencies, after all, and government regulatory schemes would fall apart without them.
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Neither the regulators nor their political masters have "skin in the game," so political and bureaucratic imperatives routinely become paramount. 

 

Alan Greenspan demonstrated no such courage as he insouciantly watched all manner of asset bubbles exuberantly inflating during his last few years as Fed Chairman.

   The government, too, is afflicted by moral hazard and conflicts of interest. Neither the regulators nor their political masters have "skin in the game," so political and bureaucratic imperatives routinely become paramount.
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  The Federal Reserve provides a prime example. Twice in the 1920s and once in the 1930s it was viciously attacked as the cause of severe economic contractions simply for doing its job when it tried to restrain speculative bubbles before they could grow to even greater and more damaging size. See, Friedman & Schwartz, "Monetary History of the U.S. (1867-1960), Part I, "Greenbacks and Gold (1867-1921),  at F) "Boom and Bust Under the Federal Reserve System," Part II, "The Engine of Deflation (1923-1933), at D) "Stock Market Boom," and Part III, "The Engine of Inflation (1933-1960), at D) "New Deal Failures and Successes," and Meltzer, "History of the Federal Reserve, vol. 1 (1913-1951)," Part I, "The Search for Monetary Stability (1913-1923)" at C) "Establishment of the System," Part II, "The Engine of Deflation (1923-1933)," at G) "The Great Depression," and Part III, "The Engine of Inflation (1933-1951)," at J) "New Deal Monetary Policy." Only Paul Volcker in the early 1980s has since had the courage as Fed Chairman to pull the plug on a serious level of price or asset inflation, and he had political cover from Pres. Ronald Reagan during the resulting depression. Alan Greenspan demonstrated no such courage as he insouciantly watched all manner of asset bubbles exuberantly inflating during his last few years as Fed Chairman. Bush (II) was no Ronald Reagan.
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Amazingly, Congress is again pressuring banks to reduce lending standards for subprime mortgage borrowers.

 

The regulatory failures are being used by the regulators as reasons to expand their authority and the scope of the regulations.

  Congress, of course, is even worse. Congress has decided that credit allocation schemes are a cheap way of rewarding their constituents and winning votes. It became government policy, enthusiastically joined by the Bush (II) administration, to expand home ownership by reducing mortgage lending standards and allocating credit into the mortgage market. It did not take long for even the most wild excesses to be justified as just an effort to increase home ownership and fulfill this virtuous national policy.
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  Why not? Credit allocation doesn't cost anything, does it? It nowhere appears in the budget or requires increases in government taxes or debt, does it? What securities or banking regulator would dare pull the plug on such virtuous and important and popular Congressional and Presidential home ownership initiatives?
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  When Congress does us favors on this scale, it cannot possibly end well. With the Credit Crunch, the costs of these costless policies are mounting into the trillions of dollars. So far, no heads have rolled in Congress, and the mess is no longer the problem of the Bush (II) administration.
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  The government has apparently learned nothing. Instead, it has vastly increased its ham handed efforts to allocate credit. It is busy extending credit guarantees in every direction. Its addiction to vast budget deficits makes it impossible for the Fed to manage the money supply in a responsible manner. Amazingly, Congress is again pressuring banks to reduce lending standards for subprime mortgage borrowers. There is already a froth of new bubbly activities based on cheap credit.
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  The regulatory failures are being used by the regulators as reasons to expand their authority and the scope of the regulations. The more they fail, the better they do. Regulatory remits are already so complicated that the regulators keep tripping over their conflicting responsibilities. Generally, the regulatory agencies have to facilitate the activities of the industries on which they must impose regulatory constraints.
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  The SEC, in its infinite wisdom, has been requiring that banks limit loan loss reserves. It fears that large reserves can be manipulated to affect reported earnings. The result was a banking system that was very fragile when the going got tough. Now, in the midst of the Credit Crunch, banks are frantically raising loan loss reserves. Some are going under, and others are being kept afloat at taxpayer expense. The SEC was the primary regulator of the investment banks that were at the heart of the mortgage madness. The SEC is thus currently out of favor, but will probably nevertheless get a substantial boost in its authority and budget as a reward for being asleep at the switch.
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They were leveraged 50-to-1, but they, too, were too big to fail, so their creditors insouciantly kept sending them more money, enabling them to keep digging themselves ever deeper into the financial hole. 

   The "too big to fail" concept is the most obvious moral hazard villain. Why shouldn't creditors keep lending to overextended financial and industrial entities if those entities are so big that the government will not permit them to fail? The creditors can always rely on bailout funds from the government. After all, it's only taxpayer money, and in Washington, the taxpayer is a joke. Thank goodness, Chrysler and General Motors were ultimately allowed to go through bankruptcy. The world has not come to an end, and creditors will be more cautious and impose more discipline on industrial borrowers in the future.
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  The investment banks were at the heart of the mortgage backed securities madness. They were leveraged as much as 40-to-1. Who would do business with such entities if they were not too big to fail and their credit thus implicitly guaranteed by the U.S. Government?
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  Fannie May and Freddie Mac - the giant government sponsored mortgage finance corporations - were vital players in the efforts to lower lending standards and allocate credit into the mortgage markets. In the beginning, it all seemed so easy. Why not? However, eventually, they, too, loaded up with toxic mortgage assets. They were leveraged 50-to-1, but they, too, were too big to fail, so their creditors insouciantly kept sending them more money, enabling them to keep digging themselves ever deeper into the financial hole.
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  Now in government hands, they continue to push tens of billions of dollars of taxpayer money at ridiculously low interest rates into the mortgage market. When interest rates return to market levels, as eventually they must, these low rate mortgages will decline in price and the taxpayer will lose more tens of billions of dollars. However, it is predictable that these mortgages will never be marked to market, the losses will thus be covered up, and the interest payments will be touted as a gain despite representing an inadequate return for the risks assumed.
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  Fannie and Freddie, too, were originally justified as a way to increase home ownership without cost for the Federal budget and its taxpayers. Now, this costless program is costing the Federal government tens of billions of dollars every few months. Such government administered alternatives to market mechanisms - government "industrial policies" - are almost guaranteed not to end well.
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The effectiveness of Keynesian policy is always temporary and dependent on the strength of the currency - and Keynesian remedies always weaken the currency.

  Government bailout madness is the response to mortgage madness. Keynesians rejoice. Like ghouls in the economic night, as FUTURECASTS predicted, they have risen from the dead to dominate government economic policy during this financial crisis. However, the effectiveness of Keynesian policy is always temporary and dependent on the strength of the currency - and Keynesian remedies always weaken the currency. It should surprise nobody that instead of ending or even moderating the business cycle, in periods when Keynesians dominate economic policy the business cycle always becomes increasingly vicious.
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  Nine months ago, the Fed threw more than a trillion dollars at the Credit Crunch, more than doubling the basic money supply, and Congress appropriated about a trillion more for Keynesian stimulation. The Keynesians claim reasonably that matters would have been much worse without these actions, but it would truly be remarkable if two trillion dollars didn't achieve something. Meanwhile, unemployment nevertheless surges towards double digit levels, and economic contraction continues.
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  The Credit Crunch is basically a housing inventory recession, and it will continue until the markets do their job and reduce housing inventories to reasonable levels. Keynesian policies failed to shorten the Great Depression, were the underlying cause of the Great Inflation of the 1970s, and are now failing to shorten the Credit Crunch. Economic recovery will be considerably more unstable because of the massive debts Keynesian policies have imposed.
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  As FUTURECASTS repeatedly warns, you have to watch the dollar.
If the dollar is allowed to weaken substantially, the bailout program will fall apart and the prosperity of the American people will receive a serious blow.

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Copyright 2009 Dan Blatt