Moral hazard? It's the American way

One of the options for the United States as it addresses the toxic asset issue concerns potentially creating new banks.

New banks would be a major step toward healing injured credit markets that have constricted commerce, both in the U.S. and internationally, for more than six months.

Further, the new banks option may draw support from economic conservatives and market absolutists on ideological grounds, as it's closer than other options forwarded to-date to the pure capitalism model these groups favor. The old banks messed up? Then they deserve to fail, and should fail. Operate a business soundly and you reap the profits; operate a business recklessly and you're bankrupt. If the federal government intervenes to save failing banks or companies, it's then condoning bad business practices and encouraging reckless behavior -- moral hazard -- and that's something the nation cannot do, the economic conservatives say, if it wants a sound economy. The economic world is economic Dawinism -- survival of the fittest -- so let the banks that got in trouble fail, to ensure that only the fit survive.

Stakeholders to stake a claim

One problem with the above argument (and there are many weaknesses in it), is that there is nothing in the American experience that suggests the nation is politically prepared to let the existing bank stakeholders (and counterparties) pay a major price for their operational mistakes and recklessness. The political system and culture has no precedent for it, and, barring a surge in public support, it's hard to envision the U.S. Treasury -- and the U.S. Federal Reserve -- suddenly pulling the plug on existing major banks.

Letting Citibank (C) or the Bank of America (BAC) or other banks fail would mean that existing shareholders, bondholders, and other investors would be wiped out. Further, thousands of counterparty relationships with these two giant banks, among others, would also be altered, most likely to the detriment of the counterparties.

Also, more than likely, another financial shockwave would roil the markets, as the federal government's (mistaken) decision to let Lehman Brothers fail did in the fall of 2008. It's impossible to accurately predict the negative consequences stemming from the end of Citibank's or the Bank of America's operations.

Equally significant, what kind of signal would that send to foreign investors about the quality of U.S. assets? The U.S. bond market? Commercial endeavors in the United States? How would foreign investors respond? Would they feel as confident -- or remain calm -- about their bond and stock investments in the United States? Or would they start pulling assets out at a record rate, concerned that future government action/inaction will allow other banks and institutions to fail? And if they did, what would the U.S. and global financial systems look like at that juncture?

In addition, as noted, not involving current stakeholders would represent a radical policy departure for the United States. Absent national security issues, the United States has always protected the interests of current financial stakeholders -- even when those stakeholders' errors were a big part of the start of the problem in the first place. The primacy of capital -- including those at the heart of the capitalist system -- is intrinsic to the United States. It's hard to envision the United States departing from generations of precedent now.

If after reading the above you've deduced that those who helped create the financial crisis will be a part of the solution, and in that sense will be 'rewarded' to a certain degree for their failure, you're correct. To be sure, there will be new institutions, new processes (especially term auction facilities), and new regulations put in place, and there's also a chance that major banks could be nationalized, temporarily. But look for the United States to include almost all major stakeholders in the toxic asset solution and in the new financial system.

To do anything else, would be to say the United States is going to implement a radical policy -- one that ignores the interests of current stakeholders in an area of contested space; it would be a European-like move.

And in case you haven't noticed, the United States does not undertake those kinds of moves too often.

Financial Editor Joseph Lazzaro is based in New York.

Learn about investing from the comfort of your own home.

Portfolio Basics

Take the first steps to building your portfolio.

View Course »

Investment Strategies

Learn the strategies you need to build a winning portfolio

View Course »

Add a Comment

*0 / 3000 Character Maximum