The Society of the Owned: Moral Hazards

Part Seven of a Series

Imagine that you've come upon two people who have somehow fallen into a very deep hole, which neither of them can climb out of on their own. (Nor, for some reason, can they help one another climb out.) In the course of figuring out what to do, you learn how they each came to be in that hole.

One of them fell in because he either didn't see the hole or should have seen it but wasn't paying attention. OK, so he could have avoided falling into the hole if he'd been more careful. The other person, you find out, apparently dug the hole for the one who fell in first, and then fell in himself.

Which one do you help out of the hole? The careless one who fell in first? Or the one who dug the hole in the first place? Which one do you leave in the hole? Which one do you help out first?

Conservatism says you definitely help the guy who dug the hole in the first place climb out of it. Not only that but you give him a brand new shovel and send him on his way. Maybe you leave the other guy in the hole, and maybe you don't. In the latter case, there are serious moral questions to consider.

At least that's what the experts say. [1]

The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.

A rescue would also create a “moral hazard,” many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.

And, as noted in an earlier installment [2], some citizens are saying pretty much the same thing [3].

Some of these municipal and state efforts have met resistance from people who consider the assistance undeserved and adamantly oppose anything that resembles a taxpayer bailout.

Seattle, which has nowhere near the kind of foreclosure problem other cities have, began a modest program last month offering loans of up to $5,000 to help a few dozen homeowners avoid losing their homes.

Not only are people in Seattle relatively prosperous, but they have a reputation for being nice, too. Yet no sooner had Mayor Greg Nickels announced the program than opposition surfaced.

“Just can’t agree with using taxpayer dollars to bail out private homeowners, no matter how the mayor tries to justify it,” read a complaint posted on the “Soundoff” section of The Seattle Post-Intelligencer’s Web site.

But moral hazards become something else when applied Wall Street firms that have gotten into trouble due to unwise or unsound financial dealings, like Bear Stearns [4].

The global credit crunch claimed its biggest victim yet yesterday when the US Federal Reserve orchestrated an emergency bail-out for Bear Stearns after a cash crisis prompted a run on America's fifth biggest investment bank.

In a move that eclipsed the enforced rescue of Northern Rock six months ago, the 85-year-old Wall Street institution admitted it was looking for a buyer after being thrown a temporary lifeline by rival bank JP Morgan Chase guaranteed by the US central bank.

By now, the details are known. Bear Stearns ened up being worth not much more than my five-year-old has in his piggy bank. So, in a move designed to keep the network of "credit swaps" that link various banks and investment firms intact, and keep the hedge funds trading that rely on Stearns, the Fed — after repeatedly lowering rates, making $200 billion available to lenders [5] — the Federal Reserve guaranteed a 28-day line of credit [6] to Bear Stearns via JP Morgan, only to end up shortly afterwards providing $30 billion in emergency funding [7] — essentially buying, with that amount, Bear Stearns' mortgage-backed securities, which may not be worth the paper they're written on now — to JPMorgan's purchase of Bear Stearns.

This is happening at the same time that, an increasing number of American home owners face foreclosure, the same government that's bailing out Bear Stearns has — up until now — been more interested in preventing future crises than addressing the current one [8], or providing much real relief for home owners in crisis.

After months of watching a growing credit crisis made worse by steadily eroding home prices, the Bush administration responded on Thursday with the outlines of a plan that officials emphasized is meant more to prevent future crises than to address the current one.

The plan, which relies primarily on state regulators and private industry to tighten their oversight of financial markets, calls on states to issue nationwide licensing standards for mortgage brokers.

...But in many ways, the plan relies on the same market participants — from mortgage brokers to credit-rating agencies and Wall Street firms — that government officials and other experts blame for the current crisis.

It gets even more interesting when Treasury Secretary Henry Paulson chimes in with what he thinks led to the current crisis.

At the news conference, Mr. Paulson said growing market problems were caused by a series of factors, including mortgage brokers who pushed risky loans on homeowners, conflicts of interest at credit-rating agencies, bond underwriters that loosened standards, and financial institutions that failed to adequately grasp the riskiness of the instruments they were buying and selling.

A report issued by an interagency group headed by Mr. Paulson also said that regulatory policies undertaken by the Bush administration had failed to adequately supervise the way financial institutions manage risk.

Well then, what is wrong with remedying the current crisis? What is wrong with keeping people in their homes? It can't be because they made poor financial decisions that make bailing them out a "moral hazard, because there was no "moral hazard for bailing out Bear Stearns for failing to "adequately grasp the riskiness," of the bundled bad debts they made bundles buying and selling for a while.. We have apparently become a society that cannot afford to let banks fail, but can afford to let people fail.

Though it still seems to apply to Main Street, there's no moral hazard [9] in bailing out Wall Street.

Consider the phrase that has been popping up all over the Bear Stearns debacle: “moral hazard.” No, Moral Hazard is not the name of a country and western singer. It’s the phrase economists use to explain why people shouldn’t be protected from the consequences of their actions. In The Wall Street Journal’s definition, moral hazards are “the distortions introduced by the prospect of not having to pay for your sins.”

...The same language of morality has been used by economic fundamentalists who don’t want to help homeowners who got subprime mortgage loans and found find themselves in deep foreclosure weeds. Mike Huckabee once said that it “is not the purpose of government to prop people up from every poor decision they make. ... It creates an enabling co-dependency.” And as recently as last weekend, Treasury Secretary Henry Paulson insisted that government actions to prevent foreclosures would “do more harm than they would do good.”

The problem is that, given all of the above, no one seemed the obvious question [10].

But why save Bear Stearns? The beneficiary of this bailout, remember, has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach. Until regulators came along in 1996, Bear Stearns was happy to provide its balance sheet and imprimatur to bucket-shop brokerages like Stratton Oakmont and A.R. Baron, clearing dubious stock trades.

And as one of the biggest players in the mortgage securities business on Wall Street, Bear provided munificent lines of credit to public-spirited subprime lenders like New Century (now bankrupt). It is also the owner of EMC Mortgage Servicing, one of the most aggressive subprime mortgage servicers out there.

And what brought Bear Stearns to the point where this big Wall Street firm could basically be bought for $2? That old often mentioned bugbear of the current crisis: bad judgement.

Bear's default rates on so-called Alt-A mortgages that it underwrote also indicates that its lending practices were especially lax during the real estate boom. As of February, according to Bloomberg data, 15 percent of these loans in its underwritten securities were delinquent by more than 60 days or in foreclosure.

That compares with an industry average of 8.4 percent.

Let's not forget that Bear Stearns lost billions for its clients last summer, when two hedge funds investing heavily in mortgage securities collapsed. And the firm tried to dump toxic mortgage securities it held in its own vaults onto the public last summer in an initial public offering of a financial company called Everquest Financial. Thankfully, that deal never got done.

But another deal did get done, one that bails out Bear Stearns [11] from its bad — and in some cases dishonest — decisions.

Bear Stearns, one of the longstanding giants of Wall Street investment banking, is now on life support, the victim of its own excessive greed and bad judgment. Apparently, the wizards who run the show at Bear Stearns (I will resist the temptation to use initials) somehow couldn't see an $8 trillion housing bubble in the US economy. They made highly leveraged bets on assets backed by mortgages.

These bets have turned bad in a big way. Bear Stearns would now have less value than a corner lemonade stand, if not for the generosity of the Federal Reserve Board. The Fed lent money to Bear Stearns under terms no private lender would have agreed to. The risk it will end up with a substantial loss on its loans to Bear Stearns is quite large, with no prospect for any real return on its investment.

Bear Stearns will be bought by JPMorgan, and its mortgage securities will be successfully unloaded. But JPMorgan won't own them. We will. Corporate entities can apparently make bad judgments without suffering the consequence of failure. As with inflation and oil prices, etc., they pass also the cost of their mistakes on to the rest of us.

The Fed, on behalf of Bear Stearns, has turned the government into the ultimate subprime lender, in a sense. And we are all its investors. We will not likely see return on that investment. But, then, it wasn't an investment we chose. It was chosen for us. For the good of Bear Stearns.

Of course, that's not what the administration or the Fed would say. Bailing out Bear Stearns, whatever its financial sins, is necessary (a necessary evil?), because to let them fail could lead to disaster.

After years of never allowing any of our financial institutions to fail, they have become so enormous that nobody will be allowed to sink beneath the waves. Otherwise, a tsunami would swamp the hedge funds, banks and other brokerage firms that remain afloat.

If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures.

As of Nov. 30, Bear Stearns had on its books about $46 billion of mortgages, mortgage-backed and asset-backed securities. Jettisoning such a portfolio onto a mortgage market that is not operative would, it is plain to see, be a disaster.

So, as distasteful as it might be to bail out Wall Street, it's really for the good of us all [12].

Bear Stearns’s collapse, similarly, could easily have provoked market chaos. Bear wasn’t among the largest Wall Street banks, but it was a major clearinghouse for stock trades and played a central role in hundreds of billions of dollars of credit deals. If not too big, it was too important to fail.

...But what [the bailout of Bear Stearns] really underscores is how badly Wall Street has managed its business in recent years. Because investment banks’ trades and investments are typically very highly leveraged—Bear Stearns, for instance, had borrowed thirty dollars for every dollar of its own—the banks need to be exceptionally good at managing risk, and they need to insure that people trust them enough to lend them huge sums of money against very little collateral.

Sound familiar yet? What would happen to the average person who borrowed thirty dollars for every one dollar of his or her own to, say, purchase a home? It gets better.

You’d expect, then, that Wall Street firms would be especially rigorous about balancing risk against reward, and about earning and keeping the trust of customers, clients, and lenders. Instead, most of these firms have taken on spectacular amounts of risk without acknowledging the scale of their bets to the outside world, or even, it now seems, to themselves.

You may be excused for suspecting that a certain degree of self-deception was going on. You'd be right, about the deception part, but — like Alan Greenspan himself — some firms were informed of the reality of their mortgage-securities bets by the people they hired to audit them. And some not only ignored warnings [13], but hid the truth from their investors.

They could see the meltdown coming.

Freelance financial watchdogs who examined the paperwork on sub-prime home loans being sold to Wall Street had an inside view of the boom in easy-money lending this decade. The reviewers say they raised plenty of red flags about flaws so serious that mortgages should have been rejected outright -- such as borrowers' incomes that seemed inflated or documents that looked fake -- but the problems were glossed over, ignored or stricken from reports.

The loan reviewers' role was just one of several safeguards -- including home appraisals, lending standards and ratings on mortgage-backed bonds -- that were built into the country's complex mortgage-financing system. But in the chain of brokers, lenders and investment banks that transformed mortgages into securities sold worldwide, no one seemed to care about loans that looked bad from the start. Yet profit abounded -- until defaults spawned hundreds of billions of dollars in losses on mortgage-backed securities.

This is similar to the way that some homeowners say that brokers and lending agents tricked them by changing terms at the last minute, or hiding the details about rates, or other costs in addition to their mortgages.

It's similar to something else too. Much in the same way that the Bush administration edits out or ignores anything that doesn't jibe with its beliefs, so did the great minds of Wall Street.  But that's just what fundamentalists do.

True believers, though, don't quietly dump $20 million in stock [14] months before disaster becomes obvious.

Bear Stearns executives sold stock in the firm worth more than $20 million in December, although they remain big shareholders in the beleaguered broker, according to Thomson Financial data.

James Cayne, chairman of Bear, sold 172,621 shares in December worth $15.4 million, while President Alan Schwartz sold 67,900 shares worth just over $6 million, Thomson data show.

Alan Greenberg, chairman of Bear's executive committee, sold 99,293 shares worth $8.8 million in December, while Chief Executive Officer Samuel Molinaro sold 27,726 shares worth almost $2.5 million, according to Thomson.

(Schwartz, by the way, was on television as late as March 12 [15] telling the world every thing was fine, just four days before breaking the bad news to Bear Stearns employees.)

Granted, $20 million is probably like 20 cents to Bear's executives, but executives in an investment firm selling off stock in great quantities is bound to raise eyebrows. (Bear's executives remained major shareholders despite selling stock.) So, these guys most likely sold as much as they thought they could without raising alarm among other shareholders, like Bear Stearns' employees who were encouraged to own stock in the firm [16].

More so than other firms on Wall Street, Bear had encouraged its employees, from secretaries to top executives, to be long-term holders in the company's stock, and the employees own over 30 percent of the company.

...Across the firm, executives and employees declined to speak publicly, a reflection of the fluid events as well as a reluctance to anger their prospective bosses from JPMorgan who were already on the premises Monday, appraising their new investment.

But privately they expressed raw dismay, their voices heavy with sadness and shock.

"My life has been flushed down the drain," said one person. There was talk Monday that with their life savings nearly depleted, some executives had moved quickly, putting their weekend homes on the market.

Sounding familiar yet? Of course, those major stockholders (called "a collection of wealthy investment bankers and billionaire investors" [17] by one columnist) will also benefit from JPMorgan's decision to raise the purchase price [18] from $2 a share to $10 a share.

Here is where the dividing line between the ownership society and the rest of us, and even between Bear Stearns employees, becomes visible. Executives may be putting their weekend home on the market, but several hundred of them are getting offers of cash and stock [19] from JPMorgan to make up their for their losses. They'll probably keep their jobs too, or land in jobs that pay as well or even better. So, the golden parachutes have come out. (And, for the former chief Jimmy Cayne, an armed body guard is on duty.) Several hundred senior managing directors will be "made whole" with new jobs and stock offers, but about 8,000 employees will pack their desks [20]. And there are no jobs on Wall Street [21].

More than 8,000 staff will face the axe at Bear Stearns worldwide once the stricken US investment bank is acquired by JP Morgan next month, as fears mount that the credit crunch could keep downward pressure on share prices throughout 2008.

Wall Street analysts believe well over half of Bear Stearns's employees will be made redundant, with around 600 jobs at risk in London, where the company employs 1,350 people. JP Morgan declined to comment.

There's tremendous value and wealth being lost in our neighborhoods and on our Main Streets too, but no one is rushing to ameliorate "shareholders" in those ventures. Even though the wealth lost on Main Street will not be as easily rebuilt, because people in that neighborhood have far fewer assets than those on Wall Street in the first place.

Despite quickly as Wall Street got its bailout last week, Main Street's bailout will be a long time coming [22], if it comes at all.

Now that the Federal Reserve has pledged billions of dollars to rescue Wall Street bankers from possible default, lawmakers and regulators are turning their attention to helping average citizens -- from homeowners in danger of foreclosure to people who want to buy a home.

But unlike the Fed's rapid moves last week to stabilize financial markets, the consumer benefits are likely to progress slowly as they face resistance from the Bush administration on some broad issues and from special interests on some narrow ones.

...The House, meanwhile, plans to move within weeks to approve a multibillion-dollar program to prevent hundreds of thousands of home foreclosures. The outlook for the plan, the most ambitious of several proposals, is uncertain; President Bush continues to resist large-scale legislation to bail out homeowners in distress.

It is the one of the (many) sad ironies of conservatism that any suggestion the the government might do anything to help most (clearly not all) citizens brings cries of "socialization," yet the transfer of public wealth (in the form of your tax dollars and mine) into private hands — thus socializing Wall Street" [23] — raises none of the "moral hazards" that supposedly block the way to helping homeowners facing foreclosure.

The Federal Reserve's announcement of an open-ended bail-out for Wall Street's endangered financial firms and banks opens an ominous new chapter in what might be called "market socialism with American characteristics." If Washington tries to do something for "losers" who are ordinary citizens, financial titans complain about violating free-market principles. When the titans themselves are going down, they rush to their patrons at the central bank and demand extraordinary relief. Government must save the big money, we are told, for the overall good of the economy. Thus, the financial system's reckless losses--approaching $1 trillion but probably far more--are being "socialized," dumped on the public, the very people victimized by its snares and falsified valuations.

"Socialized health care" scares the bejeezus out of conservatives. Socialized wealth-care — which apparently means shared risk for American tax-payers, but no shared responsibility on the other side — is getting more popular by the day. On top of everything else, the Fed has started a new discount lending program for Wall Street [24], to the tune of $28.8 billion for 20 undisclosed borrowers.

Investment banks and broker dealers borrowed $28.8 billion from the Federal Reserve on Wednesday under the new lending program set up on Sunday, the Fed announced Thursday.

The new lending program gives the 20 primary dealers of Treasury securities special access to the Fed's discount window. The overnight loans are overcollateralized and pay the prevailing discount rate, currently 2.50%.

Three investment banks -- Morgan Stanley, Goldman Sachs and Lehman Bros. -- have publicly announced they borrowed from the Fed. Others may also have done so, but the names of the borrowers are not announced by the Fed.

It's easy, at this point to lose track of the billions in tax-payer dollars have have been dedicated to propping up Wall Street and keeping its investors happy, in the past few weeks. Meanwhile, ordinary Americans, without the resources of a financial firm, must face the consequences of their financial decisions alone (even though often those decisions were made under duress and/or deception). But big financial firms and their investors? They must be shielded from their mistakes.

It all raises, or ought to raise, some questions asked by a columnist quoted earlier in this post.

"What are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year?"

And there are, our ought to be, questions about how effective the Fed's actions so far are likely to be [25].

Nobody knows if these remedies will blow off the hysteria and restore a modicum of order. Nor do we know who is being saved by our panicky federal officials. Are they saving some millions of jobs and homes, which may be in danger from the fallout stemming from this train of financial disasters? Or are they saving some of the most despicable rich guys to make an appearance in our society since the 1870s, when Jim Fisk, Commodore Vanderbilt and Jay Gould roamed the earth?

Well, what do your eyes tell you? Moral hazards do not get in the way of bailing out the Bear Stearns of the world, but then you have to understand why those entities (and the individuals who run them) are far more valued than the every day American family. I'll refer you to George Lakoff [26] for that, whose assertion that the worship of the wealthy is based on the tenet that material wealth is a sign of strength and virtue.

If you believe the market place is like a natural environment, then economic "might" makes right, in terms of "survival of the fittest." However, markets are not natural environments or organic entities. They are man made. They operate according to the rules people make. A natural organism that made the decisions Bear Stearns and any number of financial giants have made would probably not be long for this world, but we change or suspend the rules of the market place to prop them up. Of course, the consequence is that we change also change the rules to the detriment of another species.

Effectiveness depends on intention. David Sirota mentioned Naomi Campbell's book, The Shock Doctrine [27], in a previous post, and made a good point about how the current financial crisis has apparently become an opportunity to practice "disaster capitalism" [28] by transferring billions in public wealth into the privates hands of the very wealthy.

In upcoming installments, we'll look at what's happening at the other end of that transfer, and the various ways it's been facilitated. For now, suffice it to say, that what's really playing out in headlines about "moral hazards," is as much about the hazardous morality undergirding "disaster capitalism," and its consequences