The WSJ discusses the Fed's bailout of Bear Stearns. It reports that the Fed wanted to keep the purchase price down as a way of preventing a problem of moral hazard, in which the Fed would be rewarding the company's stockholders and managers for taking big risks and losing. The Fed was only partially successful in this effort, since Bear Stearns managed to push up the original price by a factor of five. This money was paid to Bear stockholders in exchange for a $30 billion guarantee from the Fed, not for the value of Bear's assets. But the direct payment is actually the less important aspect of moral hazard in this story. The far more important aspect, which was totally missing from the WSJ article, is the guarantee to Bear Stearn's customers. The Fed assured all of Bear Stearn's creditors that it would insure Bear's obligations, even though Bear lacked the capital to meet its commitments. It also explicitly made the same guarantee to the customers of the other major investment banks. This commitment creates an enormous moral hazard problem. Ordinarily, creditors would be very cautious dealing with investment banks of questionable solvency. However, if the loans come backed up by a Fed guarantee, then there is no reason to be concerned about the solvency of the bank. In such circumstances, investment banks have an incentive to take large risks. Effectively, the Fed has created a "heads I win, tails you lose" situation for the banks and their customers. If they take a big risk and win, they gain make large gains. If they lose, then the Fed covers the losses for the customers, although not for the bank. Nonetheless the opportunity for the creditors to make large one-sided bets is very valuable, so creditors will be willing to share part of this windfall with the banks in the form of large fees. (If this sounds far-fetched, it shouldn't. It happens all the time. A big bank goes to a state or local government or pension fund or anyone else with a pool of money and promises them a better return with their new swap/derivative whatever. They then tell them their investment is guaranteed by big bank. While a guarantee from Bears Stearn in February should have been seen as completely worthless, when Ben Bernanke stands behind it, such a guarantee is gold.) This is the situation that led to the huge losses for Savings and Loan institutions in the 80s. If the Fed cannot find a way to impose much more stringent oversight of the investment banks than had been in place, the moral hazard problem it has created virtually guarantees large losses for taxpayers in the future.
--Dean Baker
