The problem with the bailouts..."Moral Hazard"

What is moral hazard? Moral hazard is the presumption that an individual or more specifically in this case businesses, will behave differently in a given financial situation if they are not fully exposed to the risks that are involved in their transactions. While everyone is panicking trying to avoid the supposed next "Great Depression", lawmakers foolishly dismissed the influences of this policy of bailing out businesses.

Let's reset the time clock and go back to last year. We have all heard the stories about Bear Stearns, Lehman Brothers, Freddy Mac and Fannie Mae. We will start off with Bear Stearns. Bear Stearns was a massive global investment bank and basically when it began to fail, the government panicked and pretty much did a shotgun marriage with JP Morgan Bank. Well here is the beginning of the moral hazard dilemma. As the economy started to reel into a recession, businesses started to depend on the government to bail them out. The Fed's policy of rescuing enormous businesses because they were too big to fail had caused this moral hazard of businesses upon businesses going to the government to help them out in their time of need.

Many people often ask why these massive banks and investment companies took so much risk, knowing full well that eventually the economy would have to correct for the massive growth. The answer is simple, it was due to the policy that the Fed has had for the past 30 years of bailing out companies that were deemed "too big to fail." Well if this were only the end of the story but as we see in government time after time, this is often not the case.

Following the Bear Stearns debacle Lehman Brothers, an even larger global investment bank that was even more intertwined to other companies, went to the government fully expecting a bailout. Secretary Paulson, knowing full well about moral hazard had said enough is enough. He refused to bail out Lehman Brothers and the stock market went haywire because of the expectation of a bailout for them. Had Secretary Paulson stuck to his guns with this policy of not bailing out businesses, we could very well be on our way to a faster and more efficient recovery even though we would have had to take some lumps on the way. Sadly, we will never know what could have been because when Freddie Mac and Fannie Mae had fallen to the verge of collapse, Secretary Paulson had gone back to the bailout mentality. Instead of sending a clear message of "WE WILL NOT BAIL YOU OUT" they essentially said, if you are a large enough company, we will do anything to save your company regardless of your incompetence with previous financial transactions. That set up a plethora of industries from the auto to the porn industries asking for a government bailout.

Now to our current situation. Most economist agree that within the next two years the economy will start to recover. There are some signs that the economy is recovering and the current administration will have you believe that the costs were worth it. Getting back to the subject of this blog, the problem is that the Fed's and Treasury Department's policies in the short term as to failing companies are unclear. There is nothing worse to an investor than ambiguity. One minute they are bailing out the auto industry, just to later let them fail (hmmm...probably should have just done this in the first place). Investors want stability and to know that the rules will not change on them after they invest into a company (look at the Chrysler's bankruptcy between the unions and bondholders). On top of this the long term policy of bailing out companies that are too large to fail is still in effect within the Fed. Look at the Saving and Loans Crisis that was dealt by essentially bailing many of the banks out, creating a moral hazard and acting as encouragement to lenders to make similar high risk loans which led us to our current subprime mortgage crisis. It may not be 3, 5 or 7 years from now but if not corrected, this policy of bailing out the financial industry and businesses of any kind for that matter, will yet again lead us to another recession/possible great depression in the future.