Home > bailouts, limited laibility, moral hazard > Rot at the core: Fed Vice Chair Don Kohn`s Senate testimony reveals the Fed’s moral hazard maximizing strategy (h/t Willem Vuiter at the FT)

Rot at the core: Fed Vice Chair Don Kohn`s Senate testimony reveals the Fed’s moral hazard maximizing strategy (h/t Willem Vuiter at the FT)

The March 6 Financial Times has a great piece by Willem Vuiter, professor at the LSE and former chief economist of the EBRD, that completely rips the Fed`s bailout of AIG`s credit default swap counterparties, as emblembatic of the epidemic of moral hazard that has rotted out our financial system. 

Vuiter doesn`t focus on the dynamics that led to the problem (limited liaibility by shareholders, which has led to a vacuum in risk management, as no one had enough “skin in the game”), but correctly notes that the Fed`s actions incentivize further irresponsiblity – and that the Fed and Congress themselves don`t have enough skin in the game, as they are playing with taxpayer money, not their own.

The article is worth reading in whole; here are excerpts of the parts that resonated most with me (emphasis mine):


The reports on the evidence given by the Vice Chairman of the Federal Reserve Board, Don Kohn, to the Senate Banking Committee about the Fed’s role in the government’s rescue of AIG, have left me speechless and weak with rage.  AIG wrote CDS, that is, it sold credit default swaps that provided the buyer of the CDS (including some of the world’s largest banks) with insurance against default on bonds and other credit instruments they held.  Of course the insurance was only as good as the creditworthiness of the party writing the CDS.  When it was uncovered during the late summer of 2008, that AIG had nurtured a little rogue, unregulated investment banking unit in its bosom, and that the level of the credit risk it had insured was well beyond its means, the AIG counterparties, that is, the buyers of the CDS, were caught with their pants down.

Instead of saying, “how sad, too bad” to these counterparties, the Fed decided (in the words of the Wall Street Journal), to unwind “.. some AIG contracts that were weighing down the insurance giant by paying off the trading partners at the full value they expected to realize in the long term, even though short-term values had tumbled.”

An LSE colleague has shown me an earlier report in the Wall Street Journal (in December 2008), citing a confidential document and people familiar with the matter, which estimated that about $19 billion of the payouts went to two dozen counterparties between the government bailout of AIG in mid-September and early November 2008. According to this Wall Street Journal report, nearly three-quarters was reported to have gone to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA’s Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion).  With the US government (Fed, FDIC and Treasury) now at risk for about $160 bn in AIG, a mere $19 bn may seem like small beer.  But it is outrageous.  It is unfair, deeply distortionary and unnecessary for the maintenance of financial stability.

Don Kohn ackowledged that the aid contributed to “moral hazard” – incentives for future reckless lending by AIG’s counterparties – it “will reduce their incentive to be careful in the future.” But, here as in all instances were the weak-kneed guardians of the common wealth (or what’s left of it) cave in to the special pleadings of the captains of finance, this bail-out of the undeserving was painted as the unavoidable price of maintaining, defending or restoring financial stability. What would have happened if the Fed had decided to leave the AIG counterparties with their near-worthless CDS protection?

“I’m worried about the knock- on effects in the financial markets. Would other people be willing to do business with other U.S. financial institutions…if they thought, in a crisis like this, they might have to take some losses?”

Let’s step back a minute and ponder this.  US banks and shadow-banks (like AIG’s Financial Products Division) took on excessive leverage and excessive risk.   There was not only too much careless lending by US banks, there was too much careless lending to US banks.  When this crisis is over and when, in the fullness of time, the real economy has recovered, we want to see less lending by and to US banks than we saw in the years 2004 – 2006.  How do we get those who provided US banks and other financial institutions with too much funding at too low a cost to behave with greater prodence and caution in the future? Presumably by making sure that they pay the price for there (sp) reckless financial decisions.  The counterparties of AIG who had been unwise enough to buy insurance against default on debt instruments they held, by acquiring CDS written by AIG should have been told to eat it.



Unless the counterparties pay the full price for their hubris and recklessness, they will be back for more.  It is therefore tragic that central banks and governments everywhere are going out of their way to protect and shelter the unsecured creditors of the banks (holders of junior and senior debt among them), by raiding the tax payer or the credit and reputation of the central bank.  Significant mandatory debt-to-equity conversions and large write-downs of (haircuts on) the claims of other unsecured creditors should be an integral part of any financial assistance package. …

While the demise of Lehman and the destruction of most of its unsecured creditors was an unnecessary surprise, it was still the best option available to the authorities, given the absence of an SRR [Special Resolution Regime].  Markets and market participants are educated only by painful example.

The cardiac arrest followed the realisation, well after Lehman went kaput, that (1) most of the internationally recognisable US banks were insolvent or would be but for past, present and anticipated future government financial support; that (2) many other non-bank financial institutions (AIG) and shadow-financial institutions (GE) were either insolvent or at death’s doorstep; and that (3) the government was not on top of the issues and the Congress was deeply divided and irresponsible.

The logic of collective action teaches us that a small group of interested parties, each with much at stake, will run rings around large numbers of interested parties each one of which has much less at stake individually, even though their aggregate stake may well be larger.  The organised lobbying bulldozer of Wall Street sweeps the floor with the US tax payer anytime.  The modalities of the bailout by the Fed of the AIG counterparties is a textbook example of the logic of collective action at work.  It is scandalous: unfair, inefficient, expensive and unnecessary.



Well said!


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