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The Credit Crisis and Moral Hazards

The Credit Crisis and Moral Hazards

10 Mins
June 9, 2011

Fall 2008 issue -- The financial news this year has been filled with dire predictions of a crash and reports of frenzied government actions to avoid it.

The Federal Deposit Insurance Corporation (FDIC) has staffed-up in anticipation of hundreds of bank failures. Major investment banks are on the ropes and have had to be bailed out by the Federal Reserve. The real-estate market has tanked, and foreclosures are on the rise. The interest-bearing securities that underlie money-market funds are losing value. The two companies that stand behind over half of the mortgages in the United States—Fannie Mae and Freddie Mac—are insolvent and have had to be backed up by Congress, creating an unfunded obligation that, if recognized, could add trillions to the national debt. The judgment of the major bond rating agencies is suspect. The treasurers of major corporations invested their cash in paper that is deteriorating, and they have had to write down their companies’ “good-as-cash” assets. And it’s hard to know if you can believe the public company balance sheets anymore, especially the balance sheets of banks.

As of the middle of July 2008, banks and other financial companies have reported $468 billion in asset write-downs during the year, an amount greater than the scandalous U.S. budget deficit. Many more write-downs are to come: Professionals and pundits alike acknowledge that they are not half over. Former Federal Reserve Chairman Paul Volcker has called it “the mother of all crises.”

Millions now wonder: Is my money safe? Is my bank next?  My broker?

There is no question that the current credit crisis, which first attracted widespread public attention in the summer of 2007, is historic in its proportions and nature. Banks and depository institutions have never, ever, borrowed so much from the Federal Reserve.

Federal Reserve chairman Ben Bernanke maintains that the Fed’s new lending is a good response to a serious national and international bank liquidity crisis, a response which the Fed failed to make at the outset of the Great Depression and which, he says, would have helped avoid much financial pain.

The U.S. Federal Reserve System has encouraged excessive risk-taking by serving as the lender of last resort.

More government apparatchiks than those at the Fed are involved in forestalling a big crash. The U.S. Treasury, the Securities Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), the Exchange Stabilization Fund, the Federal Deposit Insurance Corporation (FDIC), Congress, and others have been hard at work plugging holes in the dike. As of this writing (August 1, 2008), the stock market, having not yet crashed to anywhere near the depths it did in the Great Depression, seems willing to accept the bureaucrats’ solutions. The changes are nevertheless historic, and they have grave implications for the future of economic freedom and financial stability in the United States, Europe, and elsewhere.

Here are some of the major market interventions undertaken by government agencies since last summer—attempts to stabilize the markets and avoid a meltdown of the entire financial system:

  • In March 2008, the Fed made an emergency ¾-point cut in the key lending rate it charges to its banks.
  • To calm market jitters about major-bank liquidity, the Fed offered to allow its banks to borrow up to $200 billion dollars in the aggregate, when secured by acceptably rated mortgage-backed securities. The preceding chart shows that the banks took advantage of the offer. That is a substantial portion of the Fed’s reserves. Current outstanding loans stand at about $150 billion. The Fed’s combined securities and loan portfolio is a little over $800 billion.
  • The Fed also launched a Primary Dealer Credit Facility to make collateralized loans to the Fed’s primary dealers in Treasury securities—investment banks, as distinguished from depository institutions, such as commercial banks. This is the first time since the Great Depression that the Fed made loans to investment banks. Peak borrowing was an average of $38.1 billion during the week ending April 2, 2008.
  • Because of market skepticism about the value of mortgage-backed securities held by investment banks and fear that there would be a run on those banks, the Fed also opened its vaults to primary dealers, allowing the investment banks to borrow up to $200 billion of the Fed’s Treasury securities in exchange for the dealers’ mortgage backed securities.
  • When it became clear that a run was being made on investment bank Bear Stearns, the Fed brokered a deal that had J.P. Morgan Chase & Co. buy the firm. The Fed then extended credit to J.P. Morgan Chase to finance the Bear Stearns acquisition, and the New York Fed agreed to finance $29 billion of illiquid Bear Stearns’ assets to facilitate the deal.
  • The SEC issued an order against “naked short-selling” (i.e., selling a stock without first borrowing or owning it) of the stocks of nineteen big financial companies, believing that the practice contributed to the run on Bear Stearns.
  • Congress passed a housing bill that included a $300 billion program to help beleaguered homeowners refinance mortgages and that effectively gave a blank check to the Secretary of the Treasury to bail out the federally sponsored mortgage companies, Fannie Mae and Freddie Mac. Former House Majority Leader Dick Armey wrote in the Wall Street Journal, “An explicit government guarantee for Fannie and Freddie could ultimately end up costing taxpayers more than $1 trillion, according to an analysis by Standard & Poor’s in April.” To put this in perspective, the U.S. budget deficit is less than half a trillion. The national debt is around $9 trillion.

Most of these moves are unprecedented and represent a major expansion of government manipulation of the financial markets. Ironically, these interventions will be touted as the government’s support of capitalism.

Some “capitalism”! Major banks, investment banks, and quasi-private financial institutions are being bailed out and protected at the expense of the taxpayers (through future taxes and inflation), with the excuse that these institutions are too big to fail—that if one of them failed, a systemic crash would surely follow. And popular outcry against these actions has been muted or nonexistent. Indeed, with a few notable exceptions, politicians, the financial community, and the financial press have been relieved by the hope that the government has avoided another Great Depression.

Instead, they have looked for scapegoats among the usual suspects: greedy capitalists, speculators, short sellers, the creators and purveyors of unregulated financial instruments, and advocates of free markets. Oh yes, and bloggers: The head of the FDIC is complaining that bloggers are spreading unnecessary information about the solvency of banks. And the chairman of the SEC is going after the alleged rumor-mongers that brought down Bear Stearns. Shut those people up, for goodness sake! Don’t they understand that the fate of the nation is at stake?

Well, folks, it just might be.


In a July 19, 2008 article in the Wall Street Journal, James Grant suggested a theory to explain why there has been no effective resistance to the substantial expansion of the government’s role in influencing and manipulating the economy:

Wall Street is off the political agenda in 2008 for reasons we may only guess about. Possibly, in this time of widespread public participation in the stock market, “Wall Street” is really “Main Street.” Or maybe Wall Street, its old self, owns both major political parties and their candidates. Or, possibly, the $4.50 gasoline price has absorbed every available erg of populist anger, or—yet another possibility—today’s financial failures are too complex to stick in everyman’s craw.

I have another theory, and that is that the old populists actually won. This is their financial system. They had demanded paper money, federally insured bank deposits and a heavy governmental hand in the distribution of credit, and now they have them. The Populist Party might have lost the elections in the hard times of the 1890s. But it won the future.

Without a doubt, the failures and potential failures in the financial marketsthat risk ruining us all are very difficult for the layman to understand. There are not enough pages in one magazine issue to address the vast complexities that have brought about and are exacerbating this crisis.

The current credit crisis is historic in its proportions and nature.

But it is nevertheless important to understand the fundamental nature of what is going on, if for no other reason than financial self-defense. And it is important to critique these events in ethical terms—understanding that they are an extension of the fascist-corporativist economic model, which is nominally justified by the morality of self-sacrifice and which pretends to serve the populist idea of “the general welfare.”

The origins of this crisis are simple enough. They are rooted in the popular notion that central planning and state coercion are the best ways to fix the ills of society—as perceived by those who presume to be in charge of society.

History has shown that central planning can never be as economically effective or efficient as a free market’s coordination of countless individual decisions. It was true in 1776, when Adam Smith wrote of “the invisible hand,” and it is certainly true now in our modern global economy. While an atomized free market is efficient, it is also—to borrow a phrase from Dickens—so complicated that no man alive knows what it entails. It is not out of control; it is beyond control. Imagine bureaucrats trying to watch and guide every single transaction that takes place, everywhere. It is impossible. But the attempts still continue.

Many free marketers thought that the fall of the Soviet Union had discredited central planning so thoroughly that it would become easier to persuade people to dismantle the regulatory apparatus that the economic fascists have erected during the past century. But sadly, that has not happened. There is more to central planning than a five-year plan for machinery and agriculture. Our health care system is already mired in it. And our currency is a state monopoly granted to a privately owned central bank that serves its members first. As the recent economic chaos illustrates, the road ahead for free market advocates will remain difficult, perhaps much more difficult than ever before.

We are now suffering from a failed experiment in central planning called the Federal Reserve System. The Fed has monopoly control over the U.S. currency and the regulation of major depository institutions, and its mission is to manage money and credit for price stability and full employment. But the market will not be managed. And the tools available to the Fed—the expansion and contraction of money and credit—are blunt instruments. Once Fed-directed money and credit hit the streets, they take off in directions of their own. Expansion of money and credit to fix one problem starts a problem somewhere else.

Recent decades give ample evidence of the disastrous futility of the Fed’s attempts to use its crude tools to repair the damage of its own previous actions. Injections of liquidity to stop the meltdown in the wake of the failure of Long Term Capital Management fueled the internet bubble. Injections of liquidity to avoid a market crash when the internet bubble burst fueled the housing bubble. Now, following the bursting of that bubble, the Fed is making historically huge amounts of credit available to keep the economy afloat. But the size of each of the bubbles grows progressively. If this were only a game of whack-a-mole, it would be amusing. But money is ubiquitous, and whatever moves the Fed makes can, and do, affect anyone and everyone. The human consequences of Fed-generated boom-and-bust cycles can be, and usually are, tragic.

One author in this magazine not long ago scoffed at Congressman Ron Paul’s suggestion that the Federal Reserve be abolished and the gold standard be restored, apparently seeing this as wholly impractical. Advocating that the Fed be abolished is indeed radical, and it is certainly politically impractical in the current environment, in which Congress is predisposed to give the Fed even more power over the economy. But when the Fed’s origins, objectives, powers, methods, and performance history are evaluated, the position taken by Congressman Paul makes infinite good sense.

More importantly, the ethical and political philosophy underpinning coercive monopolies such as the Fed is just plain wrong.


William Poole, former president of the Federal Reserve Bank of St. Louis, recently discussed in several venues the concept of “moral hazard,” and he attempted to draw a distinction between a government “bailout” and what he views as the insurance function served by the Federal Reserve System:

The concept of moral hazard is most easily explained in the context of insurance. The very existence of insurance may change the behavior of the insured person, who becomes less careful in taking care of insured property than he otherwise would if the property were uninsured. Being less careful with others’ property than your own is not moral behavior and is a hazard to the insurance company. (U.S. Monetary Policy Forum, February 29, 2008)

A traditional bailout involves governmental assistance to a particular firm, group of firms or group of individuals. For ease of exposition, I’ll concentrate on bailouts of firms, but the same issues apply to bailouts of households. There may be occasions when a government infusion of capital to save a firm is justified, such as a bailout of a major defense contractor during wartime. However, most economists believe that bailouts are rarely justified and only in compelling circumstances should the government bail out individuals or firm.

An important reason for opposition to bailouts is that it is essentially impossible for a bailout not to set a precedent for the future. A bailout creates what in the economics and insurance literature is known as “moral hazard” by creating a presumption that in the future the government may again rescue a failing firm. That presumption encourages a firm and its investors to be less careful than they otherwise would be about taking risks. If a firm expects a bailout, it believes that government help will cover losses while the firm’s owners can enjoy the gains, if any, from risky strategies. When the government is expected to absorb losses, bailouts unavoidably increase inappropriate risk taking, which increases the likelihood of losses in the future. (Cato Institute, November 30, 2007)

Well, that is an apt description of exactly how the Federal Reserve System has functioned throughout its history, culminating now in the massive bailouts of Wall Street investment bankers, Fannie Mae, and Freddie Mac: It has created a “moral hazard” that has affected the entire economy. We have entered an era that one observer described as the “privatization of profits and socialization of losses”—an era when Wall Street’s failures are passed off to the taxpayers, so that the bankers suffer no penalty for taking undue risks, but keep the profits if they succeed.

Our currency is a state monopoly granted to a privately owned central bank.

For almost a century, the Fed has served as the lender of last resort to its banks, ending the period in which bankers were punished by the free market for lack of “banking virtues”—honesty, forthrightness, prudence, diligence, and objectivity. This century-long experiment in regulation and central planning has failed miserably, bringing us the boom-and-bust cycle, reducing long-term price stability, and substituting massive system failures in place of occasional regional bank failures, failures that used to discipline bankers and depositors alike. Moreover, the banking system itself, as configured by new laws and regulations, was not sufficiently responsive to meet the growing credit needs of the domestic and global economy, a deficiency which gave rise to an unregulated “shadow-banking system.”

The shadow-banking system enabled a massive expansion of credit. Underlying bank credit—mortgage loans, student loans, credit card debt, and other credit—was supported by the shadow-banking system’s array of other financial instruments that were derived from it, called “credit derivatives.” These derivatives include bonds secured by the loans, special corporations servicing the bonds, private contracts insuring payments (called “credit default swaps”), and others, all of which are now traded as financial instruments in their own right. The size of the over-the-counter, unregulated market in these instruments is now many times the size of the U.S. annual Gross Domestic Product.

While the market in credit derivatives facilitated the original credit, it was also dependent on the integrity of the underlying credit. And that’s where the system broke down. Too many of the underlying loans, especially real-estate loans, were predicated on the assumption that real-estate prices would go up forever—a phenomenon that would mask a host of deficiencies, including banker, mortgage broker, and borrower dishonesty about underlying real-estate value and creditworthiness. Similar failures of forthrightness, prudence, and diligence in the shadow-banking system compounded the underlying bankers’ deficiencies. The bad assumptions and practices were so pervasive that the entire financial market has been severely affected.

Financial security is undermined by reliance on government regulation rather than on individual responsibility.

Many have argued that it is because the shadow-banking system is unregulated that it has threatened everyone’s financial security and that the government needs to regulate it. However, it is not the failure of the government to regulate but the century-long reliance on government regulation itself—as a substitute for market-based banking virtues now minimized by regulation—that has brought us to this financial crisis. The resulting mentality (if it is not regulated, anything goes) has permeated the private markets.

There are, of course, many exceptions—notably the hedge funds that have worked hard to care for their clients as this crisis has unfolded, and the bankers and investment bankers who understand and practice banking virtues. But the unraveling of the shadow-banking system that is taking place reveals that too many participants failed to practice those virtues, and some were downright dishonest. Those individuals and institutions have fouled the market.

The entire shadow-banking system sorely needed to adhere to banking virtues in order to make the system secure and stable in the long-term. However, for almost a century, the Fed and banking regulation have pre-empted the market development of banking virtues. Thus, it is the government that bears the ultimate responsibility for fostering excessive risk.

The ultimate moral hazard is the growing expectation that it is the role of government to bail people out of every sort of misfortune, stupidity, and vice.

We now face a possible run on the shadow-banking system and on every entity whose balance sheet is impaired by the instruments it created—a potential financial tsunami. As Justice McReynolds said in 1935 about Roosevelt’s confiscation of all of the gold money in the hands of private U.S. citizens, “Loss of reputation for honorable dealing will bring us unending humiliation; the impending legal and moral chaos is appalling.”

In fact, the Federal Reserve System itself is a moral hazard. By its very existence it has diminished the market role of banking virtues and preempted their development and growth. On the one hand, it has enabled and frequently encouraged excessive risk-taking by serving as the “lender of last resort,” bailing out risk-takers, rewarding poor judgment, and periodically juicing up the economy with excessive money and credit that keep the system running only by postponing needed market corrections. On the other hand, it has created an environment of ethics-neutrality by establishing government regulations as the standard. The resulting attitude is: What is important is legality, not ethics or sound judgment.

In this environment, lawyers and financial engineers thrive on Enron-type accounting, finding loopholes and creative devices to avoid reserve and disclosure requirements. Imprudent and risky attitudes have spread beyond banking itself into the shadow-banking market. Now, the government is complaining about the complexity of the system and at the same time is suggesting that we ought to create regulations to control it!

What they ought to do instead is get out of the way and let the market do its job of re-educating people about actions and consequences.


Alexis de Tocqueville warned that democracy would last only until Congress learned how to bribe the people with their own money. In the promises of the political candidates of the two major political parties, we see that this practice has now become ingrained. Beginning early in the history of the Republic, but exploding into the welfare state launched in response to the last great world financial crisis (also spawned by the Federal Reserve’s mismanagement), the federal government has pursued policies intended to relieve people of their personal responsibility to exercise due care, and has tried to eliminate reality’s harsh incentives, which train people to raise themselves from poverty. Not only has this not worked as intended and created a moral hazard among the beneficiaries; it has also preempted charity, good will, and benevolence. It has substituted inflation, taxation, bureaucratic control, government mandates, and political power for the work of voluntary organizations, cooperative associations, and philanthropists, causing people to resent being forced to become their brothers’ keeper. Where coercion is substituted for the freedom to choose the morality of benevolence, charity, and good will is rendered irrelevant.

The ultimate moral hazard is the growing expectation that it is the role of government to bail people out of every sort of misfortune, stupidity, and vice—which, in logic, does nothing but encourage the growth of misfortune, stupidity, and vice. Correspondingly, it diminishes the role of virtue, morality, and benevolence in our culture.

A society protected by a limited government may have been the ideal that the Founders sought, but it has never been achieved. Capitalism, as Ayn Rand put it, remains an unknown ideal. Even so, the fact that the people generally have taken the contrary direction does not mean that the ideal is invalid or should be abandoned.

If you want to know who can change that direction, look in the mirror. Correcting popular understanding of the role of government begins with you—in your neighborhood, in your business circles, and in your personal associations. If you wish to eliminate the moral hazards created by out-of-control government, the place to start is locally—and perhaps in your own thinking.

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Eugene C. Holloway
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