When in doubt, lend?

Timothy Geithner uses the term moral hazard fundamentalism repeatedly in his new memoir Stress Test, and clearly the former United States Treasury Secretary and Federal Reserve Bank of New York chief means to signal impatience with the notion that the prospect of a bailout affects risk-taking incentives.  Geithner’s dismissive approach avoids consideration of achieving a balance between the implications of moral hazard and the merits of the many and various choices made during his tenure.

The concept of moral hazard originated with the insurance business in the nineteenth century and recognized that an insured has lessened incentives to prevent losses when an insurance contract compensates for those losses.  The classic example is fire insurance.  A business having insurance coverage for losses in the event of a fire has less incentive to install a sprinkler system that would lessen fire damage losses.  Likewise, bankers expecting bailouts from the U.S. Treasury will underinvest in the considerable expenses of risk management. And what bothers regulators today is what lessons from 2008 were learned by Wall Street and the big banks: better risk management, or if another financial crisis hits that the Federal Government will bail them out, again.

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The financial collapse of 2008 began with the bailout of Bear Stearns when the Federal government provided loan of $30 billion to J.P. Morgan for its purchase of Bear Sterns. Geithner argues that Morgan took tremendous risk, yet acknowledges that in subsequent episodes firms “would clamor for ‘Jamie [D]eals,’” referring to what many on the Street perceived – that JPMorgan CEO Jamie Dimon sweetheart deal in acquiring a rival on the cheap using taxpayer money. He claims the Bear Stearns loan earned a profit.  It did, except that no one but a public official spending other peoples’ money would have booked the loan on such favorable terms.

Taxpayers deserve better than this and they didn’t get it.  Timothy Geithner and his associates negotiated similarly favorable terms for Fannie Mae, Freddie Mac, AIG, Citigroup, and Bank of America.  That run was broadened with a series of acronym programs—TAF, TSLF, PDCF CPFF AMLF, TALF—that lent on generous terms to participants in various financial-market segments.

One looks but will not find an instance where Geithner seems to recognize the costs of moral hazard outweighed the considerable benefits the public might derive from extending such a loan.  Geithner seems to have believed: when in doubt, lend. 

I came away from the 2008 crisis concluding that government, and by that I include politicians and regulators, will fail in its fiduciary duties to taxpayers. This outcome is unsurprising on two counts.  Firstly, these officials expect to be chastened should harm befall Main Street.  Secondly, the needed financial resources are drawn from future tax receipts.  This combination offers the prospect of investing resources provided by the public to build their own human capital as saviors.  Compare this to Paul Volcker who took tremendous personal risk in raising interest rates to end an inflationary cycle that was damaging the country’s financial institutions.

When I finished reading Stress Test, I was surprised at how little I learned about the crisis.  As a financial economist, I probably followed the news more closely than most, but I expected to learn more, especially the rationale behind the decisions.  I didn’t.  For example, the coverage of the GM case is very sketchy; you won’t find a word about favoring the pension fund over GM bondholders.

I was surprised too that Geithner takes credit for Dodd-Frank provisions covering derivatives.  Congressional Hill staffers tell me that the initial derivatives provisions were limited to clearing and a data repository.  It was Gary Gensler, chair of the Commodity Futures Trading Commission (CFTC) that championed Dodd-Frank trading provisions.  Gretchen Morgenson of the New York Times thoroughly documented Gensler’s role but nowhere does Geithner mention Gensler.  Similarly, Glen Hubbard, dean of the Columbia Business School, says in reference to a supposed conversation about tax policy, “Geithner is making it up”. 

Combining outright inaccuracy regarding tax policy and the omission regarding derivatives policy leads me wondering what else Geithner omitted.  To this, I add the lack of insight on moral hazard problems that might inform future policymaking and conclude: why bother?

Moser is an executive-in-residence at the Kogod School of Business and is the Faculty Program director for the Master in Finance (MSF) program. Before joining Kogod, Moser served as the deputy chief economist at the Commodity Futures Trading Commission for five years.