The Moral Hazzard of Bailing out Wall Street

[Michael]

Congress Takes On Credit Ratings

Throughout the financial crisis, major credit-ratings firms were criticized for their overly rosy ratings of complex debt securities, which deteriorated soon after and led to billions of dollars of investor losses.

Despite months of regulatory scrutiny and some internal changes at the firms, a recently departed Moody's Corp. analyst says inflated ratings are still being issued. He has taken his concerns to congressional investigators.

The analyst, Eric Kolchinsky, said Moody's Investors Service gave a high rating to a complicated debt security in January 2009 knowing that it was planning to downgrade assets that backed the securities. Within months, the securities were put on review for a downgrade.

"Moody's issued an opinion which was known to be wrong," Mr. Kolchinsky wrote in a July letter to the rating firm's chief compliance officer, a copy of which was reviewed by The Wall Street Journal. In the letter, Mr. Kolchinsky cited other instances in which he believes inflated ratings were given to securities.

...

At issue in Mr. Kolchinsky's internal complaint with Moody's is what ratings firms should do when they are planning to downgrade securities that were the building blocks for other rated products. These securities can go bad weeks or months before the impact registers on the product itself.

That could become a growing issue now that Wall Street bankers are again bundling assets into securities that can be sold to investors or pledged as collateral for short-term loans from central banks.

Source (http://online.wsj.com/article_email/SB125366267173132295-lMyQjAxMDI5NTIzNDYyNjQyWj.html)

Indeed - can't say I didn't see this coming. The wholesale bailout of the billionaires on Wall Street have essentially rewarded them for massive failure and they are now apparently right back playing the same games that cause the meltdown of the financial sector - and why not? If they get all the profits and the taxpayer carries all the risk, they'd be fools not to go for broke.

The bailout of Wall Street creates a moral hazzard writ large. US taxpayers are likely to regret that bailout for a long time to come.

[Americano]

Source (http://online.wsj.com/article_email/SB125366267173132295-lMyQjAxMDI5NTIzNDYyNjQyWj.html)

Indeed - can't say I didn't see this coming. The wholesale bailout of the billionaires on Wall Street have essentially rewarded them for massive failure and they are now apparently right back playing the same games that cause the meltdown of the financial sector - and why not? If they get all the profits and the taxpayer carries all the risk, they'd be fools not to go for broke.

The bailout of Wall Street creates a moral hazzard writ large. US taxpayers are likely to regret that bailout for a long time to come.

That mentality has spread to the US taxpayer. Residential housing defaults by individuals with high incomes and sterling credit scores now far outweigh defaults by lower-income people with lesser credit scores. It takes one year after a residential loan default to qualify for a new home loan. They walk away from the $1M loan on a McMansion, rent for a year and buy the same type of dwelling for $500k.

[Lily]

Something seems very wrong when the shareholders and tax payers have to take the hit when investment houses and financial institutions screw up. Perhaps the high-ranking officers and the board members are the ones who should be paying instead.

[Americano]

Something seems very wrong when the shareholders and tax payers have to take the hit when investment houses and financial institutions screw up. Perhaps the high-ranking officers and the board members are the ones who should be paying instead.

It's known as transferring private risk to the public sector. Defense 'cost plus' contracts were the beginning steps.

[Lily]

It's known as transferring private risk to the public sector. Defense 'cost plus' contracts were the beginning steps.

Okay. I'm sure some legislators thought it was a great idea at the time, but it's just wrong. Risk is one thing, avarice is a horse of a different color.

[Americano]

Okay. I'm sure some legislators thought it was a great idea at the time, but it's just wrong. Risk is one thing, avarice is a horse of a different color.

That's been in place since merchants were feeding the troops on credit at Valley Forge. They've merely perfected their techniques and expanded their scope due to an always apathetic general public.

[Lily]

That's been in place since merchants were feeding the troops on credit at Valley Forge. They've merely perfected their techniques and expanded their scope due to an always apathetic general public.

One would think the GP would be less apathetic as they watch their 401Ks circling the drain.

[Americano]

One would think the GP would be less apathetic as they watch their 401Ks circling the drain.

Their limited attention span, roughly a decade on average, is a major consideration. Most hadn't actually recovered losses from the .com swindle but few manage their own equity investments. They are at the mercy of the big boys when that group decides to take a position of liquidity.

[Michael]

One would think the GP would be less apathetic as they watch their 401Ks circling the drain.

I think human wishful thinking gets in the way. Many people seem to think that bubble-inflated values are 'real' and that that bubble-deflated reality prices are just temporary or abnormal setbacks.

I believe US housing prices are presently (bubble-deflated) quite reflective of true market value based on underlying market fundamentals.

However, most of the government, financial, investment and real estate experts reported by the media can only talk about what needs to happen to get housing back prices back up to what they were before the crash - that's what everyone wants.

In other words, most people assume that the present drop in the value of their 401K's are just a temporary abnormality of the market.

The popularity of government stimulus spending generally falls into this same line of thinking.

[Americano]

I think human wishful thinking gets in the way. Many people seem to think that bubble-inflated values are 'real' and that that bubble-deflated reality prices are just temporary or abnormal setbacks.

Excellent point, it hasn't been all that long since I remember reading poster claims of potential early retirement because their 401Ks were performing at such high levels. I seem to remember those same claims being made in 1987 and 2000.

[Lily]

Their limited attention span, roughly a decade on average, is a major consideration. Most hadn't actually recovered losses from the .com swindle but few manage their own equity investments. They are at the mercy of the big boys when that group decides to take a position of liquidity.

True enough. I took my own position of liquidity back in May 2008. Thank goodness I did.

Now, I'm shopping for a new house. There are some good deals out there, but there are an awful lot of owners who still believe we're in a 2006 housing market and freak out as they are getting offers $15,000- $30,000 below asking price. My friend, who's a real estate broker, wants to pull out his eyelashes.

[The Drunk Guy]

True enough. I took my own position of liquidity back in May 2008. Thank goodness I did.

Now, I'm shopping for a new house. There are some good deals out there, but there are an awful lot of owners who still believe we're in a 2006 housing market and freak out as they are getting offers $15,000- $30,000 below asking price. My friend, who's a real estate broker, wants to pull out his eyelashes.
I just don't understand what they think when they put their place on the market. Are they so vain that they think only the wealthy could possibly be interested in their home? Surely they have the sense to know it's a buyer's market before they decide to put it up. With construction so slow, it would be cheaper to build your own house than to pay what people are asking for their 20-year-old home.

[Americano]

I just don't understand what they think when they put their place on the market. Are they so vain that they think only the wealthy could possibly be interested in their home? Surely they have the sense to know it's a buyer's market before they decide to put it up. With construction so slow, it would be cheaper to build your own house than to pay what people are asking for their 20-year-old home.

It's normally always far less expensive to have a home built to one's own specifications. Most people don't have the expertise or time to undertake such a project, and more importantly they want to go directly from one residence to another for minimal personal disruption.

We've had our last three residences built to order. We always begin by buying the land and working with an architect firm which designs the floor plan to suit our needs. Residential construction cost is always calculated by the square foot, so a budget can be established by square footage and land land/development cost. We then have three general contractors bid on it and again use the architectural firm to analyze their bids with regard to materials and labor costs. When we've analyzed the bids we go with the contractor who has an established reputation we feel comfortable with on a cost plus 10% basis with a contract specifying stage completion dates. We've had subs go broke, crooks and all the rest but stay on top of each step and you'll seldom have any serious problems.

We always sell a residence and rent until the new one is completed.

[Lily]

I just don't understand what they think when they put their place on the market. Are they so vain that they think only the wealthy could possibly be interested in their home? Surely they have the sense to know it's a buyer's market before they decide to put it up. With construction so slow, it would be cheaper to build your own house than to pay what people are asking for their 20-year-old home.


Many of the homes I'm looking at were built anywhere between 1955 and 1980. Some have been completely rehabed; others have kitchens and baths straight out of Ozzie & Harriet. Terrazzo floors, a staple in Florida homes built in the 50s and 60s are now considered "fashionable." My ass.. literally. I still remember how slippery and hard those suckers were when wet.

[Americano]

Many of the homes I'm looking at were built anywhere between 1955 and 1980. Some have been completely rehabed; others have kitchens and baths straight out of Ozzie & Harriet. Terrazzo floors, a staple in Florida homes built in the 50s and 60s are now considered "fashionable." My ass.. literally. I still remember how slippery and hard those suckers were when wet.

I've done the home rehab thing twice. Inconvenient, but well worth it for the end result if the basic structure is acceptable. Moving walls to modify a floor plan is the worst part. Flooring is surprisingly inexpensive in the grand scheme of remodeling.

[Daktoria]

Source (http://online.wsj.com/article_email/SB125366267173132295-lMyQjAxMDI5NTIzNDYyNjQyWj.html)

Indeed - can't say I didn't see this coming. The wholesale bailout of the billionaires on Wall Street have essentially rewarded them for massive failure and they are now apparently right back playing the same games that cause the meltdown of the financial sector - and why not? If they get all the profits and the taxpayer carries all the risk, they'd be fools not to go for broke.

The bailout of Wall Street creates a moral hazzard writ large. US taxpayers are likely to regret that bailout for a long time to come.

Sorry I'm late, heh.

You agree then that the bailouts weren't the practical thing to do? The whole argument behind them was a matter of relieving a systemic risk that would otherwise choke credit lines off from the people. Perhaps populism isn't the way to go else we get screwed by the fine print? :rules:

[Michael]

Sorry I'm late, heh.

You agree then that the bailouts weren't the practical thing to do? The whole argument behind them was a matter of relieving a systemic risk that would otherwise choke credit lines off from the people. Perhaps populism isn't the way to go else we get screwed by the fine print? :rules:

I agree that the wholesale bailing out of Wall Street billionaires, millionaires massively large financial corporations was indeed quite a practical thing to do.

The US government and the US economy is entirely addicted to a maintaining a bubble in financial services. Subsidizing the game with taxpayer money isn't much of a surprise.

My critique is more about the method and process of rewarding Wall Street for failure (which is precisely what they did).

Bailing out Wall Street in a way that turns failures into fat profts and big bonuses pretty much guarentees that it be done again and again in the future.

[Daktoria]

What about on the demand side of the equation? Shouldn't consumers and workers have to learn from their failures as well? Trusting a pension fund entails risk, and while they do seem to have reliable reputations, they are not self-insured. Ergo, everyone that participates in one needs to recognize how there's a gamble no matter what. Furthermore, the government, as an internal participant in our society, is no more wise than anyone else. Heck, even the argument on counter-cyclical economic policies is shaky because it assumes that the government knows how the economy is performing in advance.

[Michael]

I don't like the idea of government intervention in private markets.

Governments ought to regulate and/or referee the marketplace - that's it, that's all.

Governments must never be cheerleaders and/or supporters and/or market-players. That's just a recipe for repeating the kind of mess we are in (over and over in the future).

[Michael]

What about on the demand side of the equation? Shouldn't consumers and workers have to learn from their failures as well? Trusting a pension fund entails risk, and while they do seem to have reliable reputations, they are not self-insured. Ergo, everyone that participates in one needs to recognize how there's a gamble no matter what. Furthermore, the government, as an internal participant in our society, is no more wise than anyone else. Heck, even the argument on counter-cyclical economic policies is shaky because it assumes that the government knows how the economy is performing in advance.
Who cares about the consumers? None of the banks, government nor media gives a crap about consumers. They are of course the only ones who actually get burned in this game. The bailout of Wall Street was all about bailing out the executives who run the firms and the idiot shareholders who let them run the firms (and creating a massive moral hazzard in the process).

Consumers received no public bailout for being defrauded by the banking interest.

Consumers get burned all the time by private corporate fraud all the time. Nothing new there.

Blaming (non-white) consumers for causing the bank failures and bank bailout is rather popular with rightwingers, but doesn't hold much credibility outside of rightwing ideological circles.

[Daktoria]

Sorry I didn't pick up on it before, you were being sarcastic in saying that the bailouts were the practical thing to do?

[Michael]

Sorry I didn't pick up on it before, you were being sarcastic in saying that the bailouts were the practical thing to do?
Yes.

Bailing out Wall Street was an entirely practical policy - if your policy was to defend or re-build the bubble.

(Guess what, the policy worked! The financial bubble has been saved!)

[Michael]

Here's a good summary of the "bubble in financial services"...

Wall Street's Growth: Like a Big Tumor

This chart from Princeton's Hyun Shin is the best illustration I've seen of the unsustainability of the boom in the securities sector:

http://www.tnr.com/sites/default/files/shin_growth.jpg

In absolute terms, most sectors grew by a factor of 80 between since 1954. But, at its peak, the non-commercial-bank financial sector had grown by a factor of 800. From Shin:

The greater detail afforded by the chart in log scale reveals that the securities sector kept pace with the rest of the economy until around 1980, but then started a growth spurt that outstripped the other sectors. On the eve of the crisis, the securities sector had grown to around ten times its size relative to the other sectors in the economy. Clearly, such a pace of growth could not go on forever. Even on an optimstic scenario, the growth of the securities sector would have tapered off to a more sustainable pace to keep in step with the rest of the economy.

Source (http://www.tnr.com/blog/the-stash/the-explosive-growth-the-securities-sector)

That pretty much sums it up nicely. One can trace the explosive growth in financial services from a variety of data-points - all show the same thing. For example, last data I saw on the topic showed that the financial services industry traditionally accounted for about 20% of profits in the US economy - but since the early 1980s, that figure has skyrocketed above 40%.

All point to the fact that the US economy is becoming dependent upon a bubble in financial services.

Indeed, money and credit are commodities. Therefore it logically follows that dealing in such products ought to be boring and generate modest/low profit margins.

[Daktoria]

Right, right. I agree with all of this since it's simple intuition (or common sense if you want). However, this seems to be a symptom of underlying cultural dissonance, not a genuine economic problem since technological growth has provided more than adequate resources for helping creditors and debtors connect transparently, the problem here being that we've been advancing empty industries such as retail, real estate, and telecommunications, none of which generate real demand since they're only efficiency purifiers that refine and clean up demand already in existence. If we became an investment economy instead that used management and marketing expertise to accelerate developing economies (rather than a consumption economy that depends upon imports from them), then this sort of advancement would have a foundation for real profits, growth, and value, but we haven't so the question is "Why?" Why do we insist on domestic hierarchical and cosmopolitan consumption instead of expanding our wealth through innovation, a question that especially deserves to be begged if we subscribe to historicist methods since America's prosperity comes from innovation if nothing else.

[wphelan]

Here's a good summary of the "bubble in financial services"...



http://www.tnr.com/sites/default/files/shin_growth.jpg



Source (http://www.tnr.com/blog/the-stash/the-explosive-growth-the-securities-sector)

That pretty much sums it up nicely. One can trace the explosive growth in financial services from a variety of data-points - all show the same thing. For example, last data I saw on the topic showed that the financial services industry traditionally accounted for about 20% of profits in the US economy - but since the early 1980s, that figure has skyrocketed above 40%.

All point to the fact that the US economy is becoming dependent upon a bubble in financial services.

Indeed, money and credit are commodities. Therefore it logically follows that dealing in such products ought to be boring and generate modest/low profit margins.

Money and credit are commodities, but we use central planning to determine their prices through a central bank. Has the dramatic growth in the financial sector been similar in other countries?

[Michael]

Money and credit are commodities, but we use central planning to determine their prices through a central bank. Has the dramatic growth in the financial sector been similar in other countries?

Entirely unique to the US as far as I know.

[Americano]

Entirely unique to the US as far as I know.

I haven't seen any data but thought the UK had followed the US in targeted asset inflation.

[Michael]

I haven't seen any data but thought the UK had followed the US in targeted asset inflation.

I believe the Brits show a similar (though considerably smaller) rise in the relative proportion of the financial sector since 1980.

It is also quite relevant to note here that Clinton's one 'balanced budget' and several of Blair's rosy budgets were achieved from capital gains taxes on dot.com stock bubble years.

That's part of the reason that Clinton's balanced budget was so quick to evaporate under Bush (even before Bush started raising spending and cutting taxes). It would be relevant to note that part of the intellectual argument for Bush's tax cuts was the projected surplus based upon Clinton's balanced budget (which was a lucky break due to the dot-com bubble).

[Daktoria]

Heh, sounds like Clinton got lucky then since capital gains taxes behaved like sin taxes. By deterring liquid from flowing gluttonously into empty industries, the economy remained stabilized. It'd be interesting to see whether those revenues could have kept social security afloat, something that's probably deserved since it was through subsidizing that the baby boomers and their parents stimulated the economy.

However, this begs two questions. One, does the ends of preventing the economy from overheating justify the means of government intervention? Two, would the baby boom generation have ever come about if government intervention hadn't occured in the first place from FDR's New Deal and deficit spending before and throughout WW2?