Moral Hazard

Travis Fast

Do you feel better now that the world has been made safe from the prospect of moral hazard by rewarding the financial markets with massive liquidity on the cheap and easy?

The problem with the Keynesian notion of irrational exuberance is that given the amount of liquidity that had been sloshing around, and further given the werewolf like hunger of investors for better returns; the rational thing to do was innovate in financial instruments and products. But then maybe that is the rub: there are different rationalities floating around out there.

The Fed cut its so-called discount rate – the rate at which banks can borrow directly from the central bank against a wide range of collateral, including subprime mortgages – from 6.25 per cent to 5.75 per cent. That is only 50 basis points above its main interest rate, the federal funds rate.

Also, the Fed said it was extending the period for which these loans would be available from one day to up to 30 days, renewable at a bank’s request.

But the real gem in this article from the FT is here:

The New York Fed convened an extraordinary conference call for leading Wall Street banks to explain its move and encourage them to use the so-called discount window, saying to do so would be a “sign of strength”.

In recent years, few banks have used the discount window, fearing that going to the Fed for cash might be interpreted as a sign that they were in trouble.

The Fed hopes that if banks know they can always access cash at not-too-punitive terms against mortgage and other securities, they will jumpstart the frozen markets for asset-backed commercial paper and securities backed by “jumbo” mortgages.

Neal Soss, chief economist at Credit Suisse, said: “This is a masterful move because it doesn’t actually feed some of the concerns about moral hazard’’ of bailing out investors who took risks.

The Fed announced the changes in its policy statement following a video conference of its open market committee on Thursday.

I know I feel reassured.

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4 thoughts on “Moral Hazard

  1. I’m not quite sure why the opening of the discount window at favourable rates addresses moral hazard issues…isn’t it an implied subsidy of risky bets to provide favourable loans that would fund the loss on those bets, or permit them to be used as collateral where they would not otherwise be accepted?
    I suppose it is not as large a moral hazard as an outright gift or a full interest rate cut; is that what Soss means?

  2. Yah it is basically a cock-up (english use, no connection to male anatomy). Any way you slice it what has been going down is a state mitigation of private risk. As you say not a whole hog gift but nonetheless a publicly orchestrated bail out of private actions. That smells of moral hazzard to me.

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