Moral Hazard and Too-Big-To-Fail Institutions: A Closer Look
In the world of finance, the term Moral Hazard is often discussed in the context of how rescue operations for failed companies can incentivize other companies to take on greater risks with the knowledge that a similar rescue is likely. This phenomenon was particularly evident during the first significant bailout of Chrysler, when concerns about moral hazard were raised. While we eventually weathered those processes, the effect on a free market was ultimately corrosive.
The Housing Crisis and Its Aftermath
One area where the consequences of moral hazard were highly visible was during the housing crisis. Despite closing the proverbial barn door—meaning measures were put in place to prevent further damage—full recovery has only just begun. The extent of the damage and the lingering effects suggest that financial crises can have a lasting impact on the housing market, making it difficult to predict whether we will ever fully recover.
Matt Taibbi's insightful piece in The Great American Bubble Machine, published in Rolling Stone on April 5, 2010, provides an excellent background on the history of bubbles and the role of Goldman Sachs and other financial institutions in creating and exacerbating these crises. The article sheds light on the interconnectedness and political power of large financial institutions and the moral hazard that results when such entities are deemed too big to fail.
The Too-Big-To-Fail Phenomenon
When an institution is classified as too big to fail, the government determines that its collapse would be too damaging to other institutions, a broad swath of consumers, or the entire financial market. This classification encompasses more than just size; it involves political power, interconnectedness, and the perception that the institution is integral to the system. Examples of such institutions before the financial crisis of 2008 included Fannie Mae and Freddie Mac, both mortgage finance giants that were quasi-government-sponsored enterprises (GSE).
While these institutions had stockholders and highly-paid employees, they also benefited from significant government ties, including a $1 trillion line of credit with the U.S. Treasury, freedom from paying local taxes in Washington D.C., and exemption from filing financial statements with the U.S. Securities and Exchange Commission (SEC). The most valuable benefit, however, was the lower cost of capital they enjoyed due to the belief that the government would not allow them to fail.
Post-Crisis Landscape and Expanded Too-Big-To-Fail
The aftermath of the 2008 financial crisis saw an expansion of the too-big-to-fail phenomenon. Major banks such as Citigroup, Wells Fargo, JPMorgan Chase, and Bank of America that received taxpayer money during the crisis are now widely perceived as too politically powerful and too interconnected to fail. Instead of addressing the fundamental issue of institutions that might be bailed out if they take risks that go awry, the crisis only increased the number of institutions at risk.
These institutions are now even larger than they were before the crisis, exacerbating the problem. The government's bailouts have only served to reinforce the notion that certain institutions are too big to fail, leading to even greater moral hazard in the financial sector.
Conclusion
The moral hazard and too-big-to-fail phenomenon remain significant issues in today's financial landscape. Understanding the historical context and the ongoing challenges can help us better address these problems and create a more stable and fair financial system.