If you Google around the web, especially the Federal Reserve’s site, you can find endless definitions and references as well as debate and discussion related to the term “moral hazard”.One definition caught my eye which seems to precisely sum up the process that has taken place on Wall Street in the wake of the Bear Stearns collapse … although I’m taking it out of context just slightly.
As Donald Kohn, Vice Chairman of the Federal Reserve, put it in his February 2007 speech entitled “Financial Stability: Preventing and Managing Crisis” moral hazard:
“refers to the heightened incentive to take risk that can be created by an insurance system. “
In light of recent events, what better “insurance system” is there but the Federal Reserve itself?
The Bear Stearns bailout succeeded in calming the markets not because any of the fundamental precursors to its collapse had been addressed but merely because Bernanke’s Fed put its balance sheet up as a backstop for all the junk securities whose collapsing value instigated the panic.
But what really has changed since the Bear Stearns bailout?
The Fed funds rate is a bit lower and inflation, especially in fuel and commodities, seems to have become “unanchored” but more importantly the housing crisis is showing itself to be incredibly severe.
In some markets, home price declines seen in just the last year are comparable or even far exceed similar past declines seen over periods of five or more years.
But the current housing decline is still in full gear.
Home prices are continuing to slide, foreclosures are growing dramatically, rates of “walking away” and even arson are on the rise.
Lastly, it appears that nearly every macroeconomic indicator is showing the typical patterns of weakness indicating recession is either upon us or very near with the most notable data tracking non-farm payrolls, industrial production and retail sales (especially inflation adjusted) all clearly presenting a bleak outlook for the future.
Bernanke’s insurance policy has done more than to simply set up a potential “moral hazard” for the financial industry, it HAS created a PRESENT moral hazard for Wall Street investors, large and small alike, who firmly believe that the Fed will stop at nothing to prevent a calamitous decline and that the Bear Stearns bailout marked the bottom of the current turmoil.
As the housing crisis continues and the recession worsens though, home price declines and increasing unemployment will usher in a whole new class of disruptions with defaults eroding its way up the chain to the prime mortgaged “homeowner” and only then would it be appropriate to attempt to discover the bottom.
