Lehman Brothers and the Persistence of Moral Hazard

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Lehman Brothers and the Persistence of Moral Hazard

Not only is it questionable public policy to use taxpayer money to bail out private companies, but, more important, it creates a moral hazard: the incentive for those companies to take excessive risks with the knowledge that the government will save them should things go wrong.

Of course, the plan backfired completely. The chaos that ensued forced the government to step in to protect almost every financial instrument involved in the credit markets, from money market funds to commercial paper to asset-backed securities, and to ride to the rescue of some of America's largest banks. In the process, the government created moral hazard on an epic scale, transforming a vague expectation that certain financial institutions were "too big to fail" into a virtual government guarantee. Moral hazard already existed in the system on at least three levels.

First, bank employees and managers had asymmetric compensation structures. In good years, they stood to make huge amounts of money; in bad years, even if the bank lost money, they would still make healthy sums. This gave employees the incentive to take excessive risks because they could shift their potential losses to shareholders.

Second, shareholders had the same payoff structure. Banks are highly leveraged institutions; every dollar contributed by shareholders is magnified by 10 to 30 dollars from creditors. This meant that in good years, shareholders benefited from profits that were juiced by leverage, but should things go wrong, they could shift their potential losses to creditors. As a result, paying bank executives in stock did not mitigate their behavior; in fact, the most senior executives at both Bear Stearns and Lehman had and lost enormous amounts of money tied up in their companies.

Third, creditors had only limited incentives to watch over major banks. Ordinarily, creditors should demand high interest rates on loans to highly leveraged...
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