Thursday, June 05, 2008

What is Moral Hazard?

Excellent speech by Richmond Fed President Jeffrey Lacker is here, where he discusses the Bear Sterns bailout and moral hazard.

Moral hazard is the central problem that the financial safety net necessarily brings with it. And this problem exists even if central bank lending ensures that the resolution of a problem institution leaves its shareholders with nothing. Market discipline on risk-taking by financial firms comes more from the cost of debt finance than from equity holders (given the limited liability nature of equity). So it is the potential consequences of central bank lending for creditors that raises moral hazard concerns by reducing the cost of debt and potentially leading to greater leverage than would otherwise be chosen.

In the Bear Sterns bailout, it is the equity holders that got hit - they got only $10 for a company whose book value was presumably north of $50. It was the debt holders who were the winners. They would have lost big had Bear Sterns gone into bankruptcy, now they have been made whole by the Fed. So, the risk of lending to an I-bank has gone down following the Bear Sterns precedent.

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