Socialism for the Super Rich - Moral Hazards in US economy

The recent bailout of Freddie Mac, Fannie Mae and AIG, by the US Govt to protect the faith in US markets has created a moral hazard. A moral hazard indicates that while you take a risk, the profits from it go exclusively to you, but losses are distributed to parties which do not have anything to do with the deal. This creates a situation which rewards an overtly risky behavior.

The US taxpayers are paying for the mistakes of a few who tried to make a lot of money in the US real estate and mortgage businesses. The Fed by arranging the shotgun marriage of Bear Sterns to JP Morgan a couple of months ago, while assuring at least $30 billion against losses from Bear's trades, indirectly rewarded the overtly risky behavior, by letting the taxpayers buttress the downside of the risks. Freddie and Fannie losses could potentially run into hundreds of billions of dollars. The Fed tried to take a stand by not bailing out Lehman, but the odds were stacked against its favor as the AIG posed a huge counterparty risk to all the financial markets. In the end, the AIG bailout cost the taxpayers $85 billion.

This is not new for the Fed. It arranged the cleaner disposal of Long Term Capital Management (LTCM) Hedge fund after it blew up in 1998, since the fund with $10 billion in deposits and controlling over $1 trillion of the economy through leverage would have brought down the entire global economy.

Moral Hazards have always existed in the world of Hedge funds, where the fund managers gets to take home a large part of any profits he makes. Losses would typically result in him getting fired, but without any monetary damage. This caused the Hedge fund managers to take up increasingly risky trades. Mutual funds were somewhat safer due to strict regulation which limited the riskiness of trades they undertook.

In a free market enterprise the Fed has to let these institutions fail for their mistakes. But they would also cause global economic collapse and cause a lot of harm to the common man. So this is amounting to near blackmail by these firms (a more apt term would be brinkmanship).

Other than the explicit bailouts of Freddie, Bear, AIG etc, The Fed is also implicitly bailing out the other firms by keeping the interest rates extremely low, at a time when inflation is eating into the savings of the common folk.

So who is at fault? The fault is the lack of proper regulation and laws governing Investment banks and financial institutions in general. For example the repeal of the Glass-Steagall act is one such action, which increased the moral hazard since banks can also do investment actions and lose lots of money rendering them insolvent. This would cause the FDIC to dole out money to the depositors from tax payers if the banks fail. This is definitely not the best solution, but can be one solution which can be used to reduce this moral hazard, which if ignored further would result in increasingly worse depressions, as traders start taking increasingly risky trades.

Although it is against the spirit of free markets, the US Govt must be more proactive in analyzing the markets and bring in relevant laws and regulation, instead of waiting for the storm, to pass new laws.