Bailouts and Moral Hazard

Bailouts and Moral Hazard
by Robert

Here we are again, just into a Bear (sterns) market and we have to face the fact that Fannie Mae and Freddie Mac are waaaaay to big to fail. A strong case can be made that a bailout will cost relatively little and failure to come to their assistance will cost a lot even when distracted by Gover Norquist’s absurd arguments. Here is the video. In defence of the BBC, the accents have gotten a lot better since 1945, no striped trousers on the broadcast at all.

OK so we have to bail out the FM’s. However, it is irritating that the people who made this mess obtained tens of millions in compensation doing so. I can translate my populist rage into gametheoryspeak noting that bailouts create moral hazard problems. The US government can’t let Fannie or Freddie or even the medium size bad Bear fail. It shouldn’t make executives decide to run risks only because they know that if they roll snake eyes, the treasury or the fed will bail them out. So What is to Be Done ?

It seems simple to me (and many many others). The institutions are too big to fail, their officers are vulnerable to bad incentives. The correct policy is to keep the institution from failing in a way which will serve as a lesson to the officers of other institutions.

I think the optimal policy is simple. The chairman of the Fed tells the CEO of To Big to Fail Bank (tbtf bank) that the FED will pick up dodgy assets with face value X if mr CEO picks up dodgy assets with face value equal to 90% of his wealth as reported in the Forbes 500 or 5 years of his (or her hah?) total compensation. Then Bernanke can mention that he is not a shareholder of tbtf bank, but, if the CEO were to say no and the bank were to go bust and he were a shareholder he sure would sue (and presumably win).

Now the CEO can appeal to the 13th amendment and resign on the spot, but he loses if he says yes and loses more if he says no. If he says he is resigning, BB (Ben Bernanke not Big Brother) says his successor will be offered the same deal with the added proviso that CEO I not be paid anything by tbtf bank beyond what CEO I can claim is due to him in court. And so on. BB will get down to someone so poor that he is willing to put 4 years of compensation at risk in order to be CEO.

Unlike the highly compensated officers, that person might even be competent to manage a bank (stranger things have happened).

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