I love the concept of karma - the idea that you do an action and the consequence depends on your action. It is just so clean. Systems that employ karma as the guiding principle for how they operate work so well! We do use this idea in various aspects of our society: We create laws such that people who harm others are punished. People who make productive contributions in their job can look forward to better earnings. People who drive carefully get better auto insurance rates.
However, when it comes to the karmic balance of our economy... well I’m not sure it exits anymore. The recent bailouts have tossed out this relationship of action and its consequences. The bailouts repulse me in many ways: first of all the govt is taking ownership in private enterprises, secondly the companies that are being bailed out have very little probability of producing any returns greater than or equal to zero, thirdly the govt doesn’t have the money!
As much as these reasons upset me, the one thing that scares me is the amount of moral hazard* now prevalent in our economy. The idea that if you make bad decisions you will suffer for it, is no longer true! Because of the bailouts, especially of the auto industry, we have removed karma as our guiding principle. What incentives do people or companies have now to manage their risk and to make good decisions? We have created a system that allows for companies to make terrible decisions without them worrying about the consequences. Rather, we have created a system where the consequences of actions have changed, and incentives are altered.
Suppose you have a situation where two events are possible. You can make a lot of money say $X with 60% probability and you can loose a lot of money say –$X with a 40% probability. Suppose, now, the situation has changed (as in the case of the bailouts). The probabilities and the amounts are the same, but what you will experience is changed. Instead of experiencing –$X profit you will end up with $0 and the government as your new owner. How will this influence your decisions?
I am not claiming that in all situations and all companies will make more risky decisions because they might feel like the government will bail them out. In depends on how –$X relates to ‘$0 and the government as the new owner’. Maybe having the government as your new owner is worse. If all other companies in your industry are functioning well and don’t need to be bailed out, but you do, then maybe it is far worse to have the government as your owner. But if all other companies in your industry are being bailout out... what kind of decisions are you going to make?
Since I am an Actuary, I love making predictions based on trends. So, here is my prediction: Many more companies will make bad decisions based on their new found security of the bailouts (at least in the short term future). Of course these companies will probably make rational decisions based on their risk analysis, but people will see them as being greedy and unreliable. And greed is bad right? So maybe we will venture off again on our quest to find the magic pill to get rid of it. And reliable? I wonder why companies don’t like to make decisions that will be similar to suicide, even though they would be doing it for the good of society. Oh well, atleast it will give us some ammunition in our fight against "Corporate America". And THIS can most definitely help the Democrats to usher in a new era of socialism.
*Moral hazard is the change in the behavior of people and organizations when their share of loss is reduced.
Monday, September 21, 2009
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Once you started mentioning this term I started to see it occurring all over the place (like the Fed refusing to give a loan to Lehman Brothers, etc). Very important concept!
ReplyDeleteVery interesting post (and well worth the wait!) . It made me hunt for the origin of the term "Moral Hazard" and actually the wikipedia article on is extremely good - http://en.wikipedia.org/wiki/Moral_hazard (there were parts of it that made me shudder : such as: "Various people suggest that this [moral hazard] may have caused 2007–2008 subprime mortgage financial crisis. In the period 1998-2007 regulators kept and published detailed statistics on the ethnicity and location of those receiving loans, but failed to pay similar attention to their credit worthiness, default rates or vulnerability to a housing downturn. The data that the regulators focused on was more relevant to politically mobilizing voting blocks in particular electorates than to keeping the financial system solvent." . The point is bailouts aren't really economically but politically motivated. Trisco's list of bailout companies that contribute to the correct administration beautifully illustrates this point.
ReplyDeleteAnd talking about Lehman brothers - they actually turned out an offer from Buffet (well after they had drowned) because they EXPECTED a better offer from Uncle Sam !! Looks like its just treated as a strategy.
One more subtle aspect of the bailouts is the negative effect it has on the competitors of the bailed out companies. Consider, for instance, Warren Buffet's comments in his 2008 Letter to Shareholders (http://www.berkshirehathaway.com/letters/2008ltr.pdf) regarding the impact of new government-backed loans on one of Berkshire's subsidiaries (Clayton Homes):
ReplyDelete"Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.
This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.
Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one."
@Anonymous: Thats a great point! So not only do Bailouts encourage Moral Hazard, but change the playing field for the other well-run companies that did NOT NEED a bailout. It makes them appear more risky (because these aren't not backed by the Govt) - creating a "Bailout Hazard". While Moral Hazard is the prospect that an agent insulated from risk behaves differently, Bailout Hazard can be defined as the increase in a party's risk without any change in behavior and is equally dangerous to a capitalist system.
ReplyDeleteOn another front, I wonder if there is a notable change in the public's behavior. Now that they partly own / funded a company, do they begin to feel partial towards it? E.g., would the average American favor GM over Ford, Chrysler etc. Perhaps this doesn't even enter the equation for most tax payers when they shop for cars (its easy enough to isolate different pieces of information). As of 2007, GM topped US sales with ~24% market share and Toyota with ~16%. During the clunker sales, GM ranked second (17.6% of sales) behind Toyota (18.9% sales) with Ford, Honda and Chrysler at 3rd, 4th and 5th respectively - so what does that mean? Perhaps its an anti-bailout effect on the consumers -why would they buy a car from a company that needed to be bailed out? Its precisely for this reason, I wish they had a Wells Fargo in town :)-. And Wells Fargo brings up another interesting point : here's a company that didn't need a bailout, but was forced to take Govt. funds, along with the rules, regulations, high-interest and fees that followed !! (one theory is that this was forced on them because the bailed out banks wouldn't look as bad). What should we call this : "Govt. Hazard"?
Car Data sources: Google-> http://autoincar.blogspot.com/2007/10/september-2007-us-new-auto-sales.html
Clunker sales: Google -> http://www.detnews.com/article/20090814/AUTO01/908140418/Toyota+tops++clunkers++sales
Disclaimer: As of today, I am invested in Wells Fargo and not in any of the other companies mentioned.
"Govt. Hazard" is redundant.
ReplyDelete