Michael Hudson — Mutual Aid vs Moral Hazard

Creditors argue, for instance, that if you forgive debts for a class of debtors – say, student loans – that there will be some “free riders.” Students freed from debt will benefit, while students who were able to carry and pay off their debts had to “meet their obligations.” It is further argued that if student debts are forgiven (or “junk mortgage” loans written down to fair real estate valuations), people will expect to have bad loans written off. This is called a “moral hazard,” as if debt writedowns are a hazard to the economy, and hence, immoral.

This is a typical example of Orwellian doublespeak engineered by public relations factotums for bondholders and banks. The real hazard to every economy is the tendency for debts to grow beyond the ability of debtors to pay. If large numbers of students remain liable to pay student loans without having obtained well enough jobs to pay, this will prevent them from being able to qualify for mortgage to buy a home and start a family. Many students today are obliged to keep living with their parents, and are unable to marry. The result is deepening economic austerity as a result of the debt overhead.

Meanwhile, defaults on student loans to for-profit colleges are projected as rising toward 40%. Is it worth it to say that to prevent giving these impecunious students a “free lunch,” it is worth keeping a large swath of the population poor and unmarried?....

The basic moral financial principal should be that creditors should bear the hazard for making bad loans that the debtor couldn’t pay — like the IMF loans to Argentina and Greece. The moral hazard is their putting creditor demands over the economy’s survival.

Michael Hudson — On Finance, Real Estate And The Powers Of Neoliberalism

Mutual Aid vs Moral Hazard
Michael Hudson | President of The Institute for the Study of Long-Term Economic Trends (ISLET), a Wall Street Financial Analyst, Distinguished Research Professor of Economics at the University of Missouri, Kansas City, and Guest Professor at Peking University

Cecchetti & Schoenholtz — Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

Money and Banking

Moral Hazard: A Primer
Stephen G. Cecchetti, Professor of International Economics at the Brandeis International Business School, and Kermit L. Schoenholtz, Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business

Cecchetti & Schoenholtz are the authors of Money, Banking and Financial Markets.

Ellen Brown — Bail-In and the Financial Stability Board: The Global Bankers’ Coup

On December 11, 2014, the US House passed a bill repealing the Dodd-Frank requirement that risky derivatives be pushed into big-bank subsidiaries, leaving our deposits and pensions exposed to massive derivatives losses. The bill was vigorously challenged by Senator Elizabeth Warren; but the tide turned when Jamie Dimon, CEO of JPMorganChase, stepped into the ring. Perhaps what prompted his intervention was the unanticipated $40 drop in the price of oil. As financial blogger Michael Snyder points out, that drop could trigger a derivatives payout that could bankrupt the biggest banks. And if the G20’s new “bail-in” rules are formalized, depositors and pensioners could be on the hook. 

The new bail-in rules were discussed in my last post here. They are edicts of the Financial Stability Board (FSB), an unelected body of central bankers and finance ministers headquartered in the Bank for International Settlements in Basel, Switzerland. Where did the FSB get these sweeping powers, and is its mandate legally enforceable? 

Those questions were addressed in an article I wrote in June 2009, two months after the FSB was formed, titled “Big Brother in Basel: BIS Financial Stability Board Undermines National Sovereignty.” It linked the strange boot shape of the BIS to a line from Orwell’s 1984: “a boot stamping on a human face—forever.” The concerns raised there seem to be materializing, so I’m republishing the bulk of that article here. We need to be paying attention, lest the bail-in juggernaut steamroll over us unchallenged.

Using state capture to institutionalize capitalizing gains and socializing losses through the force of law.

Web of Debt
Bail-In and the Financial Stability Board: The Global Bankers’ Coup
Ellen Brown

Dean Baker — Washington Post Pushes for Government Guaranteed Subprime Mortgage Backed Securities

The bulk of its lead editorialtouting the prospects for bipartisanship is focused on pushing the Johnson-Crapo bill, a measure that would replace Fannie Mae and Freddie Mac with a system whereby the government guarantees 90 percent of the value of privately issued mortgage backed securities (MBS). This means that Goldman Sachs, Citigroup and other folks who might issue MBS could now tell their customers that even in a worst case scenario they couldn't lose more than 10 percent of the value of their securities. 

Fans of the market should be asking two questions here. What problem is this intended to solve? And why do private issuers need a government guarantee?

More moral hazard and perverse incentives in FIRE.

Beat the Press
Washington Post Pushes for Government Guaranteed Subprime Mortgage Backed Securities

Dean Baker

Mel Kelly — Bank of England to help the City circumvent regulations

When Mark Carney announced last year the Bank Of England “is open for business”, at the time, he claimed it was only to be for banks who were properly and tightly regulated. But with the world distracted by the opening match of the world cup finals, it went largely unreported that George Osborne and Mark Carney also announced in their Mansion House speeches that they intend to rip up Bank Of England lending rules to allow the BofE to start lending to “shadow banks”. 

Shadow banks are not banks at all, but a term coined by economist Paul Culley in 2007 for financial institutions such as investment banks and brokers who lend and invest. If shadow banks investments go wrong their lenders, i.e. banks, consumers and investors, go bust as shadow banks have no back up security from central banks to bail them out because unlike traditional banks they are largely unregulated and have no depositors. 

During the financial crisis, about $400bn worth shadow banking investments shrank to zero within weeks, causing huge losses for lenders and investors, and as Lara Kodres, the Assistant Director of the IMF’s Monetary and Capital Market’s explained in June 2013, “Shadow Banking, in fact, symbolizes one of the many failings of the financial system leading up to the global crisis”.

What could go wrong?

openDemocracy
Bank of England to help the City circumvent regulations
Mel Kelly

Marshall Auerback — Yes Virginia, We Can Have Another ‘Big Crash’

During the bubble era the wide gyrations in all of the affected markets could not be explained in terms of gyrations in the fundamentals. It all had to do with the psychology of manias augmented by moral hazard, panics, and crashes. In today’s moral hazard market the same prevails. Market prices are not about earnings or price earnings multiples, but are rather about the perception of risk and return. I say perception. Purely adaptive behavior calls for an extremely high perceived risk of loss and very low valuations. And this is the way individuals are behaving in this market place. Mega moral hazard results in market participants perceiving very little risk of loss because of prevailing insurance provided by the “policy puts”. And this is how professionals are behaving in today’s market. 

It is my assessment that market professionals want to believe in the existence and effectiveness of these policy puts and the Fed and Treasury will provide them with expectations management and policy actions that will keep those beliefs intact. Hence, the market has continued to rise. However, I believe it is also likely that these policy measures will not be as effective as most market participants now believe, as we learned in 2008. History does repeat itself and in compressed fashion.

Macrobits by Marshall Auerback
Yes Virginia, We Can Have Another ‘Big Crash’
Marshall Auerback

Mike Whitney — The Economic Scam of the Century

This is such an outrageous, in-your-face ripoff, it shouldn’t even require a response. These jokers should be laughed out of the senate. All the same, the bill is moving forward, and President Twoface has thrown his weigh behind it. Is there sort of illicit, under-the-table, villainous activity this man won’t support?

Not when it comes to his big bank buddies, there isn’t.

Read the fine print. 

Incredible coming from the people that promised no more bailouts. Well, not really incredible at all considering who they are working for.

Counterpunch
The Economic Scam of the Century
Mike Whitney

Ellen Brown — The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives

Did you know that shadow banking carries a government guarantee, too?

According to Hervé Hannoun, Deputy General Manager of the Bank for International Settlements, investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), although most are not generally classed as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.

The Hidden Government Guarantee that Props Up the Shadow Banking System
According to Dutch economist Enrico Perotti, banks are able to fund their loans much more cheaply than any other industry because they offer “liquidity on demand.” The promise that the depositor can get his money out at any time is made credible by government-backed deposit insurance and access to central bank funding. But what guarantee underwrites the shadow banks? Why would financial institutions feel confident lending cheaply in the shadow market, when it is not protected by deposit insurance or government bailouts?
Perotti says that liquidity-on-demand is guaranteed in the SBS through another, lesser-known form of government guarantee: “safe harbor” status in bankruptcy. Repos and derivatives, the stock in trade of shadow banks, have “superpriority” over all other claims.Perotti writes....

The amendment to the Bankruptcy Reform Act of 2005 that created this favored status for repos and derivatives was pushed through by the banking lobby with few questions asked.

Talk about moral hazard. This is a financial Armageddon not just waiting to be happen but potentially being engineered by the TBTF-TBTJ banks since it would lead to an unprecedented windfall and further consolidation of banking.

The Web of Debt
The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives
Ellen Brown

Winterspeak — Ask a banker, and listen to what they say!

Nice post on Planet Money which actually gets many of the facts right! Unfortunately, they do not see how these facts actually pull together, and so do not quite capture the core insight into bank operations. But overall, it's a nice piece.

Winterspeak
Ask a banker, and listen to what they say!

Simon Johnson — Big Banks’ Tall Tales

As Bill Dudley, the president of the New York Federal Reserve Bank, put it recently, using the delicate language of central bankers, “The impediments to an orderly cross-border resolution still need to be fully identified and dismantled. This is necessary to eliminate the so-called ‘too big to fail’ problem.”

Translation: Orderly resolution of global megabanks is an illusion. As long as we allow cross-border banks at or close to their current scale, our political leaders will be unable to tolerate their failure. And, because these large financial institutions are by any meaningful definition “too big to fail,” they can borrow more cheaply than would otherwise be the case. Worse, they have both motive and opportunity to grow even larger.

This form of government support amounts to a large implicit subsidy for big banks. It is a bizarre form of subsidy, to be sure, but that does not make it any less damaging to the public interest. On the contrary, because implicit government support for “too big to fail” banks rises with the amount of risk that they assume, this support may be among the most dangerous subsidies that the world has ever seen. After all, more debt (relative to equity) means a higher payoff when things go well. And, when things go badly, it becomes the taxpayers’ problem (or the problem of some foreign government and their taxpayers).

Project Syndicate

Big Banks’ Tall Tales

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics

Out of paradigm about "taxpayers," but it shows that cross-border resolution is an issue with transnationals.

Ralph Musgrave Mervyn King on the corrupt banker / politician nexus.

Privilege » access » influence in UK finance. In the US, the financial industry just installs its people in power through the revolving door.

Ralphonomics
Mervyn King on the corrupt banker / politician nexus.

Ralph Musgrave

Galo Nuño and Carlos Thomas — Bank leverage cycles

Economists tend to agree that explosive deleveraging in the banking sector was a central element of the 2008 global financial crisis. This column argues that such deleveraging is far from unique. In fact, there is a ‘bank leverage cycle’ in which bank leverage, assets and GDP ramp up and down together; and this is true across financial subsectors. Such procyclicality strengthens the case for macroprudential regulations.

VOX.eu
Bank leverage cycles
Galo Nuño, Economist at the European Central Bank, and Carlos Thomas
Economist, Banco de España

At least they read some Minsky. Now they really need to read some Mosler. Their solutions are RHS instead of LHS.

Ann Pettifor — Mark Carney's 'shock' appointment means more of the same

Osborne's choice for governor of the Bank of England will do nothing to prevent the next collapse of the financial system...

Carney is a central banker steeped in the culture and practices of Goldman Sachs's investment banking arm. Before becoming Canada's central bank governor, he spent 13 years with Goldman Sachs in its London, Tokyo, New York and Toronto offices. He held a range of senior positions. The most significant was as managing director of investment banking.

In a speech made recently Carney made the right noises. He complained of "a system that privatises gains and socialises losses" and endorsed the approach that sets capital and leverage ratios for banks. He's even commended the Occupy movement for being "constructive".

But there is nothing in his speeches that indicates that he will help give Britain's real economy the protection it needs from its over-mighty – and still very dangerous – banking sector. Nothing, in other words, that indicates the real economy – the productive sector – will be given priority over the City's preference for reckless global speculation.

The Guardian (UK)

Mark Carney's 'shock' appointment means more of the same
Ann Pettifor | Director of Prime: Policy Research in Macroeconomics and a fellow of the New Economics Foundation

BIS warns about moral hazard and threat of second leg down

The Bank for International Settlements said in its annual report that the world economy remains out of balance, with advanced economies struggling with debt and emerging economies growing strongly but facing risks of their own version of boom and bust.

The BIS – an intergovernmental organization of central banks based in Basel, Switzerland – said it's key for governments to make banks take responsibility for their losses and force them to rebuild their finances. Meanwhile, the threat from risky bank behavior is growing again.

"The world is now five years on from the outbreak of the financial crisis, yet the global economy is still unbalanced and seemingly becoming more so as interacting weaknesses continue to amplify each other," the BIS said in its 82nd annual report. 

"The goals of balanced growth, balanced economic policies and a safe financial system still elude us."

Read it at The Huffington Post
Bank For International Settlements Report: Big Banks Take Risks Expecting Taxpayers To Cover Losses
by David Mchugh

Dirk Ehnts — Central bank independence-is China a role model?

Another reason why central bank independence is not a good idea — moral hazard.

Read it at econoblog101 (very short)
Central bank independence – is China a role model?

by Dirk Ehnts | research assistant at the chair for international economic relations at University of Oldenburg, Germany

Report on Safety-Net Benefits Conferred on TBTF Banks

In a post at vox.eu, Santiago Carbó-Valverde, Edward J Kane, and Francisco Rodríguez Fernández introduce their NBER working paper, Safety-Net Benefits Conferred on Difficult-to-Fail-and-Unwind Banks in the US and EU Before and During the Great Recession, which "models and estimates ex ante safety-net benefits at a sample of large banks in US and Europe during 2003-2008. They report that "our results suggest that difficult-to-fail and unwind (DFU) banks enjoyed substantially higher ex ante benefits than other institutions."

This result suggests that current practice increases moral hazard and creates an incentive to undertake excess risk and misprice risk. It also disadvantages banks of lesser size and political clout that do not enjoy this benefit. It also presumes upon public finance in the expectation of preferential treatment owing to systemic risk, which creates a kind of aristocratic privilege. The authors summarize:

Accounting standards for recognising losses make it hard to detect if a bank is going under. The signs of a bank’s insolvency are slow to surface. During the housing and securitisation bubbles that preceded the 2007-2008 financial meltdown, top managers and regulators of US and EU financial institutions claimed that there was no way they could see the build-up of crisis pressures.

Moreover, as the crisis unfolded, these same officials failed to offer timely estimates of the financial and distributional costs of bailing out firms that benefited from open-bank assistance. The result is simple.

• These observational difficulties encourage firms that are large, complex, and politically powerful to plan to shift their deepest downside risks onto taxpayers through the financial safety net.

• The predictability of officials’ panicky willingness in crisis situations to acquiesce in these plans gives banking organisations that are difficult to fail and difficult to unwind what can be termed a “taxpayer put”.

Unless it is perfectly administered and adequately priced, this put supplies intangible capital to every firm that safety-net managers may be expected to protect.

Although these taxpayer puts do not trade directly, contingent-claims analysis offers several ways to estimate their value synthetically from the stock prices of individual systemically-risky firms.

While MMT shows that taxpayers do not fund bail-outs directly, as the authors suggest, since a monetarily sovereign government funds itself with currency issuance rather than taxation, MMT agrees that this does divert public funds from other uses for public purpose, and it constitutes a subsidy to a particular industry segment, owing to its ability to hold the government hostage because of its importance to the economy and political influence.

The authors reject the excuse of regulators that the situation with large banks was too complicated for them to be able to foresee insolvency problems. They conclude that transparency reduces the problem, and that capture, which they label corruption, accounts for ensuing government rescues. The authors conclude:

A useful first step would be to require bank managers to report data on earnings and net worth more frequently – under civil or even criminal penalties for fraud and negligent misrepresentation if they do not. Data on market capitalisation are publicly available in real time, as are data on stock-market returns. If the values of on-balance-sheet and off-balance-sheet positions were reported weekly or monthly to national authorities, rolling regression models could be used to estimate changes in the flow of safety-net benefits in ways that would allow regulators to observe and manage taxpayers’ stake in the safety net in a more timely and effective manner.

UPDATE: To be read in conjunction with William K. Black, Why we need regulatory cops on the beat - and why they make bankers cringe. Prof. Black shows why reporting is not enough. Strict regulation, oversight, and enforcement are required in environments in which fraud is endemic.