Jan. 23rd, 2009

litch: (Default)
You hear the phrase "moral hazard" on political shows a lot, particularly from pompous rightwing popinjays complaining about government bailouts. It's a pretty simple concept, encouraging people to behave badly through the structure of your actions. I generally think the concerns spoken on TV are overblown, there are always going to be some incentives in your actions to behave badly but good management practices and the enlightened self-interest we should expect from a reasonable person should mitigate the behavior from going too far (perhaps this should be called the Greenspan fallacy).

However here is a textbook case of moral hazard that has cost us several billion dollars:

Merrill Lynch & Lehman Brothers went tits up in mid-september from bad bets in mortgage derivatives. Lehman Brothers was allowed to fail and it spawned a massive Dow collapse and pretty much undermined AIG, most people now think this was probably a bad idea. Merill lynch was slightly better off and the government negotiated a special arrangement where Bank of America would buy Merill Lynch if we (the US tax payer) would guarantee up to $120Bn in losses that came out of Merrill's mortgage trades.

This is the classic set-up for a Moral Hazard, but apparently instead of the managers there stepping up to assuage that risk, they let the traders go back to trading mortgage derivatives like they hadn't done anything wrong. They thought they were at the bottom of the market but we know now the market didn't bottom out until the end of October. Those traders racked up another $16 Billion in losses just in the 4th quarter alone after they got their asses pulled out of the fire.

What did Merrill Lynch do to those managers who let that happen? It gave them $4 Billion dollars in bonuses.

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litch

May 2009

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