Moral Hazard – was the Fed right to intervene?

No problems with liquidity in Iceland

Many column inches have been spent in the past couple of days analysing the Fed’s decision to prop up Bear Stearns while it found a buyer – in the end JP Morgan agreed to buy it for around 10% of the trading price a week before.

What the Fed did was to provide liquidity – effectively to act as a lender of last resort for Bear Stearns. This current credit crisis has in large part been a crisis of liquidity. Trust has dried up, so that banks are unwilling to lend to each other, or customers, pretty much at any price. So institutions that have been relying on being able to roll over short term debt have suddenly found themselves unable to fund themselves at any price. They may theoretically be solvent – their assets are worth more than their liabilities – but that’s worth very little if they are forced to sell their assets at fire sale prices to cover their maturing liabilities.

I certainly don’t think that the Fed should intervene in a traditional solvency situation. But the question is more nuanced if the crisis is one of liquidity. At some point, forcing institutions to liquidate their assets does risk the crisis becoming greater as fire sales of assets force prices down further than they would otherwise go if one was measuring their “intrinsic value”.

The trouble is figuring out where is that point? At what point does a reduction in asset prices that is the effect of bursting a bubble become a panic that should be avoided at all costs, even at the risk of propping up commercial enterprises that knowingly took on the risks that are now going bad?

If you do provide cover for the financial system, you run the risk of creating moral hazard – the hazard that people will be overly willing to take risks (beyond their actual costs) because they know they will get bailed out by someone. The consensus from the opinion columnists that I’ve read so far is that the intervention was the right thing to do. The panic would have been worse. And certainly the fallout from the fire sale that would have ensued otherwise would be world wide (and certainly affected the company I work for, and potentially my bonus this year). But their shareholders have been very happy on the upside of this risk.  John Quiggin points out that the senior management of Bear Stearns are going to do pretty well out of it.