Wednesday, October 15, 2008

Deja vu all over again

From a discussion with Alex Blumberg, host of NPR's Planet Money:
New York: Alex, if you are an insolvent (or near-insolvent) bank and you take a bucketful of money from the Treasury in this stock-for-capital plan, why wouldn't you just make the riskiest bets possible? If you fail, you and your shareholders lose little (as your bank was near insolvency to begin with) and if you succeed, you've made a cool buck off of Uncle Sam's generosity. Seems like Hank is just encouraging moral hazard here for small banks, no?

One of my former students (thanks Brian) recognized the question as classic moral hazard in lending. A near-insolvent borrower can make a "heads I win, tails you lose" bet with borrowed funds, so a lender has to monitor the behavior of the borrower to try to limit the riskiness of the kinds of investments borrowers can make.

This is exactly what happened during the S&L crisis in the 1980's.

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