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 In The Deal NewsWeekly Gene Colter of Peppercom, a New York-based communications firm, analyzes the lesson of the Bear bailout, and why moral hazard is here to stay.
The scariest lesson from the Bear Stearns Cos. meltdown? Moral hazard has become the premier business model on Wall Street, and we're stuck with it. Future accounts likely will hold that the Federal Reserve and other authorities did well to facilitate J.P. Morgan Chase & Co.'s fire-sale acquisition of Bear and prevent damage to the entire financial system. But the larger implications for the marketplace give pause: Do we really want our financial institutions to operate with the belief that they will never have to face the ultimate downside -- failure -- and thus have little or no incentive to undertake structural overhauls to at least lessen the pain we will all feel come the next seismic market event?
We have come to accept this sad state of affairs for certain business organizations. Amtrak, the railroad operator, comes to mind. But that perennially creaky, quasi-government outfit mainly disadvantages only a subset of commuters who are resigned to their plight. The country's largest financial firms touch all points on the globe via their work in corporate and government finance.
It's this very interconnectedness that dooms any effort to undo the moral-hazard business model. In the Bear deal, some stakeholders get a bit of relief at the expense of the always-backsliding effort to make Wall Street accountable to the economy whose fortunes it helps broker. The forces of interconnectedness run wide and deep. They were there to encourage uncontrolled risk taking on the Street even before the Fed stepped in to back the Bear Stearns deal. Chief among them in the context of the credit malaise: the "structured finance" business known as securitization, one of Wall Street's most profitable offerings. The business of turning payments on mortgages and other loans into securities began as a way to apportion risks (and their concomitant returns) to those who could and should hold it. This is a good thing. But thanks to a toxic cocktail of ready-to-abuse accounting rules, willful complexity and hubris, securitization became something else altogether: a way for even the most iffy payment streams to blow a quick kiss to Wall Street balance sheets en route to new homes in special purpose vehicles that the Street firms said (and regulators agreed) they didn't control. The structured products that followed plain-vanilla securitizations, such as collateralized debt obligations, in turn served to cast risk about in such a way that even the most sophisticated institutions couldn't keep track of their own exposures, much less that of their counterparties. The smoke is still clearing, but the symbiotic relationship between the interconnectedness of risk ownership and moral hazard is clear to see. Another, relatively new factor in the interconnectedness: sovereign wealth funds. These powerful government funds understandably do not want to see their investments fail, even if that eventuality ultimately would lead to improvements in the overall financial system. So with these and other forces of connectivity allowing firms to operate without fear of failure, what can be done to compel Wall Street to at least consider ways to better manage the downside? More regulation of course is on the table, including the Treasury-led plan to give the Federal Reserve broader oversight of the financial system. But regulation is unlikely to make Wall Street take on the truly Herculean task of creating the risk infrastructure needed to act as a counterweight to moral hazard. Such an infrastructure would need to be -- to use the term of art -- holistic. (Another way to describe it: like Goldman, Sachs & Co.) Across much of Wall Street, risk management is still a series of one-act plays, operating exclusively within each business unit and rarely getting out to meet the rest of the outfit. Some firms are looking at breaking down the operational silos that have institutionalized poor risk management. But with the prospect of a bailout always on the agenda -- thanks, moral hazard -- the temptation is to give risk management short shrift. "In an environment where you can safely reach the conclusion that you can say to a firm the size of Bear Stearns that your risk is underwritten by the Fed, why make those investments?" asks Benn Steil, director of international economics at the Council on Foreign Relations. Why indeed. Gene Colter is editorial director at New York communications firm Peppercom. Categories Deal Video
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