The Fed Bailout: Beware the Moral Hazard

Last Updated Mar 12, 2008 6:25 PM EDT

The Federal Reserve's decision to pump $200 billion into the hands of American banks deserves a cautionary yellow-flag.

The Fed is clearly putting taxpayer dollars at risk by allowing the banks to trade their funny money mortgage-related instruments for Treasury bonds and bills. The banks don't know what these instruments are worth and they may be worth a fraction of their face value. So the Fed is doing the banks a huge favor.

But in so doing, the Fed is encouraging the idea that the banks are too big to fail. If they get in trouble, the Fed will ride to their rescue. That essentially is a form of socialism in reverse: the banks are free to go out and make money and keep their profits in good times. But when bad times hit, they get government help. What incentive do they have to clean up their acts in that policy climate?

To avoid his moral hazard, the Fed should be doing three things:

--It should be holding the bankers' feet to the fire and forcing weak players to consolidate with stronger players. That's how Japanese authorities handled their bad banking problem in the 1990s. Does Citibank have some sort of god-given right to survive in the face of such massive screw-ups?
--The Fed should be pressing for significant reform in corporate governance at banks that are in trouble. Citibank and Merrill, in particular, simply didn't have the right checks and balances in place.
--Lastly, the Fed should be consolidating its grip over bank regulation. The current system is decades out of date. The Office of the Comptroller, the Securities and Exchange Commission and others are involved in regulating the banks. Which means that the banks can pick the regulators apart. They don't have a chance to understand what's happening. That problem should get fixed.

If the Fed were to engineer those steps, we might see meaningful changes in how these financial institutions conduct themselves. Otherwise, they may be wasting our dollars.