TJP

Treasury’s Moral Hazard

By Byron A. Ellis-October 26, 2008

Assistant Treasury Secretary Neel Kashkari is overseeing the $700 billion bailout of Wall Street that Congress passed on Oct. 3. Kashkari said, during the Senate hearing on October 23, 2008, that the administration was working to get federal purchases of bank stock started quickly and to mop up troubled mortgage-related assets. However, from his testimony, diligence for helping struggling homeowners avoid foreclosure was not evident.

Accordingly, Treasury would encounter difficulties identifying struggling homeowners. A somewhat lame excuse for reluctance in helping homeowners, since Treasury could setup a website where struggling homeowners could enter pertinent information, such as their mortgage holder, number of months and amount delinquent, and so on.

The major problem that Treasury would encounter might be moral hazard from mortgages. But, moral hazard is also applicable to the bailout of financial institutions, particularly when Treasury has not established guidelines for banks that would prevent inappropriate use of taxpayers’ money.

According to Kashkari the government should be careful about "not discouraging prudent acquisitions" if healthier banks wanted to use the extra capital to buy failing rivals. Thus, it appears that the purpose of the bailout has changed from providing more credit to allowing banks to use the fund for acquiring other banks.

Allowing banks to use taxpayers’ money to buy up other banks and become too big to fail will lead to the moral hazard problem.

Moral hazard is associated with individual or organizational behaviors when they do not have to bear the risk of failure. Thus, if homeowners and financial institutions know that they will be bailed out if they make wrong choices, their incentive to behave responsible will be absent.

Kashkari is a product of Wall Street, a former Vice-President at Goldman Sachs & Co. in San Francisco. Thus, he may have a greater incentive to help banks than homeowners with troubled mortgages.

Clearly, it is unlikely that he will remain as a special assistant to Treasury Secretary in the new administration. Therefore, if he forces banks to modify mortgage loans to benefit struggling homeowners, his prospects in the private industry is likely to be adversely affected.

As a result, he stopped short of endorsing Sheila Bair’s plan to use the government’s powers under the bailout legislation to guarantee loan modifications, which would result in lenders sharing any potential losses with the government.

Sheila Bair is the dynamic chairwoman of the Federal Deposit Insurance Corporation (FDIC) and an advocate for loan modification. She understands that if loans are not modified, the economy will continue to have systemic problems. Moreover, she recognizes that Treasury needs to act quickly.

Modifying loans would remedy the existing housing liquidity problem, since it would stabilize housing prices and provide flow of funds to financial institutions.

The problem with Treasury is its blind focus, which is to provide the Fat Cats of Wall Street with all the bailout benefits. Of course, that is where they expect their future remuneration to come from. Hence, there is clearly a conflict of interest between exiting Treasury personnel and the taxpaying public.

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