Thursday, February 11, 2010

Moral Hazard Made Easy

Baseline Scenario has their latest, well, "Baseline Scenario" here. I found a couple of points illuminating:
10) Good times will bring surplus savings in many emerging markets. But rather than intermediating their own savings internally through fragmented financial systems, we’ll see a large flow of capital out of those countries, as the state entities and private entrepreneurs making money choose to hold their funds somewhere safe – that is, in major international banks that are implicitly backed by U.S. and European taxpayers. 
11) These banks will in turn facilitate the flow of capital back into emerging markets –because they have the best perceived investment opportunities – as some combination of loans, private equity, financing provided to multinational firms expanding into these markets, and many other portfolio inflows. Citigroup, for example, is already emphasizing its growth strategy for India and China.

In layman's terms, emerging markets (which include countries like China, India, and Brazil) will continue to grow, and their growth will mean that they will have excess capital. These countries can't just stuff this cash under a mattress, so they have to put it somewhere.
But the banks in those countries are not exactly reliable. Or at least not as reliable as big American and European banks.
Why is this? Because the big banks in America and Europe are now guaranteed by you and me, the taxpayers.
So what will these big Western banks do with all that money?
Well, they have three basic choices:
1) They can hold on to it, and use it shore up there weak balance sheets, to ensure that, if there is another crisis (as many economists expect), they won't collapse.  or...

2) They can direct it towards less risky ventures, including things right here in the US.

They won't choose either of these two options, because shoring up balance sheets or investing in less risky ventures-while good for the banks and the financial system in the long run-doesn't pay very much. And the executives in charge of these big banks get paid a lot more when the banks make big profits. And since you and me (taxpayers) are going to bail them out anyway, there is no reason for them to try to avoid blowing up. After all, these banks were saved from blowing up by the taxpayer a year or so ago and their executives are making more bonus money then ever. So there is clearly no reason to worry about that.

3) They can direct it towards extremely risky ventures somewhere in an emerging market like China or India.

This, of course, is the option they will choose. Emerging markets are very risky. If you loan money to people in these markets, there is a good chance you'll never see it again. That's why banks can charge high interest rates on these loans. Banks that collect high interest rates make big profits, which equal big bonuses. And if the loans go bad, and the banks get in trouble, well that doesn't matter either, because the taxpayers will just bail them out again.

It's sort of like if you told your friend he could lend as much money as he wanted to the drunk guy on the corner, and that he could charge as much as he wanted for interest, and that you'd cover him if the drunk guy didn't pay up.

Don't you think that you'd want to charge your friend for this guarantee? Of course you would. (Actually, you wouldn't want to do this even if you
were charging him for it; but if you had to do it, you'd be damn sure you charged for it.)

So how much do you think taxpayers should be charging big banks for their guarantee?

You might be surprised to learn that we aren't charging them anything. And the value of that guarantee is immense. It's yet another form of bank bailout, in addition to TARP and trillion dollar guarantees and bailouts of counterparties and interest-free government loans. And all of this will lead to Baseline's 22nd and final point:

22) We are steadily becoming more vulnerable to economic disaster on an epic scale.
You aint seen nuthin' yet.

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