hazard by definition is when one is protected from risk, owning insurance for example, who acts differently if they did not have that protection. The existing problem of moral hazard is usually found in the insurance industry, and it is a constant worry for insurance companies that by subsidizing risky actions, that people are encouraged to take more risk. For example, a car owner with auto insurance may drive way over the speed limit knowing that if he gets into an accident, the cost of repairs will be covered by insurance. These same principals in insurance claims can be applied to large corporations. “These entities will now be so large that it’s virtually unthinkable to let them fail,” said David Ruder. These companies know that they are the backbone to out economy, and that the government would not let them go under. This means that the American taxpayers will be the ones bailing out the companies when they make financial mistakes. If a company believes that it will get bailed out, decisions with more risk will be made in order to maximize profits. Although the aftershock of a mega company failing may be more costly than just bailing out the company, the government needs to step in and create regulations to reduce moral hazard. “The thing that makes me so mad about this is that Congress has been so quick to spend taxpayers’ money on these companies, yet they’ve been so slow to change the rules that got us into this situation,” said Christopher Paulson. When the Federal Reserve bailed out Bear Sterns, it created a moral hazard around the board. “There’s no question that the moral-hazard question exists with banks this large,” Ruder said, and this notion needs to be reversed by letting companies fail.
Letting companies fail, and giving them no hope for a bailout will nearly eliminate moral hazard. Without the government backing up companies, the corporations will be responsible for their own mistakes. This would be true anti-government regulation which would lead to a more free-market. In an ideal free-market, large companies would be able to fail, just like many small businesses do. However, after the recent meltdown, the government did not seem inclined to let the major banks fail, so a true free-market does not exist. The American tax payers in this case we the involuntary insurers who bailed out the companies. Combined, the taxpayers acted like an insurance company, but unlike a real company, they tax payers did not profit, or gain anything from the bailouts.
Henry Paulson, US Treasury Secretary, claimed that taxpayer money would not be used to bail out companies. Barely 48 hours later, the insurance giant American International Group Inc (AIG) was considered to big to fail, and was in need of a government bailout. However, all arguments have their weaknesses, and I believe that AIG was the one company that actually was too big to fail. They had a huge role in financial insurance contracts for certain types of investments. The problem for AIG was the credit-default swaps, which AIG had to cover the losses for billions of dollars from the plummeted risky investments. If AIG were to go under, the company would have to default on all of the insurance claims where investors all over the world would lose money. AIG is expected to sell some of its assets in order to repay the large amount of debt. Later on, when Lehman brothers went under, they were not bailed out and were force to declare bankruptcy. There was also Bear Sterns which got bought out by JP Morgan Chase who was given $29 billion to buy out the company. Fannie Mae and Freddie Mac were both in trouble, and $200 billion was given to them. These bailout injections continued and were given to numerous companies on the financial district.
As for the US government, they have been working to secure and stabilize the market since the start of the meltdown in 2007. A large problem that needs to be dealt with is the fact that debt collected by companies was highly inflated. The value of these inflated assets was kept high by the assumption that prices would continue to rise, and that the assets could be sold at a high value than they were purchased for. Now with the market lowering back to reality, firms are being crushed by the losses. What the government is doing is injecting currency to prevent hyperinflation. By lowering the value of money, the price of worthless assets will be kept high. Another thing the government can do if change the banking system and apply new regulations. Right now, being “Too big to fail” seems like a reasonable clause, but that should not be the case. The way things are set up right now is that if one bank goes down, other banks have deposits within that bank, so one bankruptcy could lead to the domino effect. A possible epidemic that could happen is when one giant bank goes under, this could cause panic across the board, and would cause people to withdraw their savings from all banks like in 1933. This would end up completely freezing the financial system. During the 2008 meltdown, the government directly bailed out banks to keep them afloat. However, I believe that companies should be allowed to fail, and the bailout money should be directly to the banking customers or depositors. It was the banks faults for playing in the market of risky short term credit default swaps.