Moral hazard of bail outs

What is the length of the memory of a legislative body? Spencer Bachus, a Republican congressman from Alabama, has provided an answer: 25 years. By leading the House Committee on Financial Services last week in approving an increase in federal deposit insurance to $130,000 from $100,000 for individual accounts at savings and loans institutions and banks, Mr Bachus proved that many in Congress have forgotten what happened in 1980, the last time it increased deposit insurance. The effect was to let savings and loans executives off the hook for their actions. They responded like boys at a paintball party - spraying money wildly and making colourful messes of their balance sheets. Congress also whooped it up, tolerating - even supporting - their rampage. In the end, came the crash of the Federal Savings and Loan Insurance Corp (FSLIC), the government-backed agency managing the insurance. The bailout institution itself had to be bailed out - by taxpayers, at a cost of $125bn. The disruption was so great that for a few months the US economy felt positively Japanese.

The savings and loans story is an example of moral hazard, the creation of incentives for irresponsible behaviour. It matters because this season Congress has the opportunity to prevent another moral hazard crisis. This time the moral hazard involves traditional defined benefit pensions and their government-backed insurance office, the Pension Benefits Guaranty Corp.

United Airlines unwittingly underscored the urgency of reform recently when it announced that the PBGC would assume United's multi-billion dollar pension obligations. This new burden comes on top of a $23bn fiscal deficit already in existence, as well as exposure to problem companies worth about triple that.

But that does not include the penalty that moral hazard levies. By rescuing United workers, PBGC is letting the company off the hook. Observing this dynamic, even relatively solvent companies, with traditional pension arrangements may now feel that they too can promise the sky. In the end, in other words, PBGC's woes have the potential to cost US taxpayers just about as much as FSLIC's disaster did.

The parallels are so close as to be scary, as Randall Kroszner, professor of economics at the University of Chicago in United's own hub city, will point out this week at the Chicago Federal Reserve. The old FSLIC guaranteed deposits when thrift institutions could not cover them. PBGC guarantees pensions when companies cannot provide them. FSLIC collected premiums from members; so does PBGC. FSLIC set premiums too low; PBGC does too. Both agencies covered or cover industries that suffered serious financial shocks. In the early 1980s, interest rates rose even as property values fell, badly damaging the books of savings and loans. In the past five years, the terrorist attacks of September 11 2001, the crash of the stock market and the subsequent downturn have hurt industries that tend to maintain traditional pension arrangements. In both instances, a consumer-oriented media wilfully overlooked the potential systemic damage for years. After all, no one wanted to tell depositors they would not get their money, just as today no one wants to tell workers at other companies that their pension insurance is being traded away when PBGC bails out United. Lawmakers ignored problems for years.

Eventually, however, Congress did act on the thrift institutions, disbanding FSLIC. The ideal would have been to end government-sponsored deposit insurance altogether, so that lenders could be certain there was no chance of a bail out. Instead, it gave the deposit insurance job to another agency, the Federal Deposit Insurance Corp. New rules allowed premiums to be adjusted so that they more accurately reflected the risks involved. The effect was to make federal deposit insurance something closer to - but hardly identical to - a genuine insurance business. The shift caused a dramatic personality change among thrift executives. Paintballer boys became relatively prudent investors.

The good news in the PBGC case is that it is still early enough to forestall disaster. Elaine Chao, the labour secretary, has not proposed to kill off the PBGC nanny. But she has put forward reform proposals that would make it easier for PBGC to peg its premiums to reality. Joshua Bolten, the White House budget director, has suggested that PBGC reform might be "a caboose" tied to other legislation this year.

The bad news in the PBGC story is that nobody is acting boldly enough. The correct thing to do with PBGC is not to improve it. It is to privatise it. But only professors, such as Mr Kroszner, are brave enough to suggest that. And as long as an entity remains affiliated with government the potential for abuse remains. This is true for pensions and thrift institutions but also of larger challenges such as Social Security, as President George W. Bush noted recently. Moral hazard is the central challenge of Fannie Mae and Freddie Mac, the elephantine mortgage finance companies.

And, as Mr Bachus demonstrates, memories fade. Even the reforms of the 1990s may not be enough to counter the incentive to irresponsibility that such an increase represents. That is the pattern with moral hazard. Easy to create; nearly impossible to eliminate.

© Copyright 2005 Financial Times

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