Posts tagged ‘moral hazard’

Corporate Crony Entitlement

This story is simply  unbelievable.  Shareholders of AIG should have been wiped out in 2008 in a bankruptcy or liquidation after it lost tens of billions of dollars making bad bets on insuring mortgage securities.  Instead, AIG management and shareholders were bailed out by taxpayers.

It is bad enough I have to endure those awful commercials with AIG employees "thanking" me for their bailout.  It's like the thief who stole my TV sending me occasional emails telling me how much he is enjoying it.

Now, AIG managers and owners are considering suing the government because the the amazing special only-good-for-a-powerful-and-connected-company deal they got was not good enough.

Directors at American International Group Inc., AIG -1.28% the recipient of one of the biggest government bailout packages during the financial crisis, are considering whether to join a lawsuit that accuses the U.S. government of too-onerous terms in the 2008-2009 rescue package.

The directors will hear arguments on Wednesday both for and against joining the $25 billion suit, a person briefed on the matter said. The suit was filed in 2011 on behalf of Starr International Co., a once very large AIG shareholder that is led by former AIG Chief Executive Maurice "Hank" Greenberg. It is pending in a federal claims court in Washington, D.C....

Starr sued the government in 2011, saying its taking of a roughly 80% AIG stake and extending tens of billions of dollars in credit with an onerous initial interest rate of roughly 15% deprived shareholders of their due process and equal protection rights.

This is especially hilarious since it coincides with those miserable commercials celebrating how AIG has successfully paid off all these supposedly too-onerous obligations.  And certainly Starr and other AIG investors were perfectly free not to take cash from the government in 2008 and line up some other private source of financing.  Oh, you mean no one else wanted to voluntarily put money into AIG in 2008?  No kidding.

Postscript:  By the way, employees of AIG, you have not paid off all the costs of your bailout and you never will.  The single largest cost is the contribution to moral hazard, the precedent that insurance companies, if sufficiently large and well-connected in Washington, can reap profits on their bets when they go the right way, and turn to the taxpayer to cover the bets when they go wrong.

The Anti-Responsibility Law

Congress just passed a new $26 billion payoff to state governments, easing the pressure on states to institute some sort of fiscal responsibility.  The follows on the heals of last year's tens of billions of dollars in direct aid to state budgets in the original stimulus bill.

Taking the pressure off states for real fiscal reform is bad enough, but this is worse:

Maintaining the salaries and generous benefit plans for members of teachers unions is indeed a top Democratic priority. That's why $10 billion of the bill's funding is allocated to education, and the money comes with strings that will multiply the benefits for this core Obama constituency.Specifically, the bill stipulates that federal funds must supplement, not replace, state spending on education. Also, in each state, next year's spending on elementary and secondary education as a percentage of total state revenues must be equal to or greater than the previous year's level.

This is roughly equivalent to the government telling mortgage holders that took on too much debt that the government will bail them out, a clear moral hazard.  But then it goes further to force the mortgage-holder to promise to take on a bigger mortgage next year.  Unbelievable.

In a move right out of Atlas Shrugged, Texas is singled out for special penalties in the law because, well, it seems to be doing better than all the other states economically and is one of the few that seem comitted to fiscal responsibility

For Texas, and only Texas, this funding rule will be in place through 2013 [rather than 2011]. This is a form of punishment because the Beltway crowd believes the Lone Star State didn't spend enough of its 2009 stimulus money.

So much for equal protection.  This Congress sure has set an incredible record for itself in choosing to reward and punish individual states (remember Nebraska and Louisiana) in its legislation.

The WSJ thinks perhaps a different kind of multiplier, other than the Keynesian one, is behind this legislation.

Keep in mind that this teacher bailout also amounts to a huge contribution by Democrats to their own election campaigns. The National Right to Work Committee estimates that two of every three teachers belong to unions. The average union dues payment varies, but a reasonable estimate is that between 1% and 1.5% of teacher salaries goes to dues. The National Education Association and other unions will thus get as much as $100 million in additional dues from this bill, much of which will flow immediately to endangered Democratic candidates in competitive House and Senate races this year.

Consider the Incentives

Consider the incentives for a bank trying to set the risk profile of its investments.  Should it go for higher returns at higher risk, or dial back the risk at a cost to near-term profits?  Now consider this decision in the context of two actions from the past year:

  • Large banks that took on too much risk are bailed out and management mostly preserved
  • Banks that eschewed higher profits by avoiding bad risks are now forced to pay for the bailout of those that went wild:

Obama administration officials and lawmakers are scrambling to find a way to funnel some of the financial industry's record earnings back to the taxpayers who helped rescue the industry from looming disaster.The White House is considering a fee on banks and other financial companies

as one approach, with revenues earmarked to help recoup any losses from the government's $700 billion bailout fund, a senior administration official said.

Some in Congress want to add a new tax on bonuses or assess a small fee on all stock transactions, which would hit large banking companies the hardest.

Note that there is no attempt here to only charge banks who received bailout money, but all banks will be charged equally.  To each according to his need, from each according to his ability.  This is moral hazard in spades.

Bank Failures in Perspective

Bank failures in the last coupe of years, in terms of institutions as well as assets, are still well below the S&L crisis of the 1980's.  So what justifies the current nationalization of the banking sector and the short-circuiting of institutional failures and the subsequent creation of moral hazard.  Via Carpe Diem.

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Moral Hazard Continued at GMAC

From the AZ Republic:

GMAC, the former lending arm of General Motors Co., is in talks with the Treasury Department for a third injection of taxpayer aid, a further sign of the U.S. government's entrenchment in the U.S. auto industry.

The Treasury Department mandated earlier this year that GMAC Financial Services raise an additional $11.5 billion in capital after undergoing a "stress test" along with 18 other banks. While other banks deemed undercapitalized have been able to raise funds from private investors, GMAC has been forced to go back to the government.

Maybe the reason no one but Obama will give GMAC any money is that they know that every time GMAC gets any money, it simply starts shoveling it at every car buyer who walks within shouting distance of a dealership and can fog a mirror.

Immediately after GMAC became eligible for TARP money, GM reduced to zero the interest rate"¦ on certain models. ...

GMAC has begun making loans to borrowers with credit scores as low as 621, a significant relaxation of the 700 minimum score the company adopted just three months ago as it struggled to survive. America's median credit score is 723"¦

GMAC is a giant ponzi scheme to subsidize car sales.  Ponzi schemes last only so long as there is a sucker to keep putting in money.  No private funds are that dumb, but fortunately for GMAC there is the Obama administration.

Can You Say, "Moral Hazard?"

Moral hazard is the term for what occurs when one shelters an entity from the full cost or downside of taking risks.   The result is that the entity will tend to take on more risk than it would have had it had to bear the full costs.  For example, if a company knows that the government will make up the shortfall if its pension investments suffer, it will tend to invest in high-risk, high-return investments that reduce the company's need to contribute funds in the good years.   This is sometimes called privitizing profits and socializing losses.

One of the problems with demonstrating moral hazard is that the hazard often occurs years after the action (usually a government action) that creates the hazard.   But this week we have an amazing opportunity to see moral hazard operating within days of a government bailout:

Immediately after GMAC became eligible for TARP money, GM reduced to zero the interest rate"¦ on certain models. This, of course, penalizes GM competitors, including Toyota, Honda and other "transplants" whose cars are made in America by Americans for Americans, and Ford, which does not have the freedom of maneuver conferred by TARP money because Ford is not taking any"¦

GMAC has begun making loans to borrowers with credit scores as low as 621, a significant relaxation of the 700 minimum score the company adopted just three months ago as it struggled to survive. America's median credit score is 723"¦

If you pay people trillions of dollars in response to a bad behavior (in this case, credit lenience) then you will just encourage more of that behavior, even if everyone achnowleges it to be a bad behavior.

$485 Billion in Value Destroyed, and Counting

David Yermack has an awesome essay in the WSJ this weekend, encouraging Congress to just say no to spending $25-$50 billion bailing out Ford and GM.  Why?  Well, beyond the obvious moral hazard, these companies are value destruction machines of epic proportions.

Over the past decade, the capital destruction by GM has been breathtaking, on a greater scale than documented by Mr. Jensen for the 1980s. GM has invested $310 billion in its business between 1998 and 2007. The total depreciation of GM's physical plant during this period was $128 billion, meaning that a net $182 billion of society's capital has been pumped into GM over the past decade -- a waste of about $1.5 billion per month of national savings. The story at Ford has not been as adverse but is still disheartening, as Ford has invested $155 billion and consumed $8 billion net of depreciation since 1998.

As a society, we have very little to show for this $465 billion. At the end of 1998, GM's market capitalization was $46 billion and Ford's was $71 billion. Today both firms have negligible value, with share prices in the low single digits. Both are facing imminent bankruptcy and delisting from the major stock exchanges. Along with management, the companies' unions and even their regulators in Washington may have their own culpability, a topic that merits its own separate discussion. Yet one can only imagine how the $465 billion could have been used better -- for instance, GM and Ford could have closed their own facilities and acquired all of the shares of Honda, Toyota, Nissan and Volkswagen.

The Bailout is Back

So what does it take to overcome the opposition of Congressmen who said they opposed the bailout bill as too expensive, too big of a giveaway, and too much of a moral hazard?  Why, more moral hazard (in the form of higher FDIC insured balances), increased spending, and, incredibly, money for alternative energy.  Are these guys a joke or what?  (HT Hit and Run)

By the way, I had a conversation yesterday with a very anti-Bush, anti-Iraq-War Democrat -- the sort that can't get through a five minute conversation without making a Dick Cheney crack.  She was lamenting the failure of the bailout package in the House and excoriating Republicans for being so ignorant and narrow-minded.  My response was:

I find it surprising that you take this administration on faith in its declaration of emergency in the financial sector.   You've lamented for years about the "rush to war" and GWB's scare tactics that pushed, you felt, the nation into a war it should not be fighting, all over threats of WMD's that we could never find.  You lamented Democrats like Hillary Clinton "falling for this" in Congress

But now the mantra is the same - rush, rush, hurry, hurry, fear, fear, emergency, emergency. Another GWB declared crisis in which the country needs to give the administration unlimited power without accountability and, of course, stacks of taxpayer dollars to spend.  A decision that has to be made fast, without time for deliberation.  Another $700 billion commitment.     And here the Democrats go again.  Jeez, these guys may have the majority in Congress but it is sure easy for GWB to push their buttons when he wants to.  Heck, Pelosi is acting practically as the Republican Whip to get GWB's party in line.

This is Iraq without the body bags, and without the personal honor of brave soldiers in the trenches to give the crisis some kind of dignity.

Blogging on the Bailout

I would blog on the most recent bank bailout, but I don't really understand what the proposal is.  The administration apparently wants to take $700 billion and ... do something with it.  Frankly, I would prefer them to just let the banks totter over and spend the money, if they really feel it necessary, to clean debris up afterward, as they did with the RTC in the 1980s.   At least that way we would avoid the moral hazard and know the money was going to cleaning up the worst messes.  My guess is that $700 billion pseudo-randomly injected into whatever companies can cry the loudest at the treasury's door is not only creating bad incentives, but is probably going to waste at least half of the money.

Moral Hazard

The Anti-Planner has a series of posts of late on light rail that in total point to a perverse moral hazard in public transportation funding that helps to explain why states and cities are building so many rail projects, when the numbers almost never make any sense (as I blogged for LA, Phoenix, and Albuquerque).  Though the Anti-Planner does not state these rules, from his recent posts I have inferred three rules:

  • A city can get capital construction dollars from the feds, but you can almost never get maintenance or operations money (similar story in recreation)
  • The feds will fund big, expensive, sexy rail projects.  They will not fund purchases of buses and are unlikely to fund something so prosaic as a bus stop or terminal  (general rule of thumb:  federally funded projects must be large enough to justify being named at some future point after the local Congressman or Senator who earmarked the project.)
  • It is very easy to de-fund bus systems -- you just don't replace aging buses and cut routes over time.  It is hard to de-fund, or, god forbid, abandon a rail line, since the thing sits out there so visibly.  Sunk costs can also be a political issue if rail lines were to be closed.

For most public transportation goals, particularly in spread out western and southern cities, buses are a cheaper and higher service solution than rail.  They can carry the same passenger traffic for far less total dollars (capital plus operating costs) and they can cover far more routes.  In fact, one can argue that rail lines are inherently regressive, as they tend to serve commuting corridors of the middle and upper classes rather than the typical routes of the poor, for whom the systems are nominally built.

So what can one expect by the application of these three rules?  Well, we would expect local authorities to favor large, expensive capital rail projects rather than refurbishment or expansion of bus systems.  As operating costs rise for the trains, we would expect bus service to be cut back to pay for the rail operating deficit.

Stlouis
Which is exactly what happens.  In fact, rail tends not to increase total ridership at all, at best shifting ridership from inexpensive buses to expensive trains, and at worst decreasing total ridership as rail lines with just  a few stations and routes replace more extensive webs of bus transport.  And, in twenty years, when these rails systems need extensive capital overhauls, we find cities with huge albatrosses on their hands that they are unable to maintain or update.

New Study on Malpractice

A new study on medical malpractice decisions by Alexander Tabarrok and Amanda Agan of George Mason University was released last week.  A lot of the study is dedicated to countering some economically-ignorant canards (e.g. the charge that the recent rise in malpractice insurance is all due to price gouging and not due to malpractice awards).

The most interesting piece is where they compare malpractice awards to results of the independent medical review board rulings.

Our test finds that the tort system and review system do not correlate. Figure Five shows that
adverse actions per doctor in the medical review board system do not correlate with the number of medical malpractice cases per doctor in the tort system, nor do they correlate with the
average award per doctor....                               

In no case is the correlation large; in some
cases, it is actually slightly negative. What these results indicate is that the two systems
we have for determining malpractice, the tort
system and the medical review system, result 
in very different determinations of malpractice.
Surely, one of them is wrong!

The conclusion is one I think many neutral parties have suspected for quite a while:  The tort system is doubly broken:  Bad outcomes that truly are the result of malpractice often do not result in an award, while numerous tort awards go to people who are not the victim of any real malpractice.  Or to put it simply, people who are owed restitution aren't getting it and people who get money often shouldn't be owed anything.

The obvious result is a gross miscarriage of justice.  However, there is a second, less talked about result:  If the tort system is random, having no correlation to real doctor error or doctor quality, then it is impossible to charge doctors with risk-adjusted premiums.  In an efficient market, the worst doctors would pay the highest premiums and would get driven out of the market, just like bad drivers must change their behavior or face lifelong high auto premiums.  However, if tort awards are not correlated with bad behavior, as the study implies, then the system creates a huge moral hazard, with bad doctors underpaying for insurance and good doctors overpaying.  The result is that at best, good doctors will be driven out of the system at least as frequently as bad doctors.  At worst, good doctors, frustrated by the lack of justice in the system, will actually be more likely to leave the system than bad doctors.

Lawyer Tax on Workers Comp in Florida

First, a little background as I understand workers comp:  Years ago, government, workers and employers effectively made a deal that has worked pretty well for everyone.  In that deal, workers gave up the right to sue for workplace injuries in exchange for a program where employers were required to contribute to a workers comp fund and employees are paid by a government bureaucracy for their health care and lost time.  The system is "no-fault" to the extent that it does not matter if the worker is hurt because the employer had unsafe conditions or if the worker is hurt because he did something boneheaded in violation of rules - either way he gets paid the same.  The system avoids moral hazard at least on the employers side by charging higher premiums to employers that have higher claims rates  (based on an experience mod system explained here).  Employee moral hazard (ie cheating) is supposed to be policed by the bureaucracy, and one can evaluate how much cheating is going on by how high the rates in the state are.  California used to have very high rates and lots of cheating, but has cracked down of late and things are better.  Florida is the king of workers comp fraud and employee cheating, so much so that many national insurers won't touch Florida and our rates are twice as high (or more) in Florida than in other states.

Already frustrated with Florida over the high amount of cheating and high rates, two things I have seen here of late make me doubly depressed.  First, in the last year or so we have started to see claims paid where in addition to, say, $20,000 in actual compensation to a worker, there is an equal amount paid to lawyers.  The first time, I was irate.  Why are my workers comp dollars going to lawyers?  The whole point of the workers comp system is to substitute an administrative no-fault claims system for expensive lawyers and trials.

So this week I get my second surprise about Florida workers comp.  I am down in Florida, doing some business as well as visiting the in-laws (which is why blogging has been light) when I start to hear radio commercials by law firms that say "If you have been hurt at work, call us first before you claim workers comp."  The message is not even, "call us if you think the administrative decision was unfair" but was "get us involved with every little claim."  Does this mean that I am going to start seeing a lawyer 'tax' on every workers comp claim in Florida?  If so, Floridians must have passed some pretty dumb legislation somewhere along the way.  Now, I might understand this if this was a worker backlash in some state that administratively is over-tough on workers in filing their claims, but Florida has historically been the most generous already.  I am sure most of the employers in this state have experienced the "debilitating injury the day before I was going to quit,"  a tried and true Florida technique for supplementing unemployment insurance for a bit of paid vacation. 

Maybe some of the readers can confirm if Florida did something new legislatively over the past few years that opened this up.  By the way, and I apologize in advance to all my hard-working readers in Florida, but I don't think there is any other state with a larger population of searching-for-something-for-nothing freeloaders than one can find in Florida.  Something culturally seems to be wrong here, and I wonder if Florida might not be the next California, with businesses heading for the exits.

Hurricanes and Big Government

So, unsurprisingly, Paul Krugman and others are arguing that Katrina is a vindication for large-government liberals  (One would think we would love GWB, who has been a better large-government builder than Clinton, but that is another topic).  Anyway, I think it is worth thinking for a second about the federal government and hurricanes.  I will divide the post into two parts:  Preparedness and Response, and show that in fact, large central-government thinking is at the heart of many of the problems that are being faced.

Disaster Preparedness
I cannot come up with any justification for the US Government taking the lead role in local disaster preparation or protection.  The types of disasters are just too wide and varied:  Tidal waves in Hawaii, earthquakes in LA, mudslides in San Diego, fires in the west, tornados in the plains, hurricanes on the gulf coast, blizzards in the north, etc. etc.  And why would anyone want the feds taking over their local disaster plans anyway?  Do you really want to rely on the hope that a national organization has the same priority on your local risks that you do?  The resources, the knowledge, and the incentive to prepare for emergencies are all local, and such preparation should be done as locally as possible.

The only reason locals would even tolerate federal involvement in disaster preparedness is $$$.  Every local politician loves federal dollars.  And even a hardcore libertarian like myself is probably willing to admit that some of the preparedness investments truly are public goods.  Take levees for example.  I am willing to have them as public goods.  However, no one can convince me that levees whose sole purpose in life is to protect New Orleans are federal public goods.  Why do I need to pay for them?  Why don't New Orleans people bear the full cost of their choice to live below sea level?  My family chooses to live in a place that is relatively free of disasters (though if the Colorado River dries up you can come visit our bleached bones as we are consumed by the desert).  Why should I subsidize people's choice to live in a location that sits in mother nature's cross-hairs?

But beyond my cantankerous libertarian desire not to subsidize you, those of you who live in disaster areas should demand to take responsibility for your own preparedness.  The feds are never going to value your safety the same way you do (as evidenced in part by the 40-year ongoing fight for levee funding in New Orleans) and are never going to understand your local problems like you do.  In fact, the illusion of federal responsibility for disaster preparedness is awful.  It gives irresponsible local authorities an excuse to do nothing and a way to cover their ass.  It creates a classic moral hazard and sense of false security.

I have resisted saying this for a week or so out of respect for the plight of individuals still struggling in Louisiana and Mississippi:  If one divides the world into the ants and the grasshoppers (per the classic fable), New Orleans and Louisiana would make the consensus all-grasshopper team.  They have lived in a stew of bad and corrupt government for years, mixed with a healthy dose of Huey Long-style patronage that created expectations that "you would be taken care of".  Their state officials have for years not only been grasshoppers, but have demanded that they be supported by the ants, and seem lost and confused that the ants didn't protect them somehow from Katrina.

Disaster Response
Its probably good to have a national body that can help focus resources from around the nation onto local regions that have been devastated by some disaster.  But here is the key point.  The federal government itself is never, ever going to have the resources stockpiled somewhere to handle a disaster of this magnitude.  They can't have the doctors on staff, the firemen waiting around, the medical supplies in a big warehouse, a field full of porta-potties ready to deploy, etc. etc.  There is just too much needed, and the exact needs are too uncertain.

What they can do, though, is understand that in an emergency, Americans from all over the country are always willing to help, to volunteer their time or skills or money to aid the victims.  More than anything, the Fed's role needs to be to remove barriers from these resources gettting to the the right places as fast as possible, and to backstop these private efforts with federal resources like the military.  Take the example of refugees.  There are over a million from this hurricane.  Of those, at least 90% will be helped privately, either from their own funds or friends or family or private generosity.  Probably more like 95+%, if you include resources offered by local governments.  The feds role then is to help the remaining 5% find food and shelter.  Note, though, that the problem is not dealing with 100% of the problem, it is dealing with the 5% the leaks through bottom-up efforts, while removing barriers that might stand in the way of bottom-up efforts helping the other 95%.

Unfortunately, the feds don't think this way.  Most feds, including Krugman type large government folks, distrust private and bottom up efforts.  They are top-down technocrats, putting an emphasis on process and control rather than bottom-up initiative.  I wrote much much more about the failed technocratic response to Katrina here.  I think one can argue the reason that the refugee situation for 95% of the people worked well is that these folks quickly got out of the sphere of influence of the FEMA folks -- in other words, they got far enough away to escape FEMA control.  Can you imagine what a total disaster would be occurring if FEMA tried to control the relocation of all 1 million people?  But on the LA and MS gulf coast, FEMA is exercising total control, actually preventing private initiative from helping people, and everyone is the worse for it.  I encourage you to read more in this post about valuing control over results, but I will leave you with this one anecdote that sums up the big government technocratic top-down world Mr. Krugman longs for:

As federal officials tried to get some control over the deteriorating
situation in New Orleans, chaos was being replaced with bureaucratic rules that
inhibited private relief organizations' efforts.

"We've tried desperately to rescue 250 people trapped in a Salvation Army
facility. They've been trapped in there since the flood came in. Many are on
dialysis machines," said Maj. George Hood, national communications secretary for
the relief organization.

"Yesterday we rented big fan boats to pull them out and the National Guard
would not let us enter the city," he said. The reason: a new plan to evacuate
the embattled city grid by grid - and the Salvation Army's facility didn't fall
in the right grid that day, Hood said in a telephone interview from Jackson,
Miss.

"No, it doesn't make sense," he said.

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