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The mother of all moral hazard problems

May 11th, 2010 · No Comments

The true meaning of ‘lender of the last resort’…

Credit Crisis Mark I (2008 vintage) was in essence banks speculating with other peoples money, and getting bailed out because letting them fail (Lehman!) was a worse option.

Credit Crisis Mark II (2010 vintage) is Sovereign Debt exploding as a result of Credit Crisis Mark I.

Credit Crisis Mark II was potentially much more dangerous even than Mark I, because:

  1. Both banks and nations involved, banks involved now because they hold large amounts of Sovereign debt (indeed, it has been their most important profit machine the last year or so). Banks cannot be bought out again by overstretched Sovereigns
  2. The location of the crisis: the euro area. Slow, Byzantine decision making invariably behind the curve (up until last Friday, boy did they redeem themselves), no central authority, countries tied together by the hip because of the euro, no devaluations possible for the most problematic cases, and a central bank (the ECB) whose whole existence was founded on the belief not to play ball under these kind of circumstances.

The significance of last Sunday’s measures lies in the ECB giving up on those beliefs. Faced with an alternative that would have been worse, they had little choice.

Buying Greek debt of the books of European banks paves the way for a more orderly (and near inevitable) Greek debt restructure. ECB here to save the day. Who would have thought..

Now we know. No matter how big the problems, there will always be a lender of last resort. The mother of all moral hazard problems has been created. Although this is for later, but this should be defused. Preferably by creating banks facing incentives against risky one-way betting with other people’s money, and Sovereign States facing real consequences of shifting burdens to next generations (or the ECB).

Tags: Sovereign debt crisis