Chapter 10: Moral Hazard, Systemic Risks, and Bailout

Subprime Mortgage Crisis

A financial crisis that began as a result of the lending practices made to subprime borrowers. Mortgage delinquencies, home foreclosures, and a decline in home prices added to the crisis.

risk-taking

A moral hazard exists when a person or entity engages in ______-____________ behavior based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavorable outcome.

Banking Industry

Banks play a key role in the economy because bank lending acts as a multiplier for the money supply. If banks stop lending or are forced to call in loans, this has a direct effect on growth in the economy. Companies whose loans are called may not be able to replace the financing, forcing them to close. Companies seeking to expand will not get loans.

Executive Comp During Subprime Mortgage Crisis: Bear

CEO James Cayne was paid $163M from 2003 to 2007. The firm's executive compensation plan, adopted in 1986, mandated that Bear hit a minimum return-on-equity level before senior brass could receive bonuses. Cayne earned a $33M bonus in 2006. That relentless push for returns led Bear to make risky bets on subprime mortgages that triggered the firm's government-arranged marriage to J.P. Morgan Chase in early 2008.

Executive Comp During Subprime Mortgage Crisis: Lehman Brothers

CEO Richard Fuld was paid $184M in salary, bonuses and stock compensation from 2003 to 2007. To earn bigger fees and bigger bonuses, Lehman not only loaned money to real-estate developers, it invested the firm's own capital in development projects that went bust. The upshot: Lehman was left with billions of dollars of troubled commercial real-estate assets on its balance sheet that triggered huge write downs.

too big to fail

Companies considered to be a systemic risk are called "____________________."

History of Government Bailouts

During the Great Depression, the economy contracted severely causing record unemployment and many corporate and bank failures. The government did not step in to help until it was too late. Ever since, economists have debated actions that might have limited the severity of the Great Depression. One solution was to prevent key firms or banks from going bankrupt because this would stop the "domino effect."

contrary

Each party in a contract may have the opportunity to gain from acting __________ to the principles laid out by the agreement.

What caused the need for Chrysler's need for a government bailout?

High Gas Prices High Interest Rates Types of Vehicles Sold - the company pushed the sale of large vehicles when gas prices high and consumers wanted fuel efficient vehicles (Chrysler made more money on the big vehicles) Downgraded Debt

Chrysler Bailout

In 1979, Chrysler was on the verge of bankruptcy and in desperate need of a $1.5B loan from the federal government. The fear of millions of jobs being lost, along with resurgent Japanese auto industry, had many concerned that an already weak economy could be pushed into a depression. The problems that Chrysler faced came to the forefront in 1979. There were many factors that all worked together simultaneously to put the company on the verge of bankruptcy. All of these factors forced the company to heavily lobby both Congress and the White House for a $1.5B loan to stay in business and protect millions of jobs - a loan which they received

high risks

In the area of corporate governance and systemic risk, moral hazard applies to individual decisions like a CEO taking ________ _______ because she knows the government will step in if things go wrong.

International Perspective

Is all the concern about a "domino effect" justified? The experience of Iceland in the recent financial crisis suggests it is. All three major banks in Iceland failed following a "bank run" on one bank that spread to the others. Iceland's currency and economy quickly collapsed soon after with the stock market losing 90% of its value. The speed and severity of this collapse shows how interconnected the financial system is and the wide effects one failure can have.

simple example of moral hazard

It is rational to assume that fully insured drivers take more risks compared to those without insurance because, in the event of an accident, insured drivers only bear a small portion of the full cost of a collision.

Chrysler experienced similar detriment 30 years later in 2008 with a new bailout, how could the executives of Chrysler allow this to happen?

Maybe it is not an accident. The first bailout showed that they were "too big to fail" so they could produce the most profitable cars and let the government take the risk of gas prices rising.

So, why did the federal government bailout Chrysler, instead of letting it go under?

Saving Jobs Saving Suppliers

T

T/F? Moral hazard occurs when one party in a transaction has the opportunity to take additional risk at the expense of the other party

minimize

The basis for this intervention is the belief that the government can reduce or _________________ the ripple effect from a company-level event through targeted regulations and actions.

intervene

The federal government uses systemic risk as a justification—an often correct one—to ______________ in the economy.

Executive Comp During Subprime Mortgage Crisis: Meryll Lynch

The second largest Wall Street bonus of 2008 was the $39.4M paid out to Thomas Montag. As head of global sales and trading, Montag ran the Merrill unit that piled up the brunt of the company's $15.31B net loss in the fourth quarter of 2008. That unexpectedly large loss forced taxpayers to shell out an additional $20B to Bank of America to make sure its $50B acquisition of Merrill closed in January 2009. Montag is now head of global markets at Bank of America, which is one of the bank's best performing units

Over the years, there have been several government bailouts

U.S. Auto Industry (late 70's to early 80's) Long Term Capital Management (large investment fund) (1998) Airline Industry (2001)

Corporate Bankruptcies

U.S. corporate bankruptcies reached their worst levels in 10 years in 2020 as the coronavirus pandemic upended global industries and struggling companies faced their breaking points. A total of 630 companies declared bankruptcy in 2020. This surpassed the number of filings in every year since 2010.

Moral hazard

___________ ___________ may mean a party has an incentive to take unusual risks in order to earn a profit before the contract settles.

Systemic risk

____________ _______ was a major contributor to the financial crisis of 2008

Government's response to banking industry's major role in the economy

federal guarantees of customer deposits and federal intervention to prevent one bank failure from spreading to others

systemic risk

is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Failure of the system not of each of its parts

moral hazard

is the risk that a party has not entered into a contract or is not performing under the contract in good faith.