Cato Institute
Briefing Paper
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Monetary policy
between interest rates on subprime loans and
Introduction
those on safe treasury securities increased
can generate
dramatically, indicating rising risk aversion
moral hazard if it
to that market.3
"The Fed . . . is unwittingly contribut-
is conducted in a
ing to a form of moral hazard--that it
The carnage continued into 2008 and
stands by ready to prop up the market
eventually claimed investment house Bear
manner that bails
if it fails, but will do nothing to stop it
Stearns, bailed out by JP Morgan Chase with
investors out
going up too high."1
assistance from the Fed and U.S. Treasury.
of risky and
The U.S. economy experienced a serious
In recent years, investors have rationally
slowdown, as measured by the anemic annu-
otherwise ill-
come to believe that the Federal Reserve will
alized growth rate for real GDP of 0.6 percent
advised financial
intervene to prevent or offset the effects of
in the fourth quarter of 2007. That weak rate
declining asset prices. That belief was first
of growth was repeated in the first quarter.
commitments.
summarized in the phrase "the Greenspan
Technically, the economy did not fall into
Put," now the "Bernanke Put." The current
recession.
financial crisis is at least partly the outcome
The seeds of the subprime crisis were sown
of this new approach to monetary policy.
years earlier, and the collapse in that submar-
Since the 1930s the federal government has
ket of mortgage lending is linked to previous
insured bank deposits. That scheme inherent-
financial eruptions, such as the high-tech and
ly reduced the vigilance of bank depositors
telecom bust. The subprime collapse spread to
toward their banks, removing constraints on
other segments of housing finance. The crisis
risk taking by the insured depository institu-
in housing finance in turn spread to other
tions. The situation became acute in the 1980s
credit markets, even to interbank lending. The
and 1990s, when undeterred risk taking by
financial crisis is the latest in a series of finan-
banks and thrift institutions led to a series of
cial bubbles whose existence reflects, at least in
financial crises. Eventually the deposit insur-
part, moral hazard in financial markets.
ance system was reformed and banking put on
Moral hazard is the outcome of explicit or
a sounder basis. It is time for a similar reform
implicit guarantees to investors. At one time,
of monetary policy.
deposit insurance was a major culprit. Today,
monetary policy is fostering moral hazard.
Monetary policy can generate moral hazard if
The Subprime Mortgage
it is conducted in a manner that bails in-
Crisis
vestors out of risky and otherwise ill-advised
financial commitments. If investors come to
The popular press discovered subprime
expect that the policy will persist, then they
mortgage loans when two major originators of
will deliberately take on additional risk with-
such loans, HSBC Holdings PLC and New
out demanding commensurately higher
Century Financial, disclosed increased loan loss
returns for that risk. In effect, they will lend
provisions. HSBC is a globally diversified finan-
at the risk-free interest rate on risky projects,
cial company and survived the crisis intact. New
or at least at a lower rate than would other-
Century Financial fared much less well because
wise be the case. Too much risky lending and
of the concentration of its lending in this risky
investment will take place. Capital will have
category. Its stock price collapsed after prob-
been misallocated.
lems surfaced on February 8, 2007, and the
company eventually declared bankruptcy.2
Monetary Policy
Problems spread to other lenders in the
subprime market. By the end of 2007, more
than 100 mortgage companies had suspend-
To simplify a complex theoretical issue, an
ed operations or sought buyers. The spread
ideal monetary policy is one that facilitates
2