Saturday, May 23, 2009

Goats and Sheep and Bailouts

Picture of the World Trade Center on 9/11 shor...Image via Wikipedia

Here's an interesting quote I recently came across:

There is a history of unsuccessful outcomes to ponder when Congress has interfered, with the best of intentions, to prop up insolvent financial institutions that got themselves in trouble through poor risk management. The savings and loan crisis comes to mind.
The problem with not allowing insolvent financial institutions to fail is the law of unintended consequences. As leveraged businesses that depend on sound risk management practices to operate successfully with other people’s money, there is nothing more important in managing financial institutions that
(sic) maintaining the correct alignment of incentives for management behavior.

Anytime managements are allowed to make bad risk management decisions and escape the consequences, a precedent is set and lessons are learned. … [T]wo unfortunate consequences result: 1) customers learn not to discriminate − that is, pay for – the value of good risk management and strong ratings, driving down margins so that returns support only the lowest common denominator; 2) some managements learn there are no bad consequences for bad behavior, and take more risk, threatening the system and ultimately increasing costs to everyone.

…. Now, a time has finally arrived in which the sheep and goats of the industry will be separated. It would be unfortunate if the sheep acquiesced with or even encouraged an effort by Congress to dress up the goats to look like sheep.

We have no doubt that some … companies will fail …. These may be companies that were already weak financially … or that have simply accumulated intolerably high loss exposures …. Therefore, we hope that in considering any bailout proposal, Congress will enact it only if truly needed by the industry, with a threshold approach that triggers assistance only if the industry as a whole (not simply weak individual companies) is faltering.

…[T]he last thing the … industry needs is to have the capital of its weakest, least successful players restored through fiat of Congress so that they can rejoin the poker game with a fresh pile of chips.

This quote is from a Morgan Stanley Equity Research North American newsletter dated September 17, 2001. The subject was whether or not Congress should consider a bail out of insurers that were severely negatively affected by the 9/11 attacks.

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