G401
September 29, 1998
Professor Rasmusen, Erasmuse@Indiana.edu



NOTES ON MORAL HAZARD
  
      Insurance company  sells  fire  insurance to   a liquor store, which then
sets a fire.
    Insurance company sells  car  insurance to  Rasmusen, who drives more
recklessly then.
   Bank depositors have deposit insurance from  the US Govt., so they  are
willing to put their money in banks that make risky loans.
    A car rental agency rents a car to Rasmusen, who drives like a maniac, free
from financial concern.
  Principal  hires agent to work hard. Agent slacks off. 
 

   (1)   Long Term Capital Management borrows money from banks to  invest. They
take bigger risks with the money than the banks expected.   You might like the
book, Liar's Poker, by Michael Lewis, who was a trader at Salomon Bros. while
John Meriweather, the LTCM head, was a top executive at Salomon.  Lewis says
that Salomon made big profits by selling mortgage-backed securities to foolish
commercial banks which didn't know how to value them or shop around.
Meriweather later resigned after a scandal involving illegal bid-rigging in the
T-bill auctions, where traders conspired to  pay less for government bonds.

  (2)     Merrill Lynch shareholders elect Mr. Komansky as the chairman of the
Board.  He uses ML funds to help bail out Long Term Capital Management, in which
he has 800,000 dollars invested.  Is this moral hazard, or a good business move
by ML?  (WSJ, Tuesday Sept. 29, C1 `Hedge Fund Recently...`)

        Mr. Komansky also owns 100 million dollars of ML stock.    One reason to
have executive and board members own stock in their company is to reduce moral
hazard.  If he does things which cost ML money, that reduces the value of his
stock holdings.

 In this case,  it is not clear where his interest lies. Suppose ML has 10
billion dollars in assets,and  ML contributes to the bailout at a net cost of
50 million dollars. The loss to Mr. Komansky from that is 1/100 of that, which
is 500,000.  If LTCM would  have zero value without the bailout, then Komansky
comes out ahead by 300,000 as  a result of the deal.   But my numbers  are
hypothetical. It could possibly be that  ML would make money from the bailout,
if LTCM does recover.

(3) What is the externality from    LTCM's troubles? There needs to be an
externality to justify a government bailout-- that is, an unprofitable bailout.
(It could be that ML and the others are actually planning to make money buying
LTCM at distress sale prices, and if that is so, then clearly government help is
not needed.)

 The claim I've heard is that LTCM will have to sell i  bonds to pay for its
losses.  This will drive down the prices of bonds. I am puzzled by that.  The
world supply of  bonds will not have changed.  LTCM will stop buying and selling
certain types of  bonds, so maybe demand will change, but their demand was known
to be temporary anyway.  Even if LTCM did affect world bond markets, its actions
would raise some bond prices even tho it lowered others.  So I have doubts on
whether the claim makes sense.