During an interview on 60 Minutes on Sunday, President Obama called bankers who were bailed out by the United States “fat cats” who “don’t get it” 1. Why ought we to be surprised that bankers would behave in a way to maximize their income, when risks are assumed by the government? Some predicted a bailout of certain banks through the Troubled Asset Relief Program (TARP) would fail to restore the financial system to health, primarily because it makes financial decisions political by vesting in the Executive branch discretionary authority to save favored institutions.2
The theory behind TARP was: by buying “toxic” assets—specialized securities that had no market, the descending prices of which destroyed bank value—banks would be restored to health and normal operations would resume. TARP did not purchase a single toxic asset. Instead, taxpayer funds were exchanged for shares or warrants (options on shares) in banks, credit card companies, including American Express and Discover, an insurance company, AIG, and two car companies, GM and Chrysler. Chrysler was owned by a private equity firm, Cerberus, in which former Vice President Dan Quayle is a partner. TARP funds were also given to auto parts suppliers and investment funds including the highly successful BlackRock.3 Taxpayer funds were thus dispatched to rescue any institution approved by the Treasury Department and wealthy private investors.
Central bankers and economists speak of the “moral hazard”, defined as “the inducement to engage in riskier behavior when safeguards such as insurance are in place.” 4 This is precisely the hazard in which we have fallen by not allowing inefficient banks and companies to fail and by preventing the market from reallocating their capital and labor.
We now learn that two beneficiaries of TARP funds, Goldman Sachs (GS) and AIG, were involved in an internecine relationship between 2004 and 2006 in which GS insured the toxic securities of other banks and reinsured those securities with AIG, thus lading it with heavy risk.5 When the market sank in 2007 and 2008, TARP funds saved GS’ losses on $22 billion of such trades. It ought to be evident that if such trades have a high profit potential, largely because of their obscurity and complexity, and no downside because the taxpayer insures against “too big to fail”, the moral hazard is elevated.
Not all the bankers believe in “too big to fail”. The head of JPMorgan, Jaime Dimon, writing in the Washington Post said, “Creating the structures to allow for the orderly failure of a large financial institution starts with giving regulators the authority to facilitate failures when they occur. Under such a system, a failed bank's shareholders should lose their value; unsecured creditors should be at risk and, if necessary, wiped out.” 6 This is putting risk where risk belongs, directly on the owners of the business, the shareholders, and not the public at large. We need reforms that would encourage the market, not the government, to allocate capital to businesses better able to manage risk and return for their shareholders, provided the requisite accounting transparency exposes irregular or exotic transactions.
At a recent forum sponsored by The Wall Street Journal, an advisor to President Obama, Paul Volcker, the former head of the Federal Reserve Board under Presidents Carter and Reagan, challenged his fellow bankers, “Wake up, gentlemen … your response is inadequate” 7 as he lambasted financial “innovation” that created the complex securities distorting the social and economic missions of banks to lend prudently. Volcker amusingly remarked, the best example of financial innovation is the ATM machine.
He also deplored the exorbitant personal rewards that have become incentives for hyperkinetic trading and financial engineering. While it is not wise for a pay czar, Congress, or regulators to determine or jawbone compensation, it is unfair to ask taxpayers to subsidize compensation for decisions that erode capitalism. The answer is straightforward: end the business tax deduction for bonuses, options, and other executive perks, and place a limit on how much salary can be subsidized by the taxpayer as a normal business expense. If the shareholders wish to pay their employees more than that salary, they have the liberty to do so from their company’s profits and it should not be the public’s business, nor come from other taxpayers’ pockets.
Is the Fed unwittingly contributing to the moral hazard? In a rush to institute stop-gap facilities after the Bear Stearns meltdown in 2008, the Fed established the Primary Dealer Credit Facility (PDCF). Primary dealers are a select group of 22 domestic and international banks who have the privilege of trading directly with the Fed and borrowing from PDCF to finance their portfolio of securities. The effect is to open another discount window (the Fed facility that lends directly to institutions) to only an exclusive set of banks: a nefarious misuse of public funds especially when funds are available at or near 0% interest.
Anna Schwartz, the venerable economist at the National Bureau for Economic Research, argued in 1992, “Discount window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources. Political decisions substitute for market decisions. Institutions that have failed the market test of viability should not be supported by the Fed’s money issues.” 8
She observed about the 2008 crisis, "They [the Fed and Treasury] should not be recapitalizing firms that should be shut down." 9 The risk of failure in the market, as all other businesses face, imposes prudence on financial decisions.
It is no wonder, then, that Congressman Ron Paul (R, TX) successfully amended the financial services overhaul bill to audit the Fed. Restoring sound monetary policy by the central bank is the first step toward restoring prudence to all banks.
 “White House Lashes Out at Bankers.” The Wall Street Journal, 12 Dec. 2009, http://online.wsj.com/article/SB126073152465089651.html?mod=WSJ_hpp_LEFTWhatsNewsCollection
 Avari, Michael. “The Treasury's Hedge Fund?” American Civility, 7 Oct. 2008 http://americancivility.us/american-civility/2008/10/7/the-treasurys-hedge-fund.html
 Bailout Recipients.” ProPublica, http://bailout.propublica.org/main/list/index
 “The Federal Reserve’s Primary Dealer Credit Facility.” Current Issues, The Federal Reserve Bank of New York, Volume 15, Number 4, August 2009 http://www.newyorkfed.org/research/current_issues/ci15-4.pdf
 “Goldman Fueled AIG Gambles.” The Wall Street Journal, 12 Dec. 2009, http://online.wsj.com/article/SB10001424052748704201404574590453176996032.html?mod=WSJ_hp_mostpop_read
 Dimon, Jamie. “No more ‘too big to fail'.” Washington Post, 13 Nov. 2009 http://www.washingtonpost.com/wp-dyn/content/article/2009/11/12/AR2009111209924.html
 “Paul Volcker: Think More Boldly.” The Wall Street Journal, 14 Dec. 2009, http://online.wsj.com/article/SB10001424052748704825504574586330960597134.html
 Schwartz, Anna J.: “The Misuse of the Fed’s Discount Window.” The Federal Reserve Bank of St. Louis, Sep./Oct. 1992 http://research.stlouisfed.org/publications/review/92/09/Misuse_Sep_Oct1992.pdf
 “Bernanke Is Fighting the Last War.” The Wall Street Journal, 18 Oct. 2008 http://online.wsj.com/article/SB122428279231046053.html