Photo by flickr user <a href="http://www.flickr.com/photos/pfala/2402698820/">pfala</a> used under a <a href="http://www.creativecommons.org">Creative Commons</a> license.
Government-backed guarantees of financial assets carry “enormous risks” and created perverse incentives for businesses, but taxpayers will probably turn a profit from them, according to a report [PDF] released Friday by Elizabeth Warren‘s Congressional Oversight Panel (COP), which is charged with monitoring the bank bailouts. “At its high point, the federal government was guaranteeing or insuring $4.3 trillion in face value of financial assets” in the guarantee programs of the Federal Reserve, the FDIC, and the Treasury, according to a COP press release. That number means that guarantees were the “single largest element of the government’s response to the financial crisis.”
By standing behind high-risk assets held by “potentially insolvent institutions,” the panel said, the government was taking a huge risk. And the guarantees unquestionably distorted market behavior:
These guarantee programs also created significant moral hazard. Guarantees create price distortions and can lead market participants to engage in riskier behavior than they otherwise would. In addition to the explicit guarantees analyzed in the Panel’s report, the government’s broader economic stabilization effort may have signaled an implicit guarantee to the marketplace: the American taxpayer stands ready to provide a financial backstop for certain markets and large market players to avert possible economic collapse. To the degree that investors, lenders and borrowers believe that such an implicit guarantee remains in effect, moral hazard will continue to distort the market.
You can see this problem most clearly in the return of highly leveraged risk-taking and massive bonuses to Wall Street just months after the entire global economy nearly collapsed. Kevin Drum will have more on this in the next issue of the print magazine.
