Analysis of article: Decade of Moral Hazard Submitted By: Sandeep Kumar Singh Course: Business Ethics Instructor: Prof.

Kenneth Bigel Spring 2011

Bail 'em out! - Is it ethical?

Introduction In Economics and Finance, Moral hazard is defined as the risk that the presence of a contract will affect the behavior of one or more individuals. It is an important ethical issue in Business given the idea that individuals (typically investment managers) will tend to take more risk if they know that they are protected against the outcome. Russian default, followed by bailout of Long Term Capital Management (LTCM) raised key concerns on the Moral Hazard problem. There was a common problem that led to both disasters, that is, improper judgment of counter-party risk. The case discusses in the wake of Russian crisis and LTCM bailout as to what the moral hazard issue is and how it can lead to systematic failure. The issue of moral hazard is analyzed in the context of Teleological ethics framework.

Analysis of Key Issues The key issue revolves around the irrational, improper and irresponsible behavior of investment managers who kind of played bets using people's money. They never bothered about consequences, which is a violation of Teleological Ethics framework. According to utilitarianism, they should have enacted to preserve people's best interest and invested their money wisely, evaluated the counter-party risk thoroughly. But they didn't care. After all it wasn't their money, so why bother. It is extremely immoral behavior. They also were not worried about the consequences that may follow, because they knew the FED government would step in, bail them out and the managers would escape the sin without being penalized. According to consequentalist ethical view, in order to make correct moral choices, one should have some understanding of what might result from the

choice. Investing in an asset without recognizing the associated counter-party risk relates to immoral behavior of the fund managers.

Like a coin has two side, in the world of investment, there are always two parties- investor and investee. It would not be reasonable to put the entire blame on the fund managers. People investing in LTCM should also have thought about consequences of such high risk taken by the managers. Given the fact that LTCM yielded more than 40% returns for its investors historically, it would not be wise to turn down the fact that the investors did not know about the amount of leverage they were taking. There should have been some resistance for the public. But everyone seemed to be enjoying their fatty returns forgetting the eventuality.

Although the LTCM bail-out was based on private rather than tax payers money, the FED played a big role in it. FEDs active participation raised few eyebrows as the ethical behavior of the fund managers was questioned. There were arguments that government should step-in and preside over the moral hazard problem that had apparently been persistent over a decade. So even it was apparent that the government too violated Teleological framework by setting bad examples of bail outs. There wasn't any monitoring of investment activities and institutions like LTCM were allowed to become what is known as too big to fail. Such behavior on the part of government would help to grow moral hazard which would lead to a market that is so driven by bail-outs that vital signs about genuine risk would no longer exist, which eventually would lead to a systematic collapse.

Conclusion Bail-out or not to bail-out is a trivial decision. It should be carried-out with ought most caution. This is a step that should be taken only if the consequences are known, that is, it does not create moral hazard problem. If we run into a system where on one side you have people taking undue risks with borrowed money and not held accountable for it and on the other hand we have government always there backing up such behavior with so-called fancy tool as Bail-Out, more and more crisis will prevail in the years to come creating a systematic failure and financial melt down. Markets will freeze as counter-party risk becomes prevalent as no one would know if the other party involved in the financial transaction will be solvent, so no one trades. Hence bail-outs that vindicate Teleological Ethics framework should be avoided.