by Calculated Risk on 2/29/2008 01:41:00 PM

From St. Louis Fed President William Poole: Panel Discussion on Balancing Financial Stability, Price Stability and Macroeconomic Stability: How Important Is Moral Hazard?

We have known for many years that moral hazard is a potentially serious issue. If a firm believes that it will be bailed out if it gets into trouble, that expectation encourages excessive risk-taking and increases the probability of trouble. There are two complementary ways to deal with moral hazard. First, firms in trouble ought not to be bailed out, unless the bailout takes a form that imposes heavy costs on managers and shareholders. Second, firms subject to government regulation ought to be compelled to maintain adequate capital to reduce the probability of failure. U.S. banks entered the period of turmoil last year pretty well capitalized and have been able to withstand large losses.

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector. According to the S&P Case-Shiller home value data released earlier this week, as of December 2007 average prices had declined by 15 percent or more over the past 12 months in Phoenix, San Diego, Miami and Las Vegas. We can add Detroit to the danger list as the home price index for that city is down by almost 19 percent over the 24 months ending December 2007. With house prices falling significantly in a number of large markets, many prime mortgages issued a few years ago with a loan-to-value ratio of 80 percent may now have relatively little homeowner equity, which increases the probability of default and amount of loss in event of default.

As I emphasized some time ago, GSE losses will depend on the variance as well as the mean of changes in national home prices. Losses in markets with home prices falling more than the national average will not be offset by gains in markets with price changes above the national average. I do not have a new message here; we have known for a long time that advance preparation and a strong balance sheet are the keys to riding out a financial storm. As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.
emphasis added

Note that Poole is no longer a voting member of the FMOC. He concludes:

[A] financial firm cannot expect targeted aid for just the firms in trouble. An exception to this general statement is that, unfortunately, the GSEs probably can expect targeted aid. ... the GSEs ... might get assistance directly from Congress ...