Face It: Moral Hazard Is Dead

02/26/2009 2:26 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

Over the past weeks, as the Obama administration has rolled out plans to spend hundreds of billions of dollars to bail out homeowners, banks, and the economy, the issue of "moral hazard" has emerged front and center.

Moral hazard, according to Economist.com, means that "people with insurance may take greater risks than they would without it because they know they are protected."

The issue has applied primarily to banks and Wall Street firms that made reckless bets with shareholders' money and are now getting taxpayer funds to stay afloat.

But recently a former pit trader vented on television that the proposed $275-billion mortgage rescue package would reward "losers" at the expense of people who made their payments every month.

The merits of that claim aside, the whole discussion prompted me to wonder whether that's even the most relevant question anymore.

Because the idea that you pay a price if you screw up has disappeared in many areas of our society. There is, simply, no "hazard" anymore for many people who fail or break the rules.

Let's start with the worst: Wall Street. For 20 years, the Street has been plagued by one scandal after another.

Remember Drexel Burnham Lambert's promotion of the junk bond market in the 1980s? The mastermind behind that, Michael Milken, did go to prison and was banned from the securities business for life. But many others who worked there went on to bigger things: money management, private equity, even the derivatives business at AIG, which has become a continuing albatross for taxpayers.

Then there was Salomon Brothers' attempt to manipulate the Treasury bond market and a subsequent cover-up that cost the job of chief executive officer John Gutfreund. Salomon was saved from extinction only after big shareholder Warren Buffett agreed to become chairman.

The 1990s brought the dot.com mania, under which analysts like Henry Blodget touted terrible Internet stocks to retail investors to grease the wheels of investment banking's fee machine. Also, major banks helped fraud factories like Enron and WorldCom raise money and had to pay out billions of dollars in legal settlements.

The reforms in the early part of this decade helped fix those problems, but Wall Street made even bigger bets, claimed even greater rewards, and created an even-bigger catastrophe, which may take a decade or more to resolve.

Not too many top corporate executives have been penalized for failure, either. Most notoriously, Bob Nardelli took home more than $200 million after being booted as chief executive officer of Home Depot (NYSE: HD), and Hank McKinnell got almost the same after running Pfizer's (NYSE: PFE) stock into the ground. Stanley O'Neal, who pushed Merrill Lynch into far more risk taking than it could handle, left with over $160 million. (And while we're on the subject of Merrill, how about those cronies of former CEO John Thain who walked away with tens of millions of dollars for several months of great work as the firm lost $27.6 billion last year?)

There are many, many more examples. Shareholders have gotten more vigilant of late, and that's a good thing, but the damage to moral hazard has been done.

This goes beyond business, too.

How about politics? Remember the Clinton Administration? Remember Whitewater, Monica Lewinsky, impeachment and perjury charges, allowing big donors to sleep in the Lincoln bedroom, and the notorious Marc Rich pardon?

And the Republicans are no slouches in this area, either: Jack Abramoff, Bob Ney, Mark Foley, Sen. Ted Stevens, and the billions of dollars awarded in no-bid contracts in Iraq and Afghanistan all show that no party has a monopoly on vice or virtue.

And despite many arrests, convictions, and resignations, politicians continue to push the envelope. Their main rule: don't get caught.

As for the sports world, I have two words for you: Alex Rodriguez. If you want a few more, how about Barry Bonds, Mark McGwire, Roger Clemens, or Jason Giambi? Their alleged or admitted links to steroids and other performance-enhancing drugs has tainted an entire era of baseball history.

"Everybody has lost the presumption of innocence," Tony Kornheiser said on ESPN last weekend. "At least give people some reason to believe cheating doesn't pay."

The National Football League has toughened its suspension policy since over 300 arrests of NFL players this decade. Yet players return after suspensions or even doing hard time. Adam "Pacman" Jones got another shot with the Dallas Cowboys after a one-year suspension. Even Michael Vick, who gets out of prison this year following convictions for running a dog-fighting ring, has gotten interest from two teams

Hey, if OJ could still run, somebody would try to sign him up, too.

The mantra, of course, goes back to Oakland Raiders owner Al Davis: "Just win, baby."

Or make money, as in the entertainment world. Who can count the number of stars who go to rehab as often as they go to the gym and get second, third, or fourth chances, like Britney Spears or Robert Downey, Jr.? Or rappers like Lil Wayne, 50 Cent, and R. Kelly, for whom courtroom appearances are as routine as signing autographs?

My point is, there's been a huge breakdown in ethics in all areas of American life, and short-term gain has become the be-all and end-all for far too many. Yes, there are tens of millions of us—probably the majority—who work hard, plan for the future, and teach our children to live good lives, but it's not easy amid the corruption that pervades our society.

So, how do we stop it?

Well, actually early this decade we had a wave of corporate crime ranging from Enron, WorldCom, and Tyco International to the options backdating scandal. A little-noticed group, the President's Corporate Fraud Task Force, secured more than 1,200 convictions, including that of 214 CEOs in the five years from 2002 to 2007. That and the much-maligned Sarbanes-Oxley Act helped clean up corporate America-outside of Wall Street, of course.

I expect that to change soon when the Federal Bureau of Investigation completes its criminal investigation of the mortgage mess, which reportedly covers senior executives at 26 major firms involved in issuing and selling subprime mortgages.

I hope individuals who submitted fraudulent information to help them obtain mortgages they couldn't afford get prosecuted, too.

But if we're really serious about restoring moral hazard, we'll have to start at the top.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own.

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