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The Decade of Moral Hazard is Over

If you feel like you’re trying to muddle through absorbing and understanding what happened on Wall Street, and why we are in the mess we’re in, this short video from the Financial Times might help clear things up.

Investment editor John Authers traces many of today’s problems back to the rescue of Long Term Capital Management in 1998 — the weekend when the New York Federal Reserve and the titans of Wall Street got together to save the troubled hedge fund. From that plan came the start of cheaper money from the Fed to keep the markets moving, a trend that continued for a decade.

But the rescue also created the moral hazard problem – the belief that it was fine to take on greater risks than normal, because the government would be there to step in as a last resort.

As Authers explains, shares of the now-failed Lehman Bros. bank rose steadily from 1998, until its recent crisis. Lehman wasn’t alone, as Wall Street engaged in riskier investments, with higher returns. There always was the implicit belief — based on the Long Term Capital Management experience — that a bailout would be a possibility if things went wrong. That belief encouraged firms to take on risks they might otherwise have avoided.

Now, he says, with the government refusing to bail out Lehman, the markets are tanking and the future of other firms is shaky. No one knows what will happen.

But one thing is clear, Authers says, based on the Lehman bankruptcy and the government’s decision to draw a line in the sand — “The decade of moral hazard is over.”

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