Banking as Moral Hazard

January 1, 2009
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By Scott A. Shay

Jarmulowsky’s Bank filed for bankruptcy months before the Federal Reserve Banks (the Fed) opened their doors and two decades before either the Federal Deposit Insurance Corpora tion (FDIC) or the Securities and Ex change Commission (SEC) came into being. Since their inception, these regulators have issued myriad regulations and amassed great powers and resources. Even the trend toward mild deregulation, which began during the Clinton Administration, has not significantly changed the climate of strong federal regulators. Yet despite these regulators, the current financial mess is worse than the “Panic of 1907.”

The key to understanding the current crisis is a concept periodically mentioned, though quickly passed over and referred to as “moral hazard.” Pervasive, deep, and accepted financial immorality played a role greater in this crisis than ever before. A more accurate term for the behaviors leading to this crisis, then, would be “moral transgression.” Let’s examine the moral transgressions that caused the current situation and then look at them through the lens of Jewish tradition.

While I am oversimplifying for the sake of brevity, it is fair to say that the following chain of moral transgressions led to the current crisis. After the technology bubble burst and the economy was shaken by the events of 9/11, the Fed tried to prop up the economy by lowering its Fed Funds rate to one percent for much longer than was prudent; a popular Fed chairman who keeps rates low is more appealing than an unpopular one who worries about the long-term consequences of doing so (arguably just bad judgment but perhaps a moral transgression). Further, in this permissive environment, Congress protected FNMA (Fannie Mae) and FHLMC (Freddie Mac) because they were such potent political powers and donors (second moral transgression). This protection allowed FNMA and FHLMC to buy subprime and Alt-A mortgages several multiples beyond their capital base in order to have greater profitability and handsome bonuses (third moral transgression). Bond buyers did not care that the mortgage giants were buying risky mortgages because the debt they were buying was implicitly guaranteed by the government (fourth moral transgression). Meanwhile, the big banks found it difficult to compete in buying prime mortgages and therefore invested more heavily in riskier subprime and Alt-A loans (the risk was securitized away). These big banks paid less and less attention to whether or not the loans were credit worthy since their investments led to better bonuses for traders and ultimately senior management (fifth moral transgression). The rating agencies were persuaded to close their eyes by the tremendous fees generated by the investments (sixth moral transgression). As the public caught on, the bubble expanded even more. People with no experience in real estate suddenly started buying additional “primary residences” with FNMA/FHLMC or bank securitized mortgages with the hope of flipping these homes as quickly as possible (seventh moral transgression). If they could not qualify for a regular loan mortgage, brokers would arrange for consumers to take out no verification stated income/stated asset (SISA) loans — known as “liars’ loans” (eighth moral transgression). Appraisers offered higher values in order to keep their flow of business (ninth moral transgression). Mean while, mortgage brokers and others arranged mortgages that new homeowners would never be able to afford even as the bubble burst in 2007 (tenth moral transgression).

Unfortunately the victims of all of these moral transgressions include many innocent people. At any point along the line, a dose of financial morality might have stopped this slow-motion train wreck. Yet the sad fact is that neither our political leaders (in either party) nor anyone in the mortgage origination chain acted against or spoke out loud anything about these immoral practices.

We might draw on talmudic sources to better understand this sort of immoral behavior. For example <>Brakhot 32a cites the story of a pampered and inebriated young man led to temptation; the parable encourages us to recognize and assume responsibility when we are part of creating an environment that enables moral transgressions. And Brakhot 5b recounts the story of Rav Huna’s rationalization of underpaying a worker. The Talmud even recognizes that earning one’s living through business may lead to banditry if normal business dries up (Kiddushim 30b). Behind the famous talmudic dictum to teach children a trade lies a debate between the sages as to whether individuals should choose a more dependable, less risky profession.

Many of our prophetic teachings and our daily prayers also point out that detailed laws and regulations alone will not encourage moral action. Every day before we recite the Sh’ma, we ask that the Merciful One “put into our hearts to have insight and understanding.” We ask for love and fear of the Almighty and of the Torah so that we will act righteously when tested. Observance of specific commandments emerges from this core behavior of mensch lechkyte. Many of our blessings include the formulation kidshanu b’mitzvotav — we are holy in our actions. Lying on a loan application becomes a lot harder to do in the context of Jewish teaching; it becomes an unholy action.

Rahm Emanuel, President Barack Obama’s White House chief of staff, is known for pointing out that it is a shame to waste the opportunity of a crisis. So let us follow the Jewish way in responding to crises. Rambam, in Hilchot Ta’aniyot, writes that it is an obligation to call a fast when a calamity befalls a community. On such fast days, we are to look both toward heaven for help and within ourselves for moral failings. Given the moral causes of our present financial crisis, our rabbis should declare a public fast day in which we, as a community, look inward and join other faith communities in responding to this severe moral failure. Our future might be even more dire if we pass through this financial downturn without acknowledging its source in immorality at the political, corporate, and personal levels. No amount of regulation can prevent the circumvention of laws and rules if our hearts are not in the right place.

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Scott A. Shay is chairman of the board of Signature Bank and a partner of Selene Investments LLC (a mortgage investment fund). He is author of Getting Our Groove Back: How to Energize American Jewry (Second Edition, Devora, 2008). This essay is dedicated to the memory of his mother, Helene Razel Shay z”l.

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