Moral Hazard and the US Federal Reserve

As first reported by the WSJ, the US Federal Reserve has rescued AIG with an $85bn bridge loan, and has taken a 79.9% stake in the firm. This comes less than 24 hours after the US Treasury indicated that there would be no government bail-out of the firm. After a coordinated private-sector loan package failed to materialize, the Fed invoked its legal authority under Section 13(3) of the Federal Reserve Act, allowing it to lend to a firm in "unusual and exigent circumstances" if the borrower "is unable to secure adequate credit accommodations from other banking institutions."

AIG is a counterparty to insurance, corporate, and financial transactions around the world. It passes the "Bear Stearns test" (interconnection) for government intervention better than Bear itself. Plus, as Hank Greenberg (former Chairman/CEO of AIG and the man who literally built the firm from scratch) has argued, AIG's problem is one of liquidity, not solvency (like Lehman's). It is thus understandable, and appropriate, for the Fed to step in.

But this latest intervention has raised fresh problems for the global financial system. Moral hazard has increased substantially because the criteria for a government bail-out is undefined and poorly articulated in the current environment. No one envies Bernanke, Paulson, and Geithner, and there is no formula for this terrible mess. But government bail-outs have been entirely subjective, and future ones are now impossible to predict. Greater uncertainty is lethal to the markets in their current state, and may lead other fragile financial institutions (namely Morgan Stanley and Goldman Sachs) to assume a safety net. This is dangerous if it leads these firms to refuse asset sales or other prudent (and, most importantly, timely!) actions to raise capital and shore up confidence in their books. Both AIG and Lehman have faced the havoc that just 24 hours of inaction/delay can bring.

Many thought that the bankruptcy of Lehman was a sign that regulators were confronting moral hazard head on. But within hours, moral hazard came back with a bang. Luckily, there are only a few firms left that would qualify as truly "too interconnected to fail".
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UPDATE: Demonstrating how quickly things are changing, Reuters is reporting that Morgan Stanley is "weighing" a merger with a commercial bank. This would obviously negate much of the comment above, as it would appear banks are finally accepting the inevitable.

Prediction: by Christmas, there will be no major, independent US investment banks left. The broker-dealer model is dead.