Moral hazard, meet adverse selection
At a time when anyone on the cutting edge is talking quadrillions, it seems a bit petty to worry about a $50 billion component of the latest bailout (only $500 per US household!). Modest as it is, the insurance scheme offered to money market funds by the US Treasury provides the opportunity to explain a little bit more about the theory of insurance.
By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.
For example, if you have a money market fund with assets now worth 97 cents in the dollar, and someone offers you the chance to insure against ‘breaking the buck’ you’re going to take it, since it’s a sure thing that you can collect. (It doesn’t matter much what the premium is, since your loss will increase by an amount equal to the premium paid). As far as I can tell, that’s exactly what’s on offer from the US Treasury right now. (I’d be pretty annoyed if, like Legg Mason, I’d just tipped in $630 million of company money to protect customers against this eventuality, but I guess they can probably claw it back, and take the Treasury deal instead).
By contrast, if I have kept my customers’ money in safe assets like government bonds,it would be silly to take out insurance against a risk to which I’m not exposed. That means that the premiums have to be high, which in turn means that even moderately risky firms will find the deal unattractive, unless the public subsidy keeps increasing.
The current holdings of money market funds are around $3.4 trillion. Let’s suppose half of them are in some kind of trouble, amounting to an average loss of 3 cents in the dollar (the same as the Putnam fund that just put up the shutters). If all these funds sign up for the scheme, while the other half stay out, the losses will almost exactly wipe out the Treasury’s stake.
An interesting sidelight is that this scheme is being funded by cashing in the assets of the Exchange Stabilization Fund, established in the 1930s to intervene in foreign exchange markets. I guess they’ll never need any of those Depression era relics again.