The Anglo Tapes - moral hazard can't be avoided unless individuals have to bear a real cost

The release this morning of tapes of two Anglo Irish Bank executives discussing the bank's travails in the days before the Irish government bank guarantee has justifiably raised heckles throughout the country. Extracts from the taped conversations are available here. Transcripts are available here.

Several issues are clearly evident in the tapes. The contempt and ridicule in which the banking regulator was held is quite palpable. It is perhaps obvious why the banks felt so confident in their strategies to resolve "liquidity" issues when they perceive the regulator to be such a figure of fun. It also raises the question as to why this perception of the regulator had developed. It goes some way to explaining why the banks were allowed to get into the mess they were in.

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The particular aspect of these tapes that causes the blood to boil is the attitude adopted by the executives, John Bowe and Peter Fitzgerald, to the state pumping Irish citizens' money into Anglo Irish Bank.  They laugh at the prospect of the €7billion sought by the bank from the state being repaid.

Bowe: “In Central yeah. And I mean to cut a long story short we sort of said look, what we need is €7 billion and we’re going to give you, what we’re going to give you is our loan collateral so we’re not giving you ECB, we’re actually giving you the loan clause.

“We gave him a term sheet and we put a pro note facility together and we said that’s what we need. And that kind of sobered up everybody pretty quickly, you know.”

Fitzgerald: “Yeah.”

Bowe: “And why do you need that and what’s happening...and Jesus oh...oh...you have certainly focused our minds. So I think, em...”

Fitzgerald: “And is that €7bn a term?”

Bowe: “This is €7bn bridging.”

Fitzgerald: “Yeah.”

Bowe: “So... so it is bridged until we can pay you back...which is never.” (Both laugh)

Fitzgerald: “Yeah, yeah, and that’s in the pro note, that’s in the terms and conditions?”

Bowe (still laughing): “That’s right. So under the terms that say repayment, we say: No...” (laughing)

Fitzgerald: “None...just none. Not applicable. Okay and what did he say? ‘I need a change of underwear’?”

It's clear that the executives saw little prospect of paying back the €7 billion 'bridging' loan. And what is particularly galling is that they both make it clear that €7 billion understates the likely total level of funding required.

Fitzgerald: “Ah we are, yeah, and em, what, who did you arrive at the seven?”

Bowe: “Just, as Drummer would say, picked it out of my arse, you know. Em...I mean, look, what we did was we basically said: what is the amount we can securitize over the next six months? And basically say to them: look, our problem is time; it’s not our ability to create the liquidity, the enemy is time here.”

Fitzgerald: “Yeah.”

Bowe: “So we can rebuild, in other words, we can rebuild the liquidity off our loan book, but what we can’t do is, we can’t do it now and the balance sheet’s leaking now.”

Fitzgerald: “Yeah, yeah unless the balance sheet stabilises, then you can buy some time.”

Bowe: “Yeah and that number is seven. But the reality is that actually we need more than that. But you know the strategy here is you pull them in, you get them to write a big cheque and they have to keep, they have to support their money, you know.”

Fitzgerald: “Yeah, yeah, yeah, yeah, yeah. They’ve got skin in the game and that’s the key.”

Bowe: “They have and they have invested a lot. If they saw, if they saw the enormity of it upfront they might decide, they might decide they have a choice.

“You know what I mean? They might say the cost to the tax payer is too high. But em...if it doesn’t look too big at the outset...if it looks big, big enough to be important but not too big that it kind of spoils everything...”

Fitzgerald: “Yeah, yeah.”

Bowe: “Then, then I think you have a chance. So I think it can creep up.”

Fitzgerald: “Yeah, yeah, yeah. They’ll give you a bit of drip.”

There has been a lot of discussion of moral hazard in the context of the bank bailouts and the writing down of mortgage debt for individual mortgage holders. A lot of the time the discussions are based on an incorrect understanding of moral hazard. Moral hazard arises from the presence of asymmetric information, where one side to a transaction uses their superior knowledge to benefit at the expense of another. In this case Anglo knows the extent to which it is in the red (or if it does not know the exact extent it knows it is more than €7 billion). The regulator has less information than Anglo so it cannot be sure that €7 billion is enough to fix Anglo's "liquidity" issue.

The rest is tragedy.

However, if the issue was asymmetric information and the regulator knows that it doesn't know how much is required then it must either make funding conditional on the provision of full analysis to arrive at the figure (to avoid it being "pulled out of someone's arse") or else including a clause in funding contracts that link individuals (eg chief executive or chairman) to the contract so that they are required to sign that the analysis is correct or face disqualification or a lien over salary if the request for funding is shown to be deceitful.